How to combat recession stimulus without debt

Fortunately, a huge boost in demand can be achieved by a large fiscal stimulus— a temporary large increase in tax rebates for households, federal grants to state and local governments, t

HOW TO COMBAT

RECESSION

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1 Introduction | 1

2 How Would a Benevolent Ruler Combat a Recession? | 7

3 What Is Stimulus without Debt? | 17

4 Do Tax Rebates Work in a Recession? | 58

5 What about Other Kinds of Fiscal Stimulus? | 97

6 Would Stimulus without Debt Be Inflationary? | 127

7 Would Stimulus without Debt Weaken the Fed’s Balance Sheet? | 137

8 Would Stimulus without Debt Undermine the Fed’s

HOW TO COMBAT

RECESSION

Introduction

Are we ready to combat the next severe recession? We can be, but we’re not A severe recession always involves a plunge in ag-gregate demand for goods and services that compels producers

to sharply cut back production and employment To recover from the recession, aggregate demand must be boosted all the way back up to normal Economic analysis and experience shows that waiting for the free market to reverse the plunge in aggre-gate demand takes much too long— usually half a decade to a full decade Monetary stimulus— cutting interest rates to zero— is much too weak to induce a huge boost in demand because ex-perience shows that sensible consumers and business managers aren’t willing to go deeper in debt by borrowing to spend in a severe recession Fortunately, a huge boost in demand can be achieved by a large fiscal stimulus— a temporary large increase

in tax rebates for households, federal grants to state and local governments, tax credits to partly reimburse firms for purchases

of capital goods, and government spending on infrastructure maintenance projects

2 H O W T O C O M B A T R E C E S S I O N

So why do I say we aren’t ready? Because a large fiscal ulus has always in the past required large borrowing by the Treasury and therefore a large increase in government debt Experience shows that any policy that requires a large increase

stim-in government debt is strongly opposed by many policymakers and citizens This is especially true in a severe recession, because the recession itself causes a plunge in tax revenue that forces the Treasury into huge borrowing to avoid large cuts in government spending, thereby sharply increasing government debt, which alarms policymakers and citizens It is hardly surprising, then, that in a severe recession a proposal for a large fiscal stimulus that requires even more borrowing would be met with intense opposition That, of course, is exactly what happened during the Great Recession in the United States, when the fiscal stimulus proposed in early 2009 met stiff resistance Yes, despite oppo-sition, a two- year fiscal stimulus was enacted in early 2009 and was large by historical standards But simple calculations at the time showed that the fiscal stimulus needed to be at least twice

as large in 2009 and 2010 to overcome this severe recession, and later calculations showed that it needed to be three times

as large Yet even most advocates of fiscal stimulus didn’t dare propose a larger fiscal stimulus because even they worried about making the increase in government debt even larger Despite the continuing weak recovery, after 2010 fiscal stimulus was made much smaller, not larger, because of worry about government debt So it took until 2016 for the unemployment rate to return

to normal

The lesson, therefore, is sobering:  As long as a large fiscal stimulus requires a large increase in government debt, Congress won’t make it large enough to successfully combat a severe reces-sion The one policy— large fiscal stimulus— that has the capacity

to overcome a severe recession won’t be used to its full potential strength So we are indeed not ready to combat the next severe

recession as long as it assumed that fiscal stimulus must increase government debt.

The stimulus- without- debt proposal, however, is not simply a tactic for getting a large fiscal stimulus enacted in a severe reces-sion It is certainly better for stimulus to be implemented without

a large increase in government debt Large government debt— that is, government debt that is a large percentage of GDP— may generate negative economic consequences and risks in the fu-ture If government debt becomes a high percentage of GDP, the government may incur a heavy interest burden if interest rates rise, forcing cuts in worthwhile government programs or tax increases Moreover, as I will explain later, there is a possibility of

an anxious reaction by financial investors around the world to US government debt that is high and rising as a percentage of GDP, which may lead to a US recession or a financial crisis Thus, I have two reasons for proposing stimulus without debt The first is po-litical: a large fiscal stimulus is unlikely to be enacted by Congress

if it causes a large increase in government debt as a percentage

of GDP The second is economic: government debt that is large and rising as a percentage of GDP may have negative economic consequences and risks

Fortunately, the assumption that fiscal stimulus requires an increase in government debt is false In fact, it is astonishingly easy to implement even a very large fiscal stimulus without any increase in government debt All it takes is this: When Congress enacts fiscal stimulus, the Federal Reserve can decide to make

a transfer (not loan) to the Treasury roughly equal to the fiscal stimulus so the Treasury doesn’t have to borrow That’s it Moreover, the large stimulus would be phased out as the economy approaches full employment, so it would not be inflationary.But isn’t the paper money injected by the Fed also government debt? The answer is no Paper money is not counted in official government debt Nor should it be Government paper money

as it should, that the main component of the fiscal stimulus package will be tax rebates to each household Suppose that the

