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The extent of this muddling was clearly evident in the recent election campaign. Still, through the fog, two basic narratives have emerged: On the left of the political spectrum are the neo-Keynesians, led by New York Times columnist Paul Krugman. This group would ratchet up government spending and borrowing still more than it has been, in order to "jump-start" the economy. On the right, apart from the bias against big government, the analytical focus seems to lean toward monetary policy. This group would have the Federal Reserve, as well as the Bank of England, the European Central Bank (ECB), and other central banks keep markets well supplied with liquidity, effectively greasing the wheels of commerce until more fundamental healing can occur. There is dispute within this camp as to the appropriate extent and duration of such monetary easing, but this general approach seems to be where the bulk of their analytical effort has gone.
Paul Krugman and the neo-Keynesians have argued strenuously against any concern over the size of government or budget deficits. They contend that even higher levels of borrowing and spending would foster enough growth ultimately to pay for themselves with added tax revenues. Krugman and his colleagues, University of California at Berkeley economist Brad DeLong prominent among them, continue to argue this line despite the failure of the massive 2009 stimulus effort to accelerate the economy. Even President Obama admitted that there simply are not enough "shovel-ready" projects to allow the stimulus to work. Rather than be chastened by that failure, however, they simply claim that the effort, massive as it was, was simply insufficient. They point out how, in the setting of the Great Depression, it took the truly massive spending for the Second World War to get the economy going. So far, Krugman and company have resisted the temptation to advocate a declaration of war.
Outside the narrow confines of this analytical approach, it seems that the explanation for the failure of neo-Keynesian policy may lie less in its size than in John Maynard Keynes's own writings. While he advocated government spending, he also emphasized that government stimulus can only have an impact beyond itself when it inspires what he called the "animal spirits" of businesspeople. In other words, government spending can only prompt a general recovery, according to Keynes, when business is willing to capitalize on it with its own spending and hiring. Unfortunately, the present environment of uncertainty and doubt has dampened such spirits. The same reluctances were evident during the Great Depression. The government in the present environment has further dampened those spirits by vilifying businesspeople and threatening to tax away much of the income they might gain from capitalizing on the government's efforts. Little wonder, then, that the 2009 stimulus had no lasting impact, or what economists call "multiplier" effects. The same problem raises doubts about Professor Krugman's demands for still more spending.
Curiously, this combination of tax threats and limited confidence may explain why the monetary solution has also failed thus far to get the economy back on track. Fed chairman Ben Bernanke and other advocates of this approach have already poured huge amounts of liquidity into the system, and when confronted with the muted economic response, they have simply argued for more. Even the stock market has failed to respond fully. Though up dramatically from its lows, prices still remain depressed next to less-risky assets, such as Treasury notes and high-grade corporate bonds. No doubt the confusion and concern about what might happen has also made business and the public reluctant to take full advantage of the ocean of liquidity offered by the Fed.
This problem is evident not only in the still disappointing state of the economy but also in the benchmarks used by the Fed itself. Currency in circulation and bank reserves—two things that the central bank controls directly—have surged under the influence of this easy monetary policy. In the past two years, according to the Fed, bank reserves have jumped 15.5% a year, and the so-called monetary base, which adds currency in circulation to measures of bank reserves, has increased at a 21.1% annual rate. But because the lack of confidence has made banks reluctant to lend and the public reluctant to borrow, for either business or personal use, only a portion of these reserves has flowed into actual circulation. The broad M21 measure of money circulating in the economy, for instance, has increased at only 7.9% a year during this time—faster than the economy, to be sure, but clearly slower than the Fed intends.
It would seem in the circumstance that time offers the only solution. Whatever tax policies eventually go into effect will presumably relieve the public and the business community of uncertainty on this front.If the government ultimately takes more, at least people and business will be able to plan and so are more likely to take advantage of either fiscal or monetary stimulus. The uncertainties over how the economy works will also resolve themselves in time. Even a disappointingly slow-growing economy can reestablish in people's minds a notion of what the future holds, whether accurate or not, and so erase the sense of lingering confusion that emerged from the shock of the financial crisis and the severe recession that followed it. In the meantime, the slow pace of advance will continue to dominate, with all the disappointment and frustration it brings.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
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