October 9, 2011

FIX THE USURY, FIX THE PROBLEM:

Deleveraging and monetary policy (Matt Rognlie, 10/04/11)

[Y]es, deleveraging can be very bad for the economy. But this is only because monetary policy doesn't adjust enough to match the market.

In failing to understand this core logic, most commentary about "deleveraging" is rather bizarre. At some level, it's the same cluelessness that we once saw from central planners: they'd trip over themselves in the complexity of fixing a shortage in one market or a glut in another, never quite realizing that the price mechanism would do their work for them. Right now, historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That's what every macro model tells us is associated with contractionary policy by the Fed. Yet we see pundits lost in all kinds of complicated, small-bore proposals to stimulate the economy--when the fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.

This isn't to say that non-monetary proposals should be abandoned entirely. Monetary policy doesn't stop working at the zero lower bound, but it is a lot harder. Even an ideal Fed would probably find itself constrained. This means that we should be open to other policies that affect demand--possibly via government spending, transfers, or tax incentives. But once we recognize that the fundamental problem is monetary, the issues become much clearer.

Posted by at October 9, 2011 8:29 AM
  

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