US Treasury mails out two rebate checks to each household— one in June, one in December— each check for $6,000 Is there anyone who seriously believes that households, in a severe re-cession when most employees haven’t received a raise and some have been laid off, would save the $12,000? In a recession, doesn’t it seem more likely that hard- pressed households would spend a substantial portion within six months? The best empir-ical studies support common sense:  in a recession households

do indeed spend about two thirds of their tax rebates within six months

Similarly, does anyone seriously think that in a severe sion, when state and local tax revenues plunge, that cash grants from the federal government would be saved instead of used to maintain normal state and local government expenditures? If you managed these governments during a recession, would you really save the grants, and then do lots of borrowing or slashing

reces-of expenditures? Most empirical studies reces-of state and local ernment behavior in a recession support common sense: federal grants are mainly used to keep state and local governments from

gov-cutting spending or raising taxes, so federal grants prevent a fall

in spending by state and local governments and a fall in spending

by consumers who would not spend as much if their state and local taxes were raised So the grants prevent a fall in aggregate demand for goods and services

In this book I explain how a temporary large fiscal stimulus can be implemented without any increase in government debt or inflation I also present analysis and evidence that fiscal stimulus works in a recession— it increases aggregate demand for goods and services, which in turn leads to an increase in production and employment

Stimulus without debt isn’t the only thing that must be done when a severe recession hits The Fed, Treasury, and FDIC must perform financial rescues of key firms and inject funds into fi-nancial firms to keep credit from freezing up These essential interventions are not addressed in this book Some analysts be-lieve that these interventions are all that’s needed in a severe recession I strongly disagree A severe recession always involves

a plunge in aggregate demand for goods and services, and once that plunge occurs, it will not be reversed simply by rescuing key firms and restoring the flow of credit

Several things are needed to make us truly ready for the next severe recession First, a lot of economists, policymakers, members of Congress, financial market participants, and others must learn that it is possible to implement a large fiscal stimulus without any increase in government debt Second, they have to

be persuaded that fiscal stimulus— particularly, a tax rebate to every household— works Third, they have to be convinced that

a large transfer from the Federal Reserve to the Treasury during recession won’t be inflationary Fourth, Congress must enact an amendment to the Federal Reserve Act empowering the Federal Reserve’s Open Market Committee to decide whether to make a

6 H O W T O C O M B A T R E C E S S I O N

large transfer (not a loan) to the Treasury to finance a fiscal ulus enacted by Congress If these things happen, we will be truly ready to combat the next severe recession

stim-The purpose of this book is to help make all these things happen

of a practical policy But before I turn to stimulus without debt for our actual institutions, I want to set the stage by considering how a benevolent ruler with complete power, who takes the place

of the Federal Reserve, Congress, and the Treasury, could combat

a recession without increasing government debt The policy that

is implemented by a benevolent ruler will serve as useful guide for a stimulus without debt policy that is implemented by the Federal Reserve, Congress, and the Treasury

Government Money Held by the Public

Is Not Government Debt

Before I turn to the benevolent ruler, I need to make a mental point:  government paper money held by the public is

funda-8 H O W T O C O M B A T R E C E S S I O N

not government debt When government paper money was

introduced during the past three centuries, it was usually “backed”

by gold (or silver)— that is, if any holder of paper money wanted the government to exchange it for gold, the government prom-ised to make the exchange Thus, the government owed gold to any holder of paper money, and the government had to be ready

to provide gold to any holder of paper money who requested it Because of this promise, government paper money held by the public was viewed as government debt and included in the lia-bility column of the government’s balance sheet This promise to pay gold was probably necessary to win the acceptance of govern-ment paper money by the public

But in the last century, the public in most economically vanced countries gradually gained confidence in government paper money The governments of these countries gradually withdrew their promise to provide gold to any holder of paper money who requested it Despite the withdrawal of this promise, most of the public continued to be willing to hold paper money and use it in transactions One reason for this public willing-ness was that the government guaranteed that the public could use its paper money to pay taxes; another was that the govern-ment stated that its paper money could be used by the public to pay off private debts But it is possible that even without these guarantees by the government, the public would have been willing to hold and use government paper money because of con-fidence gained over decades of use for transactions

ad-Thus, it is now the case that in most economically advanced countries, the government does not owe anything to holders

of its paper money Paper money held by the public is fore no longer government debt By contrast, each government bond held by the public is government debt because the gov-ernment promises to pay its paper money to holders of bonds according to the schedule of interest and principal on the bonds;

there-the government there-therefore owes paper money to there-the holders of government bonds.

Nevertheless, current central- bank accounting has ignored the fundamental change that occurred when the government withdrew its promise to pay gold (or silver) to any holder of its paper money Paper money held by the public continues to be listed in the liability column of the central bank’s balance sheet Moreover, when the accountants produce the consolidated balance sheet of the government and the central bank, paper money held by the public continues to be included in the liability column of the consolidated balance sheet This inclusion causes the liabilities of the central bank, and of the consolidated gov-ernment, to be greatly overstated

By contrast, official government debt correctly includes ernment bonds held by the public and correctly excludes paper money held by the public The official government debt correctly focuses attention on the government’s obligation to pay money

gov-to bondholders and ignores paper money held by the public cause the government has no obligation to pay anything to the holders of paper money

be-Some economists, however, not just central- bank accountants, continue to call government paper money held by the public

