POLITICS NOVEMBER 3, 2011
Both the left and the right have been consistently peddling the wrong prescriptions for our economy. Most liberals are focused on the need for additional fiscal stimulus, and dead-set against any premature moves toward what they consider “austerity.” Spending cuts, they say, would weaken the economy. Most conservatives are equally insistent that spending cuts need to begin now—and claim that by reducing expectations of future tax increases these cuts would help the economy. At the same time, they consider monetary policy dangerously inflationary and want the Federal Reserve to tighten it, or at least not loosen it any further.
Both sides are mistaken: the right on monetary policy, the left on budget policy, both on the relationship between them. What the economy needs now, contrary to the right, is a permanent monetary expansion. If the Federal Reserve delivers one, the economy, contrary to the left, won’t need new federal spending—and won’t suffer from spending cuts.
There is a bipartisan misunderstanding in Washington about the important role of the Fed in creating the sharpest recession since the Great Depression. For the 25 years leading up to our current mess—the period economists have come to call “the great moderation”—the Fed did a pretty good job of stabilizing the economy. The result of its monetary policies was that the economy, measured in current-dollar or “nominal” terms, grew at about 5 percent a year, with inflation accounting for 2 percent of the increase and real economic growth 3 percent. Keeping nominal spending and nominal income on a predictable path is important for two reasons. First, most debts, such as mortgages, are contracted in nominal terms, so an unexpected slowdown in nominal income growth increases their burden. Also, the difficulty of adjusting nominal prices makes the business cycle more severe. If workers resist nominal wage cuts during a deflation, for example, mass unemployment results.
During the great moderation, people began to expect spending and incomes to grow at a stable rate and made borrowing decisions based on it. But maintaining this stability requires the Fed to increase the money supply whenever the demand for money balances—people’s preference for cash over other assets—increases. This happened in 2008 when, as a result of the recession and the financial crisis, fearful Americans began to hold their cash. The Federal Reserve, first worried about increased commodity prices as a harbinger of inflation and then focused on saving the financial system, failed to increase the money supply enough to offset this shift in demand and allowed nominal spending to fall through mid-2009.
That drop in nominal spending was the most severe decline since 1938. Since then, none of the Fed’s much-debated moves toward monetary ease have brought nominal spending back to where it would have been had the expected 5 percent growth been maintained all along. Consequently, incomes are lower, debt burdens are higher, and banks are weaker than they should be.
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: the main effect of any current fiscal stimulus is not to expand the economy but to shift economic activity around (and especially to shift it from the private to the public sector). Spending may have an economic payoff if it raises the nation’s productive capacity, but it won’t increase total economic activity in the near term because monetary policy, given the Fed’s predilections, will adjust in response to the stimulus.
Most conservatives, for their part, believe the Fed has done too much already. They look at the growth of the Fed’s balance sheet and see a troubling surge in the amount of dollars. What they don’t see is that the demand for money balances has surged even more, and that the Fed has failed to adequately respond to it. Nor are low interest rates a sign of loose money, as many people believe. As Milton Friedman pointed out in the case of late-1990s Japan, low interest rates can result from a tight-money policy that weakens the economy and reduces the expected returns on investments.
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. Each element supports the other. For example, higher nominal incomes will put a lot of homeowners above water again, ending calls for federal intervention. Fiscal stimulus, meanwhile, will not achieve its macroeconomic goals if the Fed remains committed to fighting a non-existent inflation threat and is unnecessary if it adopts a better course. Fiscal stimulus leaves us deeper in debt; monetary expansion reduces the debt burden. It’s a pity that nobody in Washington is advocating the right policy mix.
David Beckworth is an assistant professor of economics at Texas State University. Ramesh Ponnuru is a senior editor at National Review and columnist for Bloomberg View.