Tuesday, January 27, 2009

Multiply, but it may not be fruitful

On Sunday's Meet The Press, new National Economic Council (NEC) chairman Larry Summers sparred with David Gregory about the size of the stimulus package.

From the show (emphasis added):

MR. GREGORY: I, I--and I want to go through all that. But I just want to go back to your central point, which is that one of the biggest mistakes you can make is doing too little. Yes, this is the largest stimulus in our history, but the problem, as you said, is something we've never seen in our history. So if you have a hole in the economy that's at least a trillion, maybe 2 trillion, don't you need a stimulus package that fills that hole?

DR. SUMMERS: Well, no, David. We have what economists call the multiplier. A fact--when the government--when the government spends...

MR. GREGORY: Right, which is if you create a job, it creates another job.

DR. SUMMERS: ...when the government spends a dollar creating a job, that person has higher income; because they have higher income, they're able to spend more, that creates other jobs down the road. That's why we surveyed a range of economists. We talk--and this is something the president insists on--to a lot of experts, both Democrat and Republican. And you know, frankly, some of them think the stimulus should be larger, some of them think the stimulus should be, should be smaller. President balanced the different views and I think came to the approach that we've taken, and came to an approach that's balanced in another way. It's balanced between very substantial new investments that are referred to between very important protections to prevent teachers and cops from being laid off, and also--and this is a substantial part of the package--tax cuts, because we recognize that we've got to help households to be able to spend, and businesses.

Summers is correct to point out the money multiplier. It's an important economic fact. It's also a variable that we can measure. And the current measure does not bode greatly for Summers.

The money multiplier is based on how fast money moves through the economy. To multiply, a dollar needs to circulate from the backer to the miller to farmer, etc. Yet if the baker gets a bailout and stops buying, which is the concern around bailed-out banks paying dividends or not lending, then there is no multiplication. This speed is known as the velocity of money.

The figure provides two values of the velocity of money. Nominal GDP/M2 and Nominal GDP/MZM. The figures vary because they use different measure of the money supply. Both include dollars, checking accounts, and other liquid assets but MZM does not include time deposits like CDs that are not immediately accessible. As we can see removing time deposits has made a big difference in the past year, as the MZM measure has dropped quickly.

A lower velocity will supress the multiplier effect and lower the true benefit of the stimulus closer to its price tag.
Of course stimulus does not exist in a vacuum. It could on its own provide liquidity and boast velocity as people spend their stimulus. It could also just be a blip.

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