“government debt,” usually without giving any justification for using the term “debt.” Why do they do this? One reason may be inertia: government paper money was indeed government debt when the government promised to pay gold to anyone holding the paper money who wanted gold Another reason may be an in-tuition that there can’t be a “free lunch.” It seems like a free lunch when the government writes checks to members of the public and prints enough paper money to pay check recipients who re-quest paper money Surely it must be true, some think, that the government is incurring a debt when it prints pieces of paper to give to the public; it can’t really be that easy for the government

10 H O W T O C O M B A T R E C E S S I O N

to create an asset, paper money, without also creating a debt But

in a paper money system, it really is that easy

Although paper money held by the public is not government debt, injecting too much paper money into an economy that is already at full employment of resources will make aggregate de-mand for goods and services exceed potential output and there-fore generate rising prices— inflation Injection of money into the economy should not cause concern about government debt,

but should cause concern about inflation if the economy is

al-ready at full employment The policy I will call “stimulus without debt” prescribes injecting money only in a recession when em-ployment is below its potential, so that, as I’ll explain later, an increase in demand for goods and services will cause an increase

in output, not an increase in prices

Stimulus without debt in the Benevolent

Ruler’s Economy

In the benevolent ruler’s economy, money consists of official paper notes, and all transactions in this economy occur in official government paper notes These paper notes were once backed by gold, but are no longer backed by gold or anything else, so they are not government debt Assume the benevolent ruler’s economy is initially at full employment Now suppose a recession occurs be-cause of a fall in aggregate demand for goods and services There are several possible causes of a fall in aggregate demand Consider

a fall caused by a dramatic and sustained plunge in the stock market In response, anxious consumers with less stock market wealth cut their spending, so consumer demand for goods and services falls Producers of these goods and services respond by cutting production and employment Managers in firms making consumer goods or providing consumer services react by cutting

their demand for equipment to produce more consumer goods

or services, so producers of equipment— investment goods— cut production and employment Thus, in response to the fall in consumption and investment demand, most firms cut back pro-duction and employment, so the economy falls into recession

To combat a recession caused by a fall in aggregate demand for goods and services, a policy must be implemented that will in-crease aggregate demand

To increase aggregate demand for goods and services, the ruler deposits a specific amount of paper notes in the bank account of each household The deposit is a transfer from the government to the household, not a loan that the household must repay The ruler calls the transfer to each household a “tax rebate” because it gives back some of the tax that the household paid in the previous year

The tax rebates are called “fiscal stimulus” because they are a government expenditure (“fiscal”) that increases (“stimulates”) consumer demand for goods and services Households spend a portion of their tax rebates and save the rest, and the portion they spend causes producers of consumer goods and services to increase their production and employment As managers in firms making consumer goods or services observe the revival of con-sumer demand, they spend more to increase their equipment, so producers of these investment goods raise their production and employment

But how does the benevolent ruler obtain the paper notes needed to give tax rebates to households? Assume that at the beginning of the year the ruler has no notes on hand The ruler’s adviser points out that when other governments have faced a similar situation, some of these governments have borrowed from the public by selling government bonds to the public to ob-tain the paper notes But the ruler replies that there is no need to sell bonds and thereby incur government debt Instead, the ruler

12 H O W T O C O M B A T R E C E S S I O N

simply orders the printing of the amount of paper notes required

to give the tax rebates As explained in the previous section, paper money issued by the government and held by the public is not government debt Thus, to combat the recession, the benev-olent ruler implements “stimulus without debt.” The ruler keeps paying out tax rebates with new paper money until the economy approaches full- employment output As this happens, consumer and business confidence gradually rises, enabling the ruler to gradually phase out the tax rebates

The ruler’s adviser concedes that the ruler’s policy ulus without debt) has worked, but points out that when other governments have faced a similar situation, some have printed money and used the money not for tax rebates but to buy gov-ernment bonds from the public in “the open market.” These are bonds the public previously bought from the government but which some members of the public now want to sell These governments have called this bond buying “open- market opera-tions” and asked their central bank to carry it out

(stim-The ruler replies that using new money to buy government bonds in the “open market” is a much less efficient to way to in-crease aggregate demand for goods and services than using new money to give tax rebates to households The reason, says the ruler, is that in a recession households will very likely spend a larger share of the tax rebates they receive than bond sellers would spend Why? When a household receives a tax rebate, the household knows it can spend some of it, save some of it, and use some of it to pay down debt; the household instinctively realizes that the tax rebate has increased its wealth, enabling it

to do more of all three By contrast, when someone sells a ernment bond, the seller instinctively realizes that his wealth hasn’t changed: the seller knows he now has more cash, but he also knows he no longer has the government bond Why did he sell the government bond? Although his wealth is the same, he

gov-may have wanted to replenish his declining checking or savings account, or buy a corporate bond, or a corporate stock, or pay taxes, or pay down debt, or buy goods or services, and he was willing to give up the bond to do it The typical bond seller has much higher wealth and income than the typical tax- rebate re-cipient It seems likely that money used to send tax rebates to households will increase aggregate demand for goods and serv-ices much more than if that same money were used to buy gov-ernment bonds from bondholders willing to sell some bonds.After full- employment output is achieved by the stimulus- without- debt policy, confidence has returned to normal, and the tax rebates to households have been phased out, there will be more money in the economy than before due to the tax rebates

If the ruler thinks this extra money might cause too much spending and therefore inflation, the ruler can remove it from the economy by temporarily cutting government spending so it

is less than tax revenue, or by temporarily raising tax revenue so

it is greater than government spending Either action results in more money coming into the government than the government spends The government can remove this surplus money from the economy until money in the economy is back to normal Then government spending can be set equal to tax revenue

Whose Writing Guided the Benevolent Ruler?

