Tuesday, April 20, 2010

White House's Keynesianism + Easy Fed = Inflation

I chanced upon the recent speech by Christina Romer of the Council of Economic Advisers’ entitled Back to a Better Normal. It sounds to me that she is advocating a standard Keynesian fiscal response to the Great Recession. The first clue came when she stated that the problem was one of aggregate demand and the problem was cyclical:

Deficient Aggregate Demand Is Key. The high unemployment that the United States is experiencing reflects a severe shortfall of aggregate demand. Despite three quarters of growth, real GDP is approximately 6 percent below its trend path. Unemployment is high fundamentally because the economy is producing dramatically below its capacity. That is, far from being "the new normal," it is “the old cyclical."

She continued by stating that “rise in long-term unemployment is readily explained by the prolonged collapse of aggregate demand.” That is to say that the problem is not structural, but cyclical:

In short, in my view the overwhelming weight of the evidence is that the current very high -- and very disturbing -- levels of overall and long-term unemployment are not a separate, structural problem, but largely a cyclical one. It reflects the fact that we are still feeling the effects of the collapse of demand caused by the crisis. Indeed, at one point I had tentatively titled my talk "It’s Aggregate Demand, Stupid"; but my chief of staff suggested that I find something a tad more dignified.
If the problem is aggregate demand, then standard Keynesian solutions are called for. Romer appears to have gone all out for Keynesian economic solutions. She sounds even quite sanguine about the problem of the fiscal deficit:

The sensible way to address the deficit is with a long-run plan. It would be penny-wise but pound-foolish to try to deal with our long-run problem by tightening fiscal policy immediately or foregoing additional emergency spending to reduce unemployment. Immediate fiscal contraction would inevitably nip the nascent economic recovery in the bud -- just as fiscal and monetary contraction in 1936 and 1937 led to a second severe recession before the recovery from the Great Depression was complete. And nothing would be more damaging to our fiscal future than a protracted recession and permanently higher unemployment. But, a credible, comprehensive plan for deficit reduction would create a favorable climate for investment and ensure that the economy remains strong.

The Obama White House appears to have embraced the solutions advocated by Richard Koo, Chief Economist of Nomura Research Institute, whose prescriptions are to spend until it hurts and then spend some more. That's Keynesianism squared.

With the Federal Reserve leaning accommodative, this policy choice is very risky and could spark off an inflationary cycle that runs out of control. The BIS recently issued a report that concluded that all roads lead to inflation. My Inflation-Deflation Timer model has already moved to an inflation reading.

Investors should be prepared accordingly.

Full disclosure: I receive a small commission if you buy Richard Koo's book from Amazon.com

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