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Time for New Thinking on Stimulus

24 Jul 2010
Posted by Bruce Bartlett

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.

New thinking, eh? Reading

New thinking, eh? Reading E.F. Schumacher's "small is beautiful" and his admonition that we are "far too clever to be able to survive without wisdom" reminds me it is cleverness that got us into this mess.

"The neglect, indeed the rejection, of wisdom has gone so far that most of our intellectuals have not even the faintest idea what the term could mean. As a result, they always tend to try and cure a disease by intensifying its causes. The disease having been caused by allowing cleverness to displace wisdom, no amount of clever research is likely to produce a cure. But what is wisdom? Where can it be found? Here we come to the crux of the matter: it can be read about in numerous publications but it can be *found* only inside oneself.To be able to find it, one has first to liberate oneself from such masters as greed and envy. The stillness following liberation -- even if only momentary -- produces the insights of wisdom which are obtainable in no other way."

"They enable us to see the hollowness and fundamental unsatisfactoriness of a life devoted to the pursuit of material ends , to the neglect of the spiritual."

Bruce, is the "new thinking" you are calling for wise? Or is it merely clever?


That sounds like a lot of GOVERNMENT policy to me, free market *gnash teeth*, kill social security *gnash teeth*, tighten our belts *gnash teeth*.

Have you been paying attention to the mid-term primaries Mr. Bartlett? Unless it involves some crazy, libertarian conspiracy theory, the word "Fed" does not even enter the debate for most of us in the "unwashed masses" category.

Interest on Reserves

I question how effective cutting the interest rate on reserves will be.

First, let's not forget that the Fed paying interest on reserves is very new. It started in October 2008. The rationale was that it would allow the Fed to better control short rates. Ultimately, the Fed wants to move away from an open market system and towards a corridor system similar to the one used in Canada, where the Fed can directly set a floor and a ceiling via the interest rate on reserves and the Discount Rate, rather than relying on targeting the Fed Funds rate through OMO (which proved less than ideal during the crisis). My point is that the deflationary spiral was already well under way BEFORE the Fed started paying interest on reserves.

Second, 0.25% is, as you noted, an extremely low rate. Banks could very easily take the excess reserves and park them in 10yr Treasuries yielding 3% (or even 2 yr Treasuries yielding more than twice the current interest on required reserves). Right now there are still latent concerns over liquidity and solvency on the part of borrowers and lenders. Cutting the interest on reserves from 0.25% to 0.12% (or even 0%) isn't going to change that.

A more effective policy would be for the Fed to start buying longer maturity (2 yr, 10 yr, 30 yr) Treasuries. This would drive down long rates and would further stimulate the economy. However, it would also greatly flatten the yield curve, which would hurt bank profitability in a time when banks are still in a very fragile state.

The Fed does have options, but none of them are particularly good.

Effective QE2 will require a HUGE Fed balance sheet expansion

I seem to recall an analysis that looked at the required SIZE of Fed purchases of longer-term and unconventional assets. It is massive, if they actually want to achieve any meaningful effect on market rates. Like another $5+ trillion in purchases to achieve a Taylor-Rule-derived rate.

So, like further fiscal stimulus, however theoretically possible, it is an unrealistic notion.

The Fed has bullets, but they are .22s when a howitzer is needed.

Excellent post

Very clear points. It is really up to Congress to invest money in people and the future. Too many people are waiting for the Fed Monetary Fairy to swoop in and rescue the economy. Congress has forgotten that it has the power to help the economy.


You are in my opinion completely write about the need for stimulus to be in a form that accelerates the turnover of money in the economy. Given our circumstances today, this requires that stimulative resources go directly to those they will help the most. In other words, give the people's money to the people. A year ago, in a column I then wrote for The New York Observer, I proposed, only half-facetiously, that Uncle Sam write a check for $25,000 to every individual taxpayer. Some of this would pile up in banks, to be sure. But much would be spent or invested and would begin to move through the economy, creating taxable events along the way, and thereby effecting a true multiplier sequence. Banks today complain of a shortage of qualified small borrowers. So: qualify them with some sort of Federal collateral certificate program. The money, once loaned, will be in vested or spent, and will thus begin its salmon-like ascent of the economic shoals.

I don't think that would work.

The permanent income hypothesis as well as experience with tax rebates tells us that almost all the money will be saved, providing no net stimulus to spending. A better idea would be something like a gift certificate with an expiration date so people have to spend it. Of course, the certificates could be sold, allowing some people to save the money, but at the end of the expiration period the money would have to be spent one way or another. The big problem is that it would just displace funds that people would otherwise use to buy things they would have bought anyway, so the net impact on spending might be very small.

Getting people to spend is in practice much harder than people believe. 

I'd like to know why Fed

I'd like to know why Fed devotees don't get the fact that all Fed stimulus requires more borrowing to work. As you say, people don't want to spend, and they damn sure don't want to borrow. Why? Because they don't think their future prospects are good enough to pay back more than what is already owed.