When the benevolent ruler was asked whose writing was most influential, the ruler replied that the greatest influence came from two economists: John Maynard Keynes and Abba Lerner The ruler said Keynes (1936) taught the crucial importance of aggregate demand for goods and services: if aggregate demand falls, it causes the economy to go into recession, so demand must be raised Keynes warned that in a recession monetary

14 H O W T O C O M B A T R E C E S S I O N

stimulus— lowering interest rates— would prove too weak to raise demand up to normal He therefore recommended that the government increase its spending

The ruler said that Lerner specifically recommended printing money to pay for fiscal stimulus (an increase in government transfers to households, an increase in government purchases of goods and services, and/ or a decrease in taxes on households) to combat a recession Lerner said that government should practice

“functional finance,” not “sound finance,” and explained why in his “functional finance” chapter in each of his two books (Lerner

1944, 1951) The title of his 1944 book is The Economics of Control, and the title of his 1951 book is The Economics of Employment

The ruler also cited chapter  1 of his 1951 book, entitled “The Economic Steering Wheel,” as particularly clever and insightful Lerner wrote that if the unemployment rate is above normal, the government should decrease taxes so households spend more,

or increase its own spending and pay for the excess of spending over taxes by printing money instead of borrowing But won’t printing money be inflationary? Lerner said it would indeed be inflationary if it were done when there is already full employ-ment Why? Because with full employment each firm can attract employed workers away from other firms only by raising wages, which increases costs and compels firms to raise prices But if

it were done when unemployment is high, firms would be able

to attract unemployed workers without raising wages, so there would be no cost increases, and no need for firms to raise prices

Lessons for Combating Recession

with Actual Institutions

It should be possible to implement stimulus without debt under our actual institutions because the benevolent ruler was able to

do it Congress and the president should control government spending, taxes, and fiscal stimulus, with the Treasury as their administrative agent The Federal Reserve should control the printing of money and its injection into or withdrawal from the economy With this institutional separation of powers, how would stimulus without debt be implemented in a recession?The Federal Reserve would decide whether to give a transfer (not loan) to the Treasury to be used for fiscal stimulus, and if

so, how much The Fed would make its decision by estimating the depth of the recession and the magnitude of the fiscal stim-ulus needed to combat it If all transactions were conducted using Federal Reserve notes (not by writing checks or crediting bank accounts), the Fed would print new Federal Reserve notes

in the amount it wanted to transfer to the Treasury In practice, the Fed would either write a check to the Treasury or credit the Treasury’s checking account at the Fed, and print the amount

of new Fed notes needed to meet requests for Fed notes from banks and the public The Fed would continue to use its standard instruments of monetary policy such as sales or purchases of government bonds in the open market, and decide how to ad-just these sales and purchases in light of the Fed’s transfer to the Treasury for fiscal stimulus

Congress and the president would decide how much fiscal stimulus to enact in light of the magnitude of the transfer the Fed was willing to give to the Treasury for fiscal stimulus They could enact a larger fiscal stimulus than the Fed’s transfer to the Treasury, but the Treasury would have to borrow the difference

If they enacted a smaller fiscal stimulus than the Fed’s transfer

to the Treasury for fiscal stimulus, some of the Fed’s transfer would go unused and be returned to the Fed Congress and the president would decide the composition as well as the size of the fiscal stimulus As I will explain shortly, I recommend that a large portion of the fiscal stimulus be tax rebates to households

16 H O W T O C O M B A T R E C E S S I O N

Conclusion

The most important point is this: fiscal stimulus does not require

an increase in government debt To get high unemployment down

to normal, the government should implement fiscal crease its spending (mainly tax rebates to households, but also some purchases of goods and services and other expenditures) and/ or cut taxes When the government does this, it doesn’t need to borrow It can get the money it needs from its printing press As long as it does this only when unemployment is high, it will not be inflationary Thus, when unemployment is high, fiscal stimulus can be implemented without debt and without causing inflation

What Is Stimulus without Debt?

