TJP

Republicans and Democrats have different narratives of the employment-unemployment dilemma. The Republicans believe that deregulating industry and reducing taxes stimulate the economy and reduce unemployment. The Democrats believe that government spending stimulates the economy and reduces unemployment. Neither method, however, can cause more money to be produced. Thus, they're unlikely to improve employment and the income of the middle class.

The multiplier for government spending is greater than the multiplier for tax reduction. Therefore, government spending has a greater effect on gross domestic product than reduction in taxes. Additionally, reducing business taxes does not put money in the hands of consumers; it is rather a supply side policy. Thus, its impact on aggregate demand is not significant. Furthermore, businesses will not invest or hire if aggregate demand is weak, regardless of tax reductions.

If businesses were to invest when aggregate demand is low, their inventories would accumulate and they would be forced to accept lower prices for goods and services.

Demand is a function of income and prices. Thus, when consumers' incomes are low or non existent, demand is low. The problem that confronts the U.S. economy and the Obama administration is low income, which is a direct result of the Federal Reserve (Fed) policy of inflation targeting. Inflation targeting reduces the real money supply, and hence income. Historically when the Federal Reserve reduces or constrains the nominal money supply recessions occur.

Lets assume that we have a four family economy with four working heads of households and a total monetary base in the economy of $10,000 or an income of $2,500 per household. Lets assume further that the banking system restricts lending.

If one additional member of each household enters the labor force, we now have a potential labor force of eight with the same monetary base of $10,000. Thus, the four new entrants could only be employed if the wages of the working head of households diminishes or if the banking system increases the monetary base.

The banking system increases the monetary base by financing expenditure decisions of certain agents. If, however, the banking system restricts consumer and investor borrowing, the money supply will not expand. And, given the downward stickiness of wages, when banks restrict borrowing our hypothetical economy would fail to generate jobs for the entrants in the labor market.

Furthermore, if there is a supply shock, such as a rise in the price of energy, households would not be able to purchase the same quantity of goods and services, which would lead to inventory accumulation and layoffs of some of the currently employed heads of households. Additionally, if the energy is supplied by foreigners, some of the existing monetary base would be transferred to foreigners. As a resulting, the real monetary base would be even smaller.

Milton Friedman in the Quantity Theory of Money-A Restatement noted that “...any interpretation of the short term movement in economic activity is likely to be seriously at fault if it neglects monetary changes...” Bertocco in The Role of Credit in Keynesian Monetary Economy indicates that Keynes also refers to the monetary economy, which is “an economic system where the presence of fiat money radically changes the nature of exchange and the characteristics of the production process.”

The U.S. needs to radically change the nature of exchange and the characteristics of production to compete under globalization. Moreover, like high growth East Asian countries, it needs an activist role in investment, training, and industrial and trade policy to facilitated economic development and hence local jobs, see Administrative Capacity.

The Federal Reserve has failed to use its power to cajole banks to lend, or it could well be that by paying interest on the reserves that it created, it has tacitly provided a disincentive for economic expansion.

In the absence of monetary expansion; that is loans to consumers and businesses, unemployment will remain high.

Unfortunately, the administration appointed Republicans, at Treasury and at the Fed to control monetary policy. Thus, President Obama readily gave up the most effective economic expansionary tools to the Republicans.

The Treasury and the Fed used monetary policy, starting in September of 2008, to support financial institutions by purchasing toxic assets off their books; the Fed even provided $600 billion to foreign central banks. And, expanded reserve balances to about a trillion dollars. Apparently, the expansion in reserve balances was not intended for the American middle class.

In terms of macroeconomics, it appears that the Democrats are out of their league. Their actions are indicative that they do not understand economics and are likely to pay a high price in November for handing the economic keys to Republicans. It is a well known maxim that political economy is vital for political success.

My guess is that once the Republicans take over Congress in 2010, monetary infusion by the Fed and banks will be a given, paving the way for a Republican presidential victory in 2012.

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