November 4, 2011


Tight Budgets, Loose Money: Why Both Liberals and Conservatives Are Wrong About How to Fix the Economy (David Beckworth and Ramesh Ponnuru, November 3, 2011, New Republic)

Many liberals believe that the Fed is now "out of ammunition" since interest rates cannot be lowered further. Ron Suskind's recent book Confidence Men reports that President Obama, for example, told economic adviser Christina Romer that the Fed had "shot its wad." But as Federal Reserve Chairman Ben Bernanke noted in an analysis of Japan in 1999, the Fed can expand the money supply even when interest rates are very low.

For example, the mere announcement that the Fed will buy assets until nominal spending hits a target could raise expectations for nominal-spending growth. If debtors expect higher nominal income as a result, they will devote fewer resources to deleveraging. If investors expect higher nominal spending, they will rebalance their portfolios away from cash and toward higher-yield assets such as stocks, bidding prices up. Higher asset values then lead to increases in spending on both consumption and investment. The more aggressive the Fed's announcement, in fact, the fewer assets it will likely have to actually buy.

The Fed has refused to take such steps largely because it fears that a dangerous level of inflation would result. That's a foolish fear: Inflation has been low for the last few years, and the market for inflation-indexed bonds suggests that investors expect low inflation for years to come.

But the Fed's fear has an implication that liberals overlook. It means that the current "multiplier" from fiscal stimulus--the amount of extra economic activity new deficit spending will generate--is zero at most. That's because the more fiscal stimulus Congress provides, the less monetary easing the Fed feels inclined to offer. Liberals feel they are compensating for the Fed's lack of action, but they are really just encouraging it... [...]

This tight money works against conservatives' fiscal goals. It increases the deficit both by suppressing revenues and by triggering automatic spending on such programs as unemployment insurance. It also creates political pressure for new discretionary spending to help the economy. Both of the last century's most pronounced periods of monetary tightness--during the Depression, and during 2008-9--also saw substantial growth in the federal government.

Conservatives have countered liberal fiscal views by pointing to studies suggesting that other countries have cut their budgets while enjoying economic rebounds. But almost all of these success stories featured the accommodative monetary policy that today's conservatives oppose. This was true of the much-celebrated case of Canada's fiscal retrenchment in the latter half of the 1990s, and of the emergence of the budget surplus in the U.S. in the same period.

The conservative worry that monetary ease will get out of hand is also overwrought. For one thing, we now have better market indicators of future inflation than we had during the great inflation of the 1960s and 1970s. More important, monetary ease that takes the form of a nominal-spending target would constrain future inflation. The Fed should commit to return to the nominal-spending trendline of the Great Moderation, which requires both a few years of faster-than-5-percent catch-up growth now and then a slowdown to the normal rate.

What the moment calls for, then, is temporarily looser monetary policy to respond to the short-term challenges of the weak economy combined with spending cuts to solve the long-term budget crisis. 

Posted by at November 4, 2011 5:54 AM

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