“Stimulus without debt” is a policy that would increase aggregate demand for goods and services in a recession without increasing government debt Stimulus without debt consists of a transfer (not loan) from the central bank to the nation’s treasury so that the treasury does not have to borrow to finance fiscal stimulus enacted by the legislature In most of this book I illustrate stim-ulus without debt with reference to the United States, but stim-ulus without debt can be implemented in other countries and in the eurozone

The Strategy behind Stimulus without Debt

Most recessions, including the US Great Recession of 2008, involve a fall in demand for goods and services When the US housing bubble burst in 2007, followed by the plunge in the stock market and the failure of firms like Lehman Brothers in 2008, consumer wealth and confidence fell sharply Anxious consumers cut back their spending, so consumer demand for goods and

18 H O W T O C O M B A T R E C E S S I O N

services fell Producers of consumer goods and services had no choice but to cut back production and lay off workers Business firms reacted to this fall in consumer demand by cutting their demand for investment goods— why expand plant and equip-ment to produce more when consumers won’t buy more? In re-sponse to the fall in consumption and investment demand, firms cut back production and employment To combat a severe reces-sion involving a sharp fall in aggregate demand for goods and services, fiscal stimulus (an increase in government transfers

to households, an increase in government purchases or goods and services, and/ or a decrease in taxes on households) must be enacted to increase aggregate demand for goods and services be-cause monetary stimulus— lowering interest rates— alone is too weak to combat a severe recession (Seidman 2001, 2003, 2011, 2012a, 2012b)

Under stimulus without debt, Congress would enact a fiscal stimulus package that consists mainly of cash transfers (tax rebates) to households but also other temporary expenditures and temporary tax cuts; the fiscal stimulus would raise aggre-gate demand The Federal Reserve would use new money to give

a large transfer (not loan) to the Treasury equal to the fiscal ulus package so that the Treasury would not have to borrow to pay for the package Hence, there would be no increase in gov-ernment debt (Seidman 2013) The Fed’s transfer to the Treasury injects an amount of money into the economy that is equal to the Fed’s transfer By contrast, fiscal stimulus alone would require the Treasury to borrow an amount equal to the fiscal stimulus by selling new government bonds, thereby significantly increasing government debt

stim-Stimulus without debt differs crucially from a standard fiscal- monetary stimulus Under a standard fiscal- monetary stimulus, the Treasury borrows to pay for the fiscal stimulus by selling new government bonds to the public, and the Federal Reserve

enters the “open market” and buys an equal amount of ment bonds from the public Government debt increases by the amount of the fiscal stimulus, and the Fed increases its holding

govern-of Treasury bonds by the same amount A crucial point is that the Fed’s action does not prevent the increase in Treasury debt outstanding: official Treasury debt increases by an amount equal

to the fiscal stimulus Money injected into the economy is the same under stimulus without debt and standard fiscal- monetary stimulus, but government debt is greater under standard fiscal- monetary stimulus

Official government debt includes all Treasury bonds standing whether held by the public or by the Fed But should it include Treasury bonds held by the Fed? My answer is yes It is true that the Fed returns to the Treasury most of the interest it receives from the Treasury But at any moment, the Fed can de-cide to sell Treasury bonds to the public, and the public will expect principal and interest to be paid on schedule Thus, the Treasury must be ready to pay principal and interest on schedule on all Treasury bonds outstanding, including bonds held by the Fed Congress, the Treasury, and the citizenry are therefore correct to focus on the official government debt figure that includes bonds held by the Fed; and they would be correct to oppose excluding bonds held by the Fed from official government debt Thus, the difference between stimulus without debt and standard fiscal- monetary stimulus is genuine both in theory and in practice.Government paper money held by the public is not govern-ment debt Government paper money was government debt a century ago when the government promised gold to any holder

out-of government paper money who requested it But when the government removed its promise to provide gold or anything else to the holders of government paper moneypaper money ceased to be government debt because the government owes nothing to holders of its paper money By contrast, government

20 H O W T O C O M B A T R E C E S S I O N

bonds are government debt because the government promises

to pay government paper money— principal plus interest— on schedule to all holders of government bonds; the government owes government paper money to holders of government bonds Fiscal stimulus without debt, therefore, means fiscal stimulus without an increase in government bonds

I have two important reasons for proposing fiscal ulus without debt instead of the standard fiscal stimulus with debt The first reason is political and the second reason is eco-nomic My political reason comes from facing the fact that many policymakers, financial investors, citizens, and economists be-lieve that large government debt will generate negative economic consequences and risks in the future, so they oppose enactment

stim-of a large fiscal stimulus in a severe recession if it causes a large increase in government debt Without the stimulus- without- debt plan proposed in this book, a fiscal stimulus large enough to combat a severe recession would cause a large increase in govern-ment debt— and it is therefore unlikely to be enacted by Congress

By contrast, with the stimulus plan proposed here, even a large fiscal stimulus would cause no increase in government debt The stimulus- without- debt plan would therefore remove one key ob-stacle to obtaining the support of policymakers and the general public for a large fiscal stimulus in a severe recession

My economic reason is that large government debt— that is, government debt that is a large percentage of GDP— may gen-erate negative economic consequences and risks in the future Although large government debt may not lead to this negative scenario, it is a risk that is worth avoiding: (1) If interest rates rise in the future, large debt will result in large interest payments; (2) large interest payments will force Congress to raise taxes or cut spending or borrow more; (3) more government borrowing and still larger government debt may at some point make finan-cial investors anxious and cause them to sell corporate stocks,

resulting in a fall in the stock market; (4) a fall in the stock market would reduce wealth and confidence and cause consumers and businesses to cut spending, precipitating a recession; (5) the fall

in the stock market and the recession would generate still more anxiety among financial investors and managers, generating a financial crisis, worsening the recession Thus, the public and Congress are right to be concerned about the possible negative economic consequences of letting government debt become a large percentage of GDP

