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Wednesday, October 06, 2010

Monetary versus Fiscal Policy

Joseph Stiglitz says that, for the most part, monetary policy has been a failure:

The Federal Reserve’s Relevance Test, by Joseph E. Stiglitz, Commentary, Project Syndicate: With interest rates near zero, the US Federal Reserve and other central banks are struggling to remain relevant. The last arrow in their quiver is called quantitative easing (QE), and it is likely to be almost as ineffective in reviving the US economy as anything else the Fed has tried in recent years. Worse, QE is likely to cost taxpayers a bundle, while impairing the Fed’s effectiveness for years to come.
John Maynard Keynes argued that monetary policy was ineffective during the Great Depression. Central banks are better at restraining markets’ irrational exuberance in a bubble – restricting the availability of credit or raising interest rates to rein in the economy – than at promoting investment in a recession. That is why good monetary policy aims to prevent bubbles from arising. ...

The best that can be said for monetary policy over the last few years is that it prevented the direst outcomes that could have followed Lehman Brothers’ collapse. But no one would claim that lowering short-term interest rates spurred investment. ...
They still seem enamored of the standard monetary-policy models, in which all central banks have to do to get the economy going is reduce interest rates. ... So, while bringing down short-term T-bill rates to near zero has failed, the hope is that bringing down longer-term interest rates will spur the economy. The chances of success are near zero.
Large firms are awash with cash, and lowering interest rates slightly won’t make much difference to them. ... In short, QE – lowering long-term interest rates by buying long-term bonds and mortgages – won’t do much to stimulate business directly.
It may help, though, in two ways. One way is as part of America’s strategy of competitive devaluation. Officially, America still talks about the virtues of a strong dollar, but lowering interest rates weakens the exchange rate. ... The fact is that a weaker dollar resulting from lower interest rates gives the US a slight competitive advantage in trade. ...
The second way that QE might have a slight effect is by lowering mortgage rates, which would help to sustain real-estate prices. So QE would produce some – probably weak – balance-sheet effects. But potentially significant costs offset these small benefits. ...

Not the anyone paid much attention, but I've been worried about the ability of monetary policy to stimulate the economy as much as needed for several years now, and have called for aggressive fiscal policy as an important complement to attempts to revive the economy through monetary policy. I was making this point at a time when others who get credit today as strong proponents of fiscal policy were saying let's wait to see if monetary policy works, and if not, we can turn to fiscal policy. I thought that was a mistake, and still do. For example, from January 2008:

Monetary policy is very good at slowing down an overheated economy, but it is not always so good, for the reasons just stated, at stimulating a lagging economy. It might do the trick, lower interest rates and other measures might provide the needed stimulus, but it wasn't all that long ago that some of the smartest people in this business argued that money had little if any effect on the real economy - some still do - and there are still uncertainties about the extent to which monetary policy can revive a lagging economy, especially an economy in a fairly steep downturn. I don't think it's a given that monetary policy will work.
Unfortunately, a serial approach won't work either. If we wait to see if monetary policy will work, and if it doesn't then turn to fiscal policy, it will be too late for fiscal policy to do much good...
So why not shoot with both barrels? Implement both monetary and fiscal policy measures as soon as possible, hope like heck one of the two works because there's no guarantee either will do enough to matter, and if the economy recovers and begins to overheat due to the dual stimulus, use monetary policy to cool things down. As I said, using monetary policy to temper an overheated economy seems to be the one place we are pretty sure policy can be effective, and monetary policy can be reversed fairly quickly... And even if we do provide too much stimulus for a time, if we put extra people to work, build a few more roads and bridges, give rebates to struggling families when less would have sufficed, measures such as that, well, I can think of worse mistakes to make. So the danger of overstimulating the economy isn't as large as the danger of failing to provide adequate stimulus, thus, why not use both types of policies?

Or, more than three years ago, before the recession officially started, in March 2007:

Recall Keynes' contention that monetary policy may be ineffective in a depression. Keynes said "there's many a a slip twixt the cup and the lip" meaning lots can go wrong with monetary policy - a change in the money supply must lower interest rates, which must then stimulate investment, which in turn must stimulate output. If, for example, interest rates don't fall when the money supply is increased (as in a liquidity trap), or if people are unwilling to invest even if interest rates do fall, monetary policy is ineffective. Keynes noted that fiscal policy, by contrast, operates directly on aggregate demand so it can work even in severe depressions where monetary policy has too many slips twixt cup and lip to be effective.

As I said, that was before the recession officially began, and interest rates weren't yet at zero (federal funds rate=5.25% at this time), so unconventional policy tools weren't considered. I made the same point about monetary versus fiscal policy the other day as well, and Krugman makes the same point today:

why did some of us emphasize the need for fiscal stimulus, rather than just calling for more expansionary monetary policies? ... I wanted and still want fiscal expansion because it’s relatively certain in its effect: if the government goes and buys a trillion dollars’ worth of stuff, that will create a lot of jobs. On the other hand, if the Fed goes out and buys a trillions dollars’ worth of long-term bonds, the effect is quite uncertain, with many possible slips between the cup and the lip.
The truth is that it’s very hard for central banks to get traction in a zero-rate world. This doesn’t mean that they shouldn’t try. But nobody is sure how much effect quantitative easing will have on long-term rates; even a decade ago, I thought Ben Bernanke was too optimistic on that front, which is why I was more of an advocate of inflation targeting — yet I was also aware that making inflation targets credible is itself tricky. Furthermore, even if long rates can be reduced, how much effect will they have? Business investment is relatively insensitive to interest rates, mainly because equipment doesn’t have all that long a lifetime. Housing is the place where the rubber usually meets the road; but not in the aftermath of a huge bubble and vast overbuilding.
So I didn’t and don’t think that we can count on monetary policy to do the job; blithely declaring that the Fed should target nominal GDP misses the difficulties. And that means we need fiscal policy.
Of course, at this point, with the loss of political will, it looks as if we’re going to see an attempt to do the trick with quantitative easing alone. I hope it works, but I wouldn’t bet on it.

I appreciate Stiglitz' shining the spotlight on the ineffectiveness of monetary policy in a recession, but I think fiscal policy is where the biggest mistakes were made and I wish he would have talked about that as well.

    Posted by on Wednesday, October 6, 2010 at 10:33 AM in Economics, Fiscal Policy, Monetary Policy | Permalink  Comments (20)


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