Perhaps you could use your purported expertise to devine why more anti-business policies (taxes and regulations) make people feel less secure. The strength of an economy is more dependent on expectations, than math.

Have Some Faith Bruce


You underestimate the ability of the Fed to stabilize spending. Yes, the Fed has increased the monetary base with little to show but this is very different from what folks like Scott Sumner and me have been arguing. Nowhere have we said that further increases to the monetary base alone will cause everything to fall into place in the economy. Our message has been more nuanced than that. We have argued primarily for the Fed to adopt an explicit nominal target that would help shape expectations and thus stabilize velocity. We have also argued the Fed should abolish the interest paid on excess reserves and engage in further quantitative easing (i.e. expansion and alteration of the Fed's balance sheet) as needed to hit its nominal target. Then, and only then, you would see some real traction.

Let me present our case--the way I see it anyhow--using the expanded equation of exchange. First take the regular equation of exchange, MV=PY (where M = money supply, V=velocity, and PY = nominal GDP or aggregate demand) and expand the money supply term, M, such that M=Bm where B = monetary base and m = money multiplier. This expanded version of the equation of exchange can be stated as follows:

BmV = PY

In this form, the equation says (1) the monetary base times (2) the money multiplier times (3) velocity equals (4) nominal GDP or total spending (i.e. aggregate demand). The Fed has complete control over the monetary base, B. It has less control over the money multiplier,m, but still can shape it to some degree as it is currently doing by paying banks interest payments to sit on excess reserves. (Imagine what might happen to m if the Fed started charging a penalty for holding excess reserves? We saw how excited the stock market got just at the idea of dropping interest paid on excess reserves.) The Fed can also influence V by setting an explicit nominal target that stabilizes expectations (e.g. inflation, price level or nominal GDP target--the latter being my first choice). In short, the Fed has enough influence that if it really wanted to it could do much to stabilize BmV (or MV). And all of this could happen without resorting to more fiscal policy.

This is not just a theory. Christina Romer and others have shown it was the reason for the rapid recovery of 1933-1936. Have some faith Bruce. There is much moneary policy can still do.

Bruce, I am new here. I

Bruce, I am new here. I really enjoyed your column...the best I have read on this break down our policy options quite succinctly.

What do you think about the "do nothing" option. I guess I don't understand why we always think the government has to do something when the problem is miscalculation by borrowers and lenders...they need to feel the pain of their mistakes to learn from their mistakes. Its OK if overextended borrowers default and we have to live less lavishly until deleveraging is completed.

Aren't we mature enough as a people to be told the truth by our leaders rather than always trying to find cheesy ways out of a simple problem?

We are missing an opportunity to educate our citizenry on basic economic/financial principles ... "Don't borrow too might default...and if you default all of your equity/savings will be wiped out."



I am completely supportive of stimulus, but I think our focus should be on measures that save individuals, businesses, and government agencies money.

So if we spent a considerable amount of stimulus money on programs that are guaranteed to save people money, such as larger deductions for home and business energy efficiency, we could potentially get that significant unemployed population of construction workers re-tooled to upgrade our existing commercial and residential properties. They would get work and individuals and businesses struggling to pay their bills would get immediate savings on their electrical and heating bills. There is hundreds of billions of dollars of 3-5 year ROI efficiency upgrades that could be made across the country and hundreds of billions more in 6-10 year ROI.

I know that our highway infrastructure needed a massive upgrade due to considerable neglect. But that money doesn't make us more efficient, we have reached diminishing returns on highway spending, the millions spent adding another lane may reduce travel time by a few minutes. Except for safety considerations it seems like we are just putting money down a hole.

Bartlett: "The big problem is

Bartlett: "The big problem is that it would just displace funds that people would otherwise use to buy things they would have bought anyway, so the net impact on spending might be very small."

Which is why the "vouchers" need to be directed to those who are too poor and/or cash-strapped to offset them by saving from other income.

In an earlier era, those "vouchers" were called unemployment insurance checks. But that was before we as a nation decided to forget everything we learned in the '30s about deflationary economics.

Fed Action

Bruce, you haven't considered that the Fed could buy privately issued debt (as it bought MBS in 2009-2009) and cancel some or all of the unpaid principal balance on that debt. Such action would immediately increase the net worth of the households and businesses affected, which we ought to expect to generate an increase in consumption via the wealth effect. Whatever other challenges implementing such a program might pose, it would not require any action by Treasury or Congress, nor would it step on Treasury's exclusive jurisdiction over the exchange rate. I suppose the "other challenges" (which I think are far from insurmountable) include:

1) Some legitimating rules: I would suggest the Fed seek to buy all residential and commercial mortgages issued during the bubble, and write principal down to reflect the increase in prices at the time of the loan's origination above the inflation-adjusted 1998 price (the base year wouldn't matter hugely). The Fed could even start with the mortgages issued pursuant to the most-false prices, ie 2006 vintage mortgages, to maximize the impact of whatever scale of action it undertook.