The phrase “stimulus without debt” also means “without vate debt.” Standard monetary stimulus reduces interest rates in order to induce households and/ or businesses to borrow more in order to spend more on goods and services, so standard monetary stimulus works by inducing households and firms to incur more private debt in order to spend more on goods and services By con-trast, fiscal stimulus in the form of tax rebates (cash transfers) to households enables recipients to spend more without increasing their debt; empirical studies that I  will review later show that households spend a significant portion of their tax rebate and use the remaining portion to pay down debt and save

pri-Under the stimulus- without- debt policy, the Federal Reserve would transfer (not lend) X dollars to the Treasury In turn, the Treasury, after authorization by Congress, would mail out a large portion of the X dollars as “tax rebate” checks (cash transfers)

to households (a small portion of the X dollars would be spent

on other kinds of fiscal stimulus such as temporary government purchases of goods and services or temporary tax cuts) Thus, the Treasury would not have to borrow to finance X dollars of fiscal stimulus because of the Fed’s transfer (not loan) of X dollars to the Treasury Moreover, households would spend some or most

of their tax rebate without doing any borrowing Thus, this policy would increase aggregate demand for goods and services without increasing government debt or private debt

22 H O W T O C O M B A T R E C E S S I O N

The stimulus- without- debt plan is designed to maintain a separation of powers and checks and balances: both Congress and the Federal Reserve play crucial independent roles Congress sets the size and composition of the fiscal stimulus package The Federal Reserve decides the size of the transfer (not loan) it will make to the Treasury; the Fed therefore sets the amount of fiscal stimulus that can be implemented without increasing government debt, but Congress is free to enact a fiscal stimulus that is larger or smaller than the Fed’s transfer

to the Treasury

The plan for stimulus without debt in a recession has five elements:

1 If the Federal Reserve judges that the GDP of the economy

is significantly below the Fed’s estimate of potential GDP, the Fed would decide whether to give a transfer (not a loan) to the Treasury, and if so, how much, on the condi-tion that it be used only for fiscal stimulus Authority for the Fed to make this transfer might require an amendment

to the Federal Reserve Act The Fed could implement its transfer by writing a check to the Treasury or crediting the Treasury’s checking account at the Fed

2 Congress would decide whether to enact fiscal stimulus, and

if so, how much; its main component would be tax rebates

to households, though other components should also be included in the fiscal stimulus package The Treasury would mail tax rebate checks to households in amounts specified

by Congress

3 If the amount Congress enacts for fiscal stimulus is no greater than the Fed’s transfer, then the Treasury would not have to borrow to finance the fiscal stimulus; if the fiscal stimulus is greater than the Fed’s transfer, the Treasury would have to borrow the difference

4 The Fed would decide how much to adjust its bond purchases

or sales to try to keep employment high and inflation low

It is very likely that the Fed, having injected money into the economy through its transfer to the Treasury, would de-cide either to inject less money into the economy through bond purchases or to withdraw money from the economy through bond sales

5 The Fed would order (from the Treasury’s Bureau of Engraving and Printing) an amount of new Federal Reserve notes equal to its transfer to the Treasury, and would store these notes in the Fed’s vault; this Fed vault cash would be

an asset on the Fed’s balance sheet, and as a consequence

of this new vault cash the Fed’s transfer to the Treasury

would not reduce the Fed’s capital (net worth) on its

24 H O W T O C O M B A T R E C E S S I O N

without debt, primarily tax rebates to households, would tially be set large enough so that, even with low consumer and business confidence and expectations, spending on goods and services would increase enough to launch a strong recovery

ini-As a solid recovery takes hold, surveys again confirm the vious: consumer and business confidence and expectations start rising This rise in confidence and expectations raises demand for goods and services As confidence and expectations return to normal, stimulus can be gradually phased out

ob-Some macroeconomists have ignored the role of confidence and expectations in determining demand for goods and services, and the role of the state of the economy in determining confi-dence and expectations But many economists and laymen rightly regard the connection, confirmed by surveys and anecdotes, as obvious As the economy moves from recession to a strong re-covery generated by stimulus, confidence and expectations will rise in step with the economy, thereby enabling the gradual phasing out of the stimulus

There is one caveat Suppose the economy hasn’t plunged into recession due to a shock like a plunge in housing prices or stock prices, but has instead experienced a gradual decline in demand relative to potential output— a “demand- induced secular stagna-tion.” If demand- induced secular stagnation is really a problem, could stimulus without debt treat it? Should it? With secular stagnation, would the treatment have to be permanent rather than temporary? I will discuss this at the end of this book

Tax Rebates to Households

The purpose of having the US Treasury mail a tax rebate check (a rebate of a portion of the income, payroll, and sales taxes paid by the household in the previous year) to every household

in a recession is to increase consumption spending and thereby stimulate production of goods and services Strong evidence for

a significant impact of tax rebates on consumption spending will be presented in depth in the next chapter A tax rebate to households is one type of fiscal stimulus (tax cuts and/ or gov-ernment spending)

