A proposal to avoid deep recession

I am afraid to say this: We have to take Keynes‘ General Theory from our backmost shelf: Financial markets currently exhibit something similar to what Keynes told us is a liquidity trap. Not in a sense of people hoarding money but treasuries. The Fed has finally started to encounter this by a policy of quantitative easing inter alia by taking corrective actions directly in private credit markets.

The recent decline in treasury yields below 3 per cent does not incite private investors to put their money into firms. Given the uncertainty and gloomy prospects it is likely that firms do not want to raise a loan because there is no business to finance. Is that what Keynes called an investment trap?

What remains for policy makers to do about this misery? Taxes down, government expenditures up? Monetary policy? Given that Keynes is even right about effectiveness of economic policy in times of severe distress, lowering direct taxes will not work as private savings will simply eat them up without having any effect on interest rates (rates are already at historical lows). Other riskier investments than treasuries will not be made because of uncertainty and gloomy prospects. Even if savings finally find their way to banks, it is most likely that banks will put most of them into treasuries in order to clear their balance sheets at least as long as the financial crisis continues to hold.

In the light of its importance for economic activity, economic policy must do anything suited to foster consumption. For this we need a temporary and sharp reduction in the real interst rate that rapidly affects foremost consumption. Given dysfunctional financial markets, the traditional interest rate pass through from monetary policy instruments to consumption relevant interest rate is broken. Traditional monetary policy hence does not help. Only if central banks intervene directly in markets for private credit (what the Fed‘s new TARF instrument seems to aim at) one may expect a monetary impulse. This, however, can turn out badly in terms of allocative efficiency as it cannot be warranted that funds will flow where they are needed most. Effective fiscal policy seems more appropriate to boost consumption when it reduces value added tax or sale tax temporarily and surprisingly (admittedly, this proposal is in sharp contrast to what Taylor suggests) because that way the real interest rate that is directly relevant for consumption will decrease.

But there is a problem at least for continental Europe: price rigidity. It cannot be expected that firms will reduce prices in an instant when sale taxes fall even if competition is fierce. However, price rigidity also means that they will not increase simultaneously when consumption gains momentum.

What about this: At the end of, let say, each month, households can present their bills and receipts to fiscal authorities or tax offices to get allowances for their tax expenditures. For this being most effective, sale taxes are refundable in full and limited for one year.