It would be harder to develop a legitimation for credit card debt purchases & cancellations, but they would if anything have an even more immediate effect on consumption.

2) Securitization: It would be a lot easier to implement such a program if all loans were whole loans. Since the Fed would in practice need to buy up a lot of MBS (and it already has a bunch), it would presumably need to own at least a majority of, and perhaps all of, the interests in a trust in order to cancel part of the principal in the underlying loans.

3) Municipal/state bonds: Here, a likely rule could be based on the level of overall economic activity in a state/region, with the Fed buying up a larger share of outstanding obligations the higher the unemployment rate, or something like that. Not sure if interest payments are currently large enough for such a measure to ease the fiscal burdens of the states, but it can't hurt.

4) Corporate bonds: The fed could develop a rule such that it will buy an share of newly issued bonds at a certain rating (like Baa) or higher, and that this share would rise as the UE rate rises and fall to zero as the UE rate declines to, say, 5%. Here, principal reduction would be less important than just the scale of purchases, making this more like conventional unconventional policy.

Like RueTheDay, I don't think

Like RueTheDay, I don't think changing the rate from 0.25% to 0% will affect anything. The real problem is bank insolvency (every month that goes by sees more of the boom-generated "assets" on their books going bad) and the regulatory reserve requirements intended to reduce the odds of actual bankruptcy.

It also seems to me to be a very bad idea to pull yet more consumption forward via government stimulus spending today of money we won't have until sometime well into the future.

If good investments in future production capacity are available, THAT CREATE THE MEANS TO REPAY THE MONEY BORROWED to make the investments, those are a good idea. Investments in clean energy technology may be in that category, but I think most infrastructure spending is not. Only infrastructure that actually reduces the cost of our exports by more than the cost of the infrastructure is really a good investment.

Spending just to reduce people's pain today should be paid for by taxes levied today (yes, "soak the rich" to rescue those in dire straits). Our future already involves having to earn a lot more than we spend, because of our already-existing debts both governmental and private - and because we haven't planned ahead as a society for the upcoming tsunami of retired people.

Where do you see deflation?

Where do you see deflation? The seasonally adjusted CPI rose 1.1% the past twelve months as of the June report.

Nominal GDP now exceeds pre-recession levels, but job creation sucks because productivity is off the charts.

We live in strange times when a former conservative claims a $14.6 trillion economy needs government intervention to stimulate it.

Stimulus Ideas

Here are some stimulus ideas you won't hear discussed very often because they threaten Democrat constituencies.

1. When revenues to states, school districts and municipalities decline, institute across the board proportional salary cuts to all government workers. Reducing their wages will increase the overall multiplier effect more than holding wages constant for some and laying off others. Plus taxpayers won't suffer decreased services or deficits. It's not as if a government worker getting a pay cut has an alternative opportunity to puruse in the middle of a recession, anyway.

2. Decrease the minimum wage below its pre-recession levels. Unemployment rates for the workforce under age 25 is staggering. Lowering the minimum wage will increase new hires in this age group.

Yeah, that'll work

In response to DebtRefer, I'm sure lowering the wages of the only subset of people still employed will cause everyone to start spending, and pull the economy out of the massive hole it's dug itself. Offshoring got us here, and the only thing that will pull us out is de-offshoring. Penalize any company who outsources, make it painful to employ illegals, and use carrots and sticks to bring back the manufacturers who have decamped. In the end, the only remedy that will cause people to begin spending again is to restore their confidence that their job won't disappear tomorrow. Until then, they will be hunkering down in the relative's basement, where they were forced to move after losing their well-paying job, and possible their house. The Dollar Store and Big Lots are good bets until that changes.

Sounds familiar.

Respond to a deep, prolonged contraction by erecting trade barriers. Where have I heard of that before?

No thanks, evodevo. Next.

Didn't do *enough*?

Has it ever occurred to you that perhaps the problem with the 4 different Keynesian stimulus bills we've had in the past few years is not that they "weren't enough", but that they were cures worse than their disease?

Keynes famously answered his critics who asked about "the long run" by saying "In the long run, we're all dead." And, true to his word, he's dead. But those of us who aren't are left with the albatross of his ideas' legacies hanging around our neck. And, for better or worse, we simply are not in a position to afford the kind of stimulus it would take to pull us from our economic funk.

We need to formulate policies which promote certainty, not ones which expand and extend uncertainty. And we've been doing a whole lot of the latter in recent times, alas.

The single best thing policymakers could be doing right now is getting our long-term spending in order. It's way out of whack and our day of reckoning is, at long last, upon us. And if Republicans are smart, they'll do their best to promote leaders like Paul Ryan, Chris Christie, and Mitch Daniels....who, more than anybody else, seem to have their hands around this existential problem.

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