A tax rebate is a giving back to each taxpayer a portion of the taxes (income, payroll, and sales) that the taxpayer paid in the previous year Congress does this in a recession to help citizens cope with the recession and to boost their spending on goods and services, which will stimulate production and employment.Why focus on tax rebates to households rather than other kinds of fiscal stimulus? There are at least eight reasons First, and most important, as I will document in chapter 4, tax rebates work: a significant portion of tax rebates are spent within half

a year of being received This should not be surprising Both surveys of recipients and econometric analysis of spending data following the payment of tax rebates indicate that households spend a significant portion of it: one- third within three months and two- thirds within six months Note: any recession almost al-ways involves a fall in consumption below its trend growth path

Second, tax rebates clearly increase household spending on all

goods and services rather just a subset of goods and services, so all businesses would recognize that rebates boost customer demand for their goods or services Third, with tax rebates, there would

be no “shovel- ready” problem that may occur with infrastructure projects; there is no limit to how much households can spend promptly on goods and services Fourth, with tax rebates there would be no temporary or permanent increase in the size of gov-ernment: rebates simply give spending power to millions of indi-vidual consumers, whose spending stimulates the private sector Fifth, tax rebates to combat a recession are clearly temporary and require a new vote by Congress to be continued Sixth, every

26 H O W T O C O M B A T R E C E S S I O N

household would receive a rebate check in the mail from the US Treasury, so every voter would actually see a concrete personal benefit from this kind of fiscal stimulus Seventh, the inclusion

of every household would cause most voters to regard tax rebates

as a fair way to implement fiscal stimulus Eighth, rebates have been enacted with bipartisan support three times— 1975, 2001, and 2008 Thus, a tax rebate has many important advantages as

an instrument for fiscal stimulus in a recession

There is a good reason why tax rebates were able to pass with bipartisan support three times Conservatives and liberals, Republicans and Democrats, have differing long- term agendas for government spending and taxation For example, conservatives generally want permanent tax cuts, while liberals want per-manent increases in social insurance and education programs Neither side wants an antirecession stimulus that would advance the agenda of the other side if it became permanent Tax rebates are obviously and inherently temporary They do not favor the long- term agenda of either side This is undoubtedly one reason that tax rebates were enacted three times with bipartisan support, whereas most other proposals, such as permanent tax cuts, or permanent increases in social insurance or education programs, have generated partisan opposition The tax rebate does not favor one side’s long- term agenda over the other It is neutral toward long- term agendas The details of the design of a tax rebate in re-cession will be discussed in the last section of chapter 4

A Transfer from the Fed to the Treasury

in a Recession

The purpose of the Fed’s transfer to the Treasury in a recession

is to enable the Treasury to pay tax rebates to households and undertake other fiscal stimulus without borrowing The Fed’s

transfer to the Treasury is not a loan; the Fed would not ceive Treasury bonds in return for its funds If the Federal Open Market Committee (FOMC) judges that the total amount of tax rebates chosen by Congress is appropriate to the severity of the recession, the FOMC would decide to make its transfer roughly equal to the total amount of the tax rebates so that the rebates don’t increase the debt of the federal government.

re-Later in this chapter, I will explain why the Fed should have transferred $450 billion to the Treasury every six months from June 2008 through December 2010, six transfers summing to

$2,700 billion, and Congress should have authorized $450 billion

of fiscal stimulus every six months from June 2008 through December 2010, so each year there would have been $900 billion

of fiscal stimulus— 6% of GDP ($15,000 billion) Most of the fiscal stimulus should have been tax rebates to households The fiscal stimulus would not have required any new borrowing by the Treasury— it would not have required any sale of new Treasury bonds Thanks to the Fed’s transfer to the Treasury, the fiscal stimulus would not have increased federal debt

What the Federal Reserve Would Do

under Stimulus without Debt

It is important to distinguish between two roles for the Federal Reserve when the economy suffers a plunge in aggregate demand resulting in a severe recession: (1) acting aggressively as a lender

of last resort to perform financial rescues and unfreeze credit markets; (2) cutting interest rates to try to induce households and firms to maintain borrowing and spending The Fed should

do both aggressively The first role can succeed; the second role can help, but cutting interest rates is not nearly powerful enough

to overcome a severe recession

28 H O W T O C O M B A T R E C E S S I O N

The recession began in late 2007 in response to the plunge

in housing prices but proceeded moderately through the first half of 2008 with below- normal growth in aggregate demand

In September 2008, however, in part due to the failure of Lehman Brothers, a financial crisis was triggered as fear swept over managers of financial institutions and investors that they might follow Lehman Brothers to a similar fate Institutions and investors sought liquidity and sharply cut their lending

