Dig Holes and Fill them

Day after day we are bombarded with stories about the recession, job losses, the TARP bailout program, companies going bankrupt, store closures, etc. In times like these it is tough to makes sense to take a step back and try to understand where we are and what should happen in order to get ourselves out of this economic downturn.One way to analyze the situation from a Keynesian perspective.Deflation is finally here. The classic Keynesian problem of production cuts due to lower demand which in turn was caused by lower salaries that curtails reduced spending. When this disastrous cycle begins Keynes mentioned that the only solution to this problem was the government to invest in infrastructure even if it means hiring people to “dig holes and fill them”. This is one of the solutions proposed by our President-Elect Barack Obama. Under a section title “New Jobs Through National Infrastructure Investment” his site says

Create a National Infrastructure Reinvestment Bank: Barack Obama and Joe Biden will address the infrastructure challenge by creating a National Infrastructure Reinvestment Bank to expand and enhance, not supplant, existing federal transportation investments. This independent entity will be directed to invest in our nation’s most challenging transportation infrastructure needs. The Bank will receive an infusion of federal money, $60 billion over 10 years, to provide financing to transportation infrastructure projects across the nation. These projects will create up to two million new direct and indirect jobs and stimulate approximately $35 billion per year in new economic activity.” (emphasis added)

Usually policymakers use monetary and fiscal policies to increase economic growth. With the current Zero Interest Rate Policy (ZIRP) since Dec 16,2008 is not working just like it did not work in Japan. The logic behind keeping interest at 0% is encourage investment and increase economic activity. So far we haven’t seen any new major investments happening with thousands of jobs created as a result.

Fiscal policy is the changing of taxes by the government to reduce or increase demand. Currently no changes in taxes have occurred.However President-Elect Obama has promised to make many tax changes including a tax cut for middle class families and the elimination of “all capital gains taxes on startup and small businesses to encourage innovation and job creation.”

In situations where deflation and high unemployment persist, the final solution of government spending on infrastructure may have to be used as Keynes proposed. As mentioned above Obama promises to implement this solution. Lets see in the next six months to a year where this strategy leads us.

However from a US perspective, implementing the Keynes solution of government spending to stimulate demand raises many questions such as:

1. Who will pay for the expenditures? Certainly it can’t be taxes from citizens.

2. Will the Japanese, Chinese and others continue to buy our Treasuries?

3. What will be the impact on the US Dollar?

4. What kind of infrastructure do we need to spend it on?

5. Finally what if this solution also does not work?

These are some interesting questions that I can think of. Comments welcome.

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