Over at Econlog I have a new post pointing out that central banks have never actually explored whether the zero rate bound limits monetary policy. They don’t seem curious. I pointed out that, at a minimum, they’d first have to lower interest on reserves (IOR) so far that excess reserves fell close to zero.
Here I’d like to look at things from a different perspective—when is fiscal policy appropriate?
The place to begin is with the powers of the central bank—let’s use the Fed as an example. What are their powers? Who sets them? Are they vague, or clearly spelled out?
Policy will be more effective if each branch of government clearly understands its role. Unfortunately, we don’t live in that world. But even so, the Fed can certainly try to spell out its policy options, even if the set of options is rather complex.
As you know, I’d prefer a policy regime where fiscal stimulus was never needed, and instead the Fed bought up whatever was necessary to hit its target, even if it ended up owning the entire world. Of course we don’t live in that world, so when should fiscal policy click in?
Like everything in economics, it’s all about costs and benefits. Recall that in 2012 Fed chairman Ben Bernanke talked vaguely about various “costs and risks” of using unconventional monetary policy. In his memoir, he gives the impression that this was more a concern of the committee, rather than him personally. But nonetheless the perception of costs and risks is real, and influences policy. So let’s assume these two costs:
The marginal cost of adding $1 to the Fed balance sheet is an increasing function of the size of the balance sheet.
The cost of a cut in the IOR is negatively related to the level of IOR. The lower the interest rate, the higher the cost of an additional one basis point cut.
Fiscal policy also has costs and benefits, which increase with the size of the deficit. In my view, the lowest cost fiscal stimulus, per job created, is a payroll tax cut. This ignores possible supply-side effects of cuts in capital taxation, which is of course a highly contentious issue. Or external benefits from more infrastructure, which is also controversial.
In other words, it’s always possible to point to fiscal changes that are desirable even if no fiscal stimulus were needed. (“Now more than ever, blah blah blah . . .) Conservatives want lower MTRs and liberals want more infrastructure or social programs. But that’s sort of cheating, as those would presumably be done even if there were no need for fiscal stimulus. And if they are not done, then policymakers clearly don’t agree that they are desirable. Here I’m trying to approach the subject from a non-political angle, how to generate more AD. (And yes I know, it’s hopeless—just trying to do thought experiments)
A cut in the payroll tax on employment seems like it would give the most bang for the buck, in terms of job creation. An increase in the Earned Income Tax Credit is another possible policy aimed directly at more employment.
So let me summarize what I’ve got so far:
In an ideal world, the central bank does whatever it takes; no fiscal stimulus is called for. The costs of more monetary stimulus are near zero, and certainly lower than the costs of fiscal stimulus.
In the second best world, Congress and Fed clearly describe the powers of the Fed, and the costs of things like a big balance sheet and/or lower IOR.
In the third best world it’s all a big muddle. Congress doesn’t even know what the Fed’s powers are, and indeed barely even understands what the term ‘monetary policy’ actually means. (They probably think it means control of interest rates, not NGDP.)
In that sort of world the Fed must decide what it thinks it is entitled to do, and the costs of more aggressive monetary stimulus (bigger balance sheet, more strongly negative IOR.) Then it must weigh those costs against both the cost of high unemployment and also the cost of alternative fiscal stimulus, as well as the probability that this alternative fiscal stimulus will actually occur.
Here’s an example of the third best world (which is obviously the world we live in.) In late 2012, the Fed saw that Congress was about to sharply reduce the budget deficit (which fell by $500 billion in calendar 2013). Up until that point in time, the Fed had not done as much monetary stimulus as would normally be appropriate, because (according to Ben Bernanke) the FOMC was worried about the “costs and risks” of a larger balance sheet. They had done QE up to the point where the perceived marginal cost of an additional dollar of QE was equal to the perceived benefit in terms of lower unemployment. (I think they misjudged this, but let’s set that aside.)
