For the last three weeks, my Fiscal Times columns have been focusing on Fed policy. The main reason is that although I think there is scope for additional fiscal stimulus, there is simply no support in Congress for doing more than has been done. Like it or not, those favoring stimulus got one bite at the apple and they didn’t do enough.*
With fiscal policy effectively off the table, the burden of further stimulus necessarily falls on the Fed, which still has freedom of action. This may be a blessing in disguise because I have believed all along that monetary policy is at the root of our economic problem. We are essentially suffering from a deflationary recession identical to the Great Depression except about one-third the size.
I tried to explain why this is the case in my July 9 column
, where I showed that the economy’s fundamental problem is a decline in velocity—the speed at which money turns over in the economy. When velocity falls it has exactly the same economic effect as a decline in the money supply—reducing both prices and output. By my calculations, velocity has fallen by 11 percent—exactly equivalent to an 11 percent shrinkage in the money supply.
From the beginning of the crisis there have been economists who said that monetary policy was sufficient to stem the deflation and turn the economy around without fiscal stimulus. Just pump up the money supply, they said; that will stem the deflation all by itself and save the country from a destabilizing increase in debt, a lot of wasteful pork barrel spending, and avoid an implicit tax increase via Ricardian equivalence. (I explained this mechanism in more detail in my July 2 column
The problem is that the Fed did increase the money supply a lot. So much so, in fact, that some of the very economists who said that the Fed could end the recession all by itself quickly became alarmed and began warning about imminent inflation.**
Of course, there has been no inflation because deflation remains the economy’s central problem. That is because all the money created by the Fed never got spent; it just piled up in bank reserves. I explained this problem in my July 16 column
. This was the fallacy of the monetarist view. Monetarists just assumed that increases in the money supply would be spent.
In my 2009 book
, The New American Economy
, I went through the economic debate of the early 1930s very thoroughly. There were monetarists then too, the great Irving Fisher being the prime example. And there were also Austrian-types like Henry Hazlitt and Benjamin Anderson who kept crying “inflation” every time the money supply rose, even as the price level fell 25 percent between 1929 and 1933.
In my book I explain how virtually all economists, including Fisher, eventually came around to the view that monetary policy by itself was impotent in a deflationary situation because the money simply would not circulate by itself. It needed fiscal policy to generate spending in the economy to be effective.
Another problem, which I discuss in my July 23 column
, is that the Fed can’t cut the fed funds rate below zero. But a Taylor rule calculation says that we need a negative funds rate of five percent or so. Since the funds rate is the Fed’s primary monetary tool, the zero bound essentially makes that tool impotent.
Of course, this doesn’t mean that the Fed is completely out of ammunition. One thing it could do, which I advocated in my July 23 column, is for it to stop paying interest to banks on reserves. Even though the rate is low—just 25 basis points—it reduces the opportunity cost for banks not to lend. It also sends an important signal to banks that the Fed is okay with having them sit on more than a trillion dollars of excess reserves. Eliminating interest on reserves, therefore, would be a signal to banks to get the money moving. If this failed to lift lending, I suggest that the Fed follow the lead of the Swedish central bank and start imposing a penalty rate on bank reserves.***
On Thursday, Ben Bernanke was asked about why the Fed doesn’t cut the rate on reserves to zero. He responded
that interest on reserves was necessary to the functioning of the fed funds market. This strikes me as a very weak argument, especially given that the Fed is now allowed to pay interest on reserves, which is essentially a substitute for managing the fed funds rate. Unfortunately, bureaucratic inertia often determines policy at the Fed until a crisis forces action.
I still believe that monetary policy requires fiscal expansion to be effective under current economic conditions. For example, those who advocate a monetary helicopter-drop of money to stimulate growth concede that the Fed doesn’t have the capacity to do it without some action by Treasury to distribute the funds, which would be fiscal in nature. It would also require congressional action that is very unlikely in the current political environment.
That basically leaves two things that the Fed can do: buy longer term securities and buy very unconventional assets such foreign currency denominated bonds. The first it has already done some of without doing much to get money circulating. The second would put the Fed at war with the Treasury, which jealously guards its dominion over exchange rate policy. It will also raise holy hell with the “strong dollar” crowd and undoubtedly invite foreign retaliation. It’s even possible that China could effectively sterilize the intervention by soaking up all the dollars created by the Fed.
Thus it appears that there is virtually nothing that can be done to stimulate the economy. For various reasons—political, institutional and substantive—there is no prospect of either fiscal or monetary stimulus. It’s time for new thinking.
* In a revealing interview
with the Fiscal Times
on July 16, outgoing House Appropriations Committee chairman David Obey said that Obama administration economists originally wanted a $1.4 trillion stimulus package. But Republicans demanded that the package be scaled back and the White House political people were unwilling to fight for a bigger package. Perhaps they thought they would be able to get more stimulus through the regular appropriations process.
** See Allan Meltzer, “Inflation Nation,” New York Times
(May 4, 2009
); Arthur Laffer, “Get Ready for Inflation and Higher Interest Rates,” Wall Street Journal
(June 10, 2009
); Alan Greenspan, “Inflation Is the Big Threat to a Sustained Recovery,” Financial Times
(June 25, 2009
***I put together a bibliography of research on the problems of deflation, the zero bound, and the payment of interest on reserves in a July 23 Fiscal Times post
It appears that Paul Krugman and I were channeling each other. He posted this
while I was writing the above. Stephen Williamson has a related comment
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