In a financial crisis, the Federal Reserve has a vital role to play

as a lender of last resort, providing emergency loans to financial institutions and other firms in order to prevent the freezing up

of credit markets and to keep funds flowing to business firms

so that production can continue The Fed and the Treasury gressively engaged in financial rescues in the fall of 2008 and the winter of 2009 In my judgment, these actions were essential to preventing a full- scale great depression The Fed must also make sure that interest rates are cut sharply to zero in order to give households and firms as much inducement as possible to keep borrowing and spending The Fed also performed this task well

ag-in 2008

But a key question then becomes whether the Fed’s sharp cut in interest rates is enough to stimulate a sufficiently large increase in aggregate demand for goods and services in a severe recession When the Federal Reserve wants to stimulate demand for goods and services, its standard method is to lower interest rates in the hope that consumers and businesses will respond by borrowing more in order to spend more on goods and services The Fed buys US Treasury bonds from financial firms and other institutions When the Fed writes checks to buy the bonds, it

is injecting money into the economy When the sellers of these bonds receive checks from the Fed, they deposit the checks in their banks The banks try to induce households and firms to borrow by cutting interest rates But in a severe recession, it is

doubtful that cutting interest rates can induce enough borrowing and spending to fully reverse a deep plunge in aggregate demand because in a deep recession people and businesses are pessimistic and reluctant to take on more debt.

Under the stimulus- without- debt policy, the Fed injects money into the economy a new way When the Fed transfers

X dollars to the Treasury, it injects X dollars of high- powered money into the economy because the Treasury, after authoriza-tion by Congress, mails out most of the transferred X dollars as tax rebates to households and spends the rest The Fed would decide how much to adjust its bond purchases or sales to try to keep employment high and inflation low; it is likely that the Fed, having injected money into the economy through its transfer to the Treasury, would inject less money into the economy through bond purchases or would withdraw money from the economy through bond sales

Under the stimulus- without- debt policy, the Fed would order

X dollars of new Federal Reserve notes and store these notes in its vault This vault cash would be an asset on the Fed’s balance sheet As a consequence of this action, the stimulus without debt would have no effect on the Fed’s net worth (capital) on its balance sheet

Money for Tax Rebates versus Money to Buy Government Bonds

Now let me compare money for tax rebates versus money to buy government bonds Under stimulus without debt, the Fed creates money and uses it to make a large transfer to the Treasury, which, at Congress’s request, uses the money to pay tax rebates

to households By contrast, under standard monetary stimulus, the Fed creates money and uses it to buy government bonds “in

30 H O W T O C O M B A T R E C E S S I O N

the open market” from members of the public who want to sell government bonds that they previously bought Which of these two uses of new money created by the Fed is likely to cause a larger increase in aggregate demand for goods and services?

A person who receives a tax rebate realizes she can spend more, save more, and pay down more debt The rebate increases her wealth, enabling her to do all three But when someone sells

a government bond, the seller realizes her wealth is the same cause the cash replaces her bond The seller may have sold the bond to replenish her declining checking or savings account, or buy a corporate bond, or a corporate stock, or pay taxes, or pay down debt, or buy goods or services, and was willing to give up the bond to do it The typical bond seller has much higher wealth and income than the typical rebate recipient It seems likely that money used for tax rebates will increase aggregate demand for goods and services more than if that same money were used to buy government bonds Thus, to increase aggregate demand, paying rebates is likely to be a more efficient use of money by the government than buying bonds

be-Debt Worry Prevents Sufficient Stimulus

in a Big Recession

Influential economists have warned against enacting a very large fiscal stimulus to combat a severe recession because they worry about the rise in government debt that it will generate (Seidman

2011, 2012a, 2012b, 2013) I  believe some economists have exaggerated the risks of the resulting rise in government debt But I will now cite a few economists to show that a very large fiscal stimulus in a severe recession will be opposed by influential economists as long as it generates a very large increase in debt

Olivier Blanchard, for many years a professor of economics

at MIT and then chief economist of the International Monetary Fund during part of the Great Recession, supported some fiscal stimulus during the Great Recession but opposed a fiscal stim-ulus that would have been large enough to overcome that re-cession He explained why in a section of his intermediate macroeconomics textbook entitled “High Debt, Default Risk, and Vicious Cycles” (2017) If financial investors start worrying about whether the government can fully pay principal plus in-terest on schedule for all its bonds held by the public (domestic and foreign), they will refuse to buy new government bonds unless the bonds offer high interest rates to compensate for de-fault risk; but these high interest rates on government bonds will make it even harder for the government to fully pay prin-cipal plus interest on schedule To avoid this scenario, Blanchard argues that each government must limit its fiscal stimulus in a recession so that its debt doesn’t get high enough to worry fi-nancial investors

Carmen Reinhart and Kenneth Rogoff, the authors of This Time

Is Different: Eight Centuries of Financial Folly (2009), presented a

paper (2010) at the American Economic Association’s annual conference in which they asserted that their empirical study of data from many countries over the past two centuries found that government debt greater than 90% of GDP on average reduces

a country’s annual economic growth rate by one percentage point— for example, from 3% to 2%— in this example, a 33% re-duction in the growth rate Their paper received a lot of attention and publicity They said the sharp rise in government debt as a percentage of GDP during the Great Recession was worrisome because it might slow future economic growth They implied that fiscal stimulus to combat a recession should therefore be limited They said that when government debt as a percentage of GDP