Saturday, November 29, 2008

What kind of Aggregate Demand?

Most of the commentary I have read so far seems to support a Keynesian 'go big or go home' fiscal stimulus to prevent the recession from getting worst. I have read suggestions ranging anywhere from $US 300 billion to one trillion needed to push that Aggregate Demand (AD) curve enough to the right to escape a liquidity trap. The only problem with that prescription is that well...nobody really knows if it will work.

Now don't get me wrong, I am an admirer of Keynes and I believe he is (arguably) the brightest economic mind of the past century. The only problem is that Keynes's prescriptions came at a time when the most powerful country in the world (the U.S.) basked in a current account surplus making it the world's #1 creditor. Americans produced, produced and produced some more, and consumed less than...well...they produced. The Great Depression hit, the Second World War came and the U.S. well, produced even more!

Things are much different this time around. Number one, the U.S.'s manufacturing and industrial capacity has greatly diminished relative to the world. The ability for the U.S. to pull itself from the bootstraps by producing its way out of the crisis is simply no longer there - manufacturing and production has gradually shifted overseas. The only thing that has maintained U.S. GDP going strong in recent years is the consumption power of its population - made possible by the abundance of cheap credit to a degree never before seen in history.

Which brings me back to my original worry. So we push that AD curve by providing a massive fiscal stimulus. Then what? The only part of GDP growth that can sustain the economy operating at its pre-crisis equilibrium guessed it, consumption spending! The credit freeze might thaw, banks might start lending again, businesses and consumers might start borrowing and consuming again, but the question remains; if the problem began because of excessive borrowing and spending, what would we have solved?

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