Now with Congress about to do austerity, the perceived costs and risks changed. Now the 2012 Fed policy stance would be associated with more unemployment than previously expected. Still applying cost/benefit analysis, the Fed decided that more QE (and forward guidance) would be appropriate, as the risk in terms of lost employment of not acting was greater than in 2012, due to the fiscal austerity. So they did act, and indeed overreacted if you buy my model. That’s because growth actually accelerated, whereas my model predicts a tradeoff, with growth slowing, but not as much as it would have slowed with no action.
This post is rather messy because the real world is messy, so let’s conclude by trying to add some structure:
First, we need to think about what the Fed can and cannot do. In my view we need clear instructions for the Fed, but I accept that this won’t happen.
Second, if we lack instructions, the Fed must decide on its own what it can and cannot do, and how much it is able to do things like QE and negative IOR. In my view, it currently has enough power so that fiscal stimulus is not appropriate, if the powers are used wisely.
Third, the Fed doesn’t agree with me that it has enough power so that fiscal stimulus is never appropriate. However the Fed has never clearly spelled out why it disagrees with my view. For instance, Bernanke favored Bush’s spring 2008 fiscal stimulus, even though we were not at the zero bound. But he doesn’t explain why. What were the “costs and risks” of additional rate cuts, instead of fiscal stimulus? Or was this about a split within the Fed, where Bernanke couldn’t get enough support for more stimulus, and hence he wanted Congress to do the Fed’s job? Unfortunately, he doesn’t tell us, which is the weakest aspect of his recent memoir.
And finally, I understand that my view of the risks and costs of monetary stimulus is less important than the Fed’s view. I do see that if the Fed views unconventional policies (and maybe even conventional?) as involving costs and risks, then they will sometimes fail to take adequate steps to maintain appropriate NGDP growth. But it’s not really clear what this means. It would be really easy if the Fed just sort of hit a wall, a legal limit on what they could buy, and then suddenly “ran out of ammo.” In that sort of case the solution would be clear, let fiscal policy take over at that point, but not when the Fed can still cut rates. But as we saw in late 2012, we don’t live in that world either; the Fed will do more costly and risky stuff when they see the need as being greater.
So in the end the problem is too complicated for any sort of “scientific” solution. And thus we should not be surprised that people end up all over the map. Monetarists like me want more monetary stimulus. Keynesians like Christy Romer want the same, but also employer-side payroll tax cuts. Paul Krugman worries that employer-side tax cuts would be deflationary, and favors more spending on infrastructure or social programs. Supply-siders favor cuts in MTRs to boost growth from a supply-side perspective. The policy “game” being played here is far too complex for even our most advanced game theory models, and hence people will fall back on the solutions that they find the most appealing.
For me, I’m skeptical that Congress can ever do the “NGDP targeting” job adequately. In contrast, I saw signs in 1984 through 2007 that the Fed was reasonably good at the NGDP targeting, and I want to push hard for some additional modifications to overcome the zero bound problem, rather than throw up my hands and hope that Congress solves the problem next time. I see the Fed’s ability to learn from past mistakes as being far superior to Congress’s ability, at least in the realm of macroeconomic stabilization. So that’s why I focus like a laser on monetary reforms. It’s not that I don’t understand why others might find fiscal stimulus appealing—in a game this complex I can see how it might be an option. I just don’t think it’s the best option.
We are about to exit zero rates. Now more than ever we need to fix monetary policy—before the next recession. If we go into the next recession with the current monetary policy regime then the entire community of macroeconomics will have failed, and failed shamefully, to address the clear need for better options at the zero bound. The Fed needs to act NOW. I’m glad to see that the Bank of Canada understands the need for reform, and I hope the Fed also reaches this conclusion.
Most like we won’t solve the problem, and in the next recession a GOP government would do tax cuts and a Democratic government would boost spending. That’s reality. But I do predict that we will make some progress, and not be as woefully unprepared as in 2008.