David Beckworth has a post discussing when it is appropriate to use fiscal policy:
Here is how I would operationalize this policy. First, the Fed adopts a NGDP level target. Doing so would better anchor nominal spending and income expectations and therefore minimize the chance of ever entering a liquidity-trap. In other words, if the public believes the Fed will do whatever it takes to maintain a stable growth path for NGDP, then they would have no need to panic and hoard liquid assets in the first place when an adverse economic shock hits.
Second, the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.
This two-tier approach to NGDP level targeting should create a foolproof way to avoid liquidity traps. It should also reduce asset boom-bust cycles since NGDP targets avoid destablizing responses to supply shocks that often fuel swings in asset prices. This approach is consistent with Milton Friedman’s vision of monetary policy, would impose a monetary policy rule, and provide a solid long-run nominal anchor. Finally, per Cardiff Garcia’s request it would satisfy both fiscalists and monetarists. What is there not to like about it?
A curmudgeon like me always finds a few things not to like. While I certainly agree with the thrust of David’s proposal, here’s how I’d tweak it:
1. I think the first sentence of the second paragraph is slightly misleading, conflating two quite different situations. First, there is the zero bound situation. And second, there is the “Fed is out of ammo” situation. They are quite different. So I’d be inclined to say:
If rates fall to zero, and if the Fed sets IOR at negative 2%, and if the Fed buys all eligible assets, and NGDP expectations still remain below target, then go for fiscal stimulus.
I would add that eligible assets include T-securities and government-backed mortgage bonds, at a minimum. I believe that’s around $20 trillion in eligible assets. Recall that with IOR at negative 2% there are basically no ERs left in the system. So unless the public’s appetite for $100 bills is much greater than imagined (greater than $130,000 per family), I think we can safely assume the Fed will never run out of ammo. Nevertheless, if it will make the Keynesians feel better to have a backup plan. . . .
2. What if we do need fiscal policy? First of all, we won’t. ”Yes, but what if we do?” OK, OK. I’m opposed to the helicopter drop idea, for several reasons. First, it’s less effective than people think. No country has been doing more “helicopter dropping” over the past 20 years than Japan. They’ve massively boosted both their national debt and their monetary base (which is what “helicopter drops” mean to economists.) And their NGDP is lower than 20 years ago. Not good.
Second, there are much better options than helicopters drops. The fiscal authorities can overcome nominal wage stickiness by cutting the employer-side payroll tax. This may not boost NGDP, but it will boost employment for any given NGDP level. Then as NGDP recovers in the long run, the payroll tax can be raised again.
Helicopter drops must be reversed in the long run, at the cost of distortionary taxation. Better to cut distortionary taxes today.
I believe that many people exaggerate the need for using “every available option” because they wrongly believe money has been easy in recent years, and then infer it hasn’t worked. (Obviously these remarks do not apply to Beckworth.)
Yichuan Wang has an excellent new post showing that money was not easy in late 2008, at a time most people assumed it was:
The zero lower bound didn’t always bind. For three months after Lehman’s collapse on September 15, 2008, the federal funds rate stayed above zero. In this period of time, the Fed managed to provide extensive dollar swaps for foreign central banks, institute a policy of interest on excess reserves, and kick off the first round of Quantitative Easing with $700 billion dollars of agency mortgage backed securities. Finally, on December 15, 2012, the Fed decided to lower the target federal funds rate to zero.
It is important to remember the sequence of these events. It is easy to think that the downward pressure on interest rates was the inevitable consequence of financial troubles. Yet the top graphic clearly contradicts this. Each of the dotted lines represents a FOMC meeting, and each of these meetings was an opportunity for monetary policy to fight back against the collapsing economy. The Fed’s sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in late 2007. As, the decision to wait three months to lower interest rates to zero was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history. The chaos in the markets did not cause monetary policy to lose control. Rather, the Fed’s own monetary policy errors forced it up against the zero lower bound.
Read the whole thing.
HT: Paul and Marcos