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Wednesday, September 30, 2009

"Monetary Policy, Fiscal Policy, Capital Markets Policy"

Brad DeLong places government policy into "three boxes," fiscal policy, monetary policy, and capital markets policy:

Monetary Policy, Fiscal Policy, Capital Markets Policy, by Brad DeLong: Paul Krugman is three doors down the hall right now, but I am going to talk to him through the magic of the internet rather than mosying down:
Does unconventional monetary policy solve the zero bound problem?: Some comments on my post on the true cost of fiscal stimulus argue that the zero lower bound aka liquidity trap isn’t really binding, because the Fed is using other measures to expand the economy. A few commenters imply that I haven’t been paying attention.
Well, yes I’m aware that BB is doing a bunch of unconventional stuff. But the available — albeit thin — evidence is that it takes a huge expansion of the Fed’s balance sheet to accomplish as much as would be achieved by a quite modest cut in the Fed funds rate. And the Fed isn’t willing to expand its balance sheet to the $10 trillion or so it would take to be as expansionary as it “should” be given, say, a Taylor rule.
Which means that the zero bound is still binding, which means that right now we’re very much still in liquidity trap territory.
I would put it somewhat differently. There's fiscal policy--using the government to expand output holding the risky long-term real interest rate that governs business investment and household borrowing decisions constant. There's monetary policy---using open-market operations to boost or retard the economy holding the short-term safe nominal interest rate constant. And then there is capital markets policy: operating on the wedge between the risky long-term real interest rate and the short-term safe nominal interest rate.
If you set up those three boxes, then a huge number of things fall under the rubric of "capital markets policy"--banking recapitalization. loan guarantees, nationalizations, bank rescues, asset purchases, and the sending of signals that alter the expected rate of future inflation.
You can call Federal Reserve policies aimed at the sending of signals that alter the expected rate of future inflation "monetary policy" if you want, but then you lose analytical clarity--because the way such policies work (if they work) is not the "normal" way that "normal" monetary policy works. Normal monetary policy works by shifting the private sector's asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What is does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly.

I would add risk management to the definitions (e.g., I have called the central bank the "risk absorber of last resort"). When the Fed (or any other government agency) trades T-Bills for risky private sector assets, it changes the overall level of risk in the private sector since the risk has been absorbed onto the Fed's balance sheet (this is not the only way to reduce risk, e.g. government provided insurance against losses would also have this effect, and most of these actions can also create moral hazard). The risk management function of policy is something Brad has talked about in the past as well, and I'm not sure if he'd identify risk management as a separate category, or whether it fits into the the capital markets policy categories he identifies (it would also operate on the wedge between safe and risky assets by reducing the risk premium, so I'd include it there). Either way, I think it's worth mentioning since these actions can also affect the level of economic activity. When markets are frozen with fear, reducing the chance that hidden losses will be discovered after a transaction is complete can help to restore these markets.

    Posted by on Wednesday, September 30, 2009 at 12:01 PM Permalink  Comments (31)


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