Good monetary policy means never having to worry about fiscal policy.

In today’s interview Ben Bernanke denied that Fed policy was enabling a reckless fiscal policy.  He noted that the Fed’s mandate related to inflation and jobs, not telling Congress what to do with fiscal policy.  He pointed out that a tighter monetary policy would make the deficit larger, and even more difficult to address.

I’ve always had a lot of sympathy for that argument.  But a recent post by Andy Harless suggests that the same argument can be turned against the Fed:

If the US goes off the fiscal cliff – that is, if tax increases and spending cuts go into effect in 2013 as currently scheduled – can monetary policy actions offset the macroeconomic impact?  Ben Bernanke doesn’t think so – indeed he’s certain they can’t – and he has said as much.

But on some level he must be wrong.  True, it’s hard to think of any feasible monetary policy action that would both be strong enough and have a sufficiently quick impact to offset the fiscal cliff directly.  But what matters more for monetary policy is not the direct effect but the effect on expectations.  Surely the Fed could alter expectations of future monetary policy in such a way that the resulting increase in private spending would be enough to offset the decreased spending due to fiscal tightening.  Just think, for example, if the Fed were to increase its long-run inflation target.  .  .  .

One way to implement the long-run inflation target would be as follows.  First, estimate the economy’s potential output path that was, as of 2007, consistent with maximum employment.  Then add to this a 2% inflation path starting from the 2007 price level.  Express the result as a target path for nominal GDP, and project that path into the future at the estimated future growth rate of potential output plus 2%.  Pursue this path as a level path target.

Because nominal GDP has fallen so far below the path that would, in 2007, have been consistent with 2% inflation at estimated potential output, this approach implies a very dramatic period of catch-up.  Essentially, the Fed would be committing to follow a very aggressive pro-growth, pro-inflation policy over the medium run as soon as it is able to get some traction on the economy.  But it would be doing so in a way that is consistent with its 2% long-run inflation target.  .  .  .

If Ben Bernanke were contemplating anything like what I am suggesting, he clearly wouldn’t be justified in being certain of his inability to offset the fiscal cliff.

OK, this isn’t going to happen either.  At least it’s highly unlikely.  Ben Bernanke isn’t going to have his “Volcker moment,” as Christina Romer called it, just in time to offset a huge tightening in fiscal policy.  And, with any luck, the tightening in fiscal policy won’t be as huge as current law prescribes:  after the election, hopefully, either one party will be in power, or Democrats and Republicans will be able to come to enough of an agreement to prevent disaster.

But the sad thing is that preventing disaster almost certainly means putting the US back on an unsustainable fiscal path – because there’s very little chance that Congress will be able to agree on a credible long-run fiscal plan at the same time that it agrees on a way to avoid going over the cliff in the short run.  Assuming that we do go over the cliff and that the Fed doesn’t offset the impact, the long-run fiscal results may not be much better, because the growth impact of the fiscal shock – allowing for hysteresis effects – will undo at least part of the improvement in the budget.  For those whose primary concern is fiscal sustainability, the best-case scenario would be that we do go over the cliff and that the Fed acts aggressively to offset the macroeconomic impact.

Again, it isn’t going to happen.  And that’s kind of sad.  The Fed’s timidity is creating a situation where the only realistic choices – for the moment anyhow – are economic disaster and fiscal irresponsibility.  Doesn’t that mean that the Fed bears some responsibility for the fiscal problems that are eventually likely to emerge?

That’s right.  And I think this also helps explain (to my critics) why I tend to favor a more stimulative monetary policy.  If I didn’t think monetary policy was excessively contractionary, then I’d have absolutely no concern about the fiscal cliff.  I’d simply assume the Fed would cut rates to offset the impact.  This was Paul Krugman’s assumption when he called for the Bush administration to tighten fiscal policy.  And Krugman was right.

But I do have concern about the fiscal cliff (and the slowdown in growth in other countries.)  The fact that I am concerned, whereas during 1983-2007 I never once had this sort of concern, tells me that I instinctively worry that money is still too tight.  My hunch is that most other economists also worry that the fiscal cliff might lead to a double dip recession, which I take as meaning that they think NGDP growth is too slow.

Under current Fed policy we have an NGDP growth track that is not considered strong enough to prevent a recession if we got hit by a severe adverse shock.  That means we are on the wrong track.  And because the Fed is too tight, fiscal deficits are too large.  Stop asking if the Fed is enabling an excessively stimulative fiscal policy by being too easy, and start asking whether the Fed is forcing Congress to run up excessive deficits because NGDP isn’t growing fast enough.  And if they are, doesn’t that mean money is too tight?

PS.  Matt O’Brien has an excellent piece  on Bernanke in The Atlantic



14 Responses to “Good monetary policy means never having to worry about fiscal policy.”

  1. Gravatar of Gregor Bush Gregor Bush
    2. October 2012 at 05:50


    Do you think it’s unhelpful that central banks (the Fed, ECB, BoJ, BoC) go out of their way to insist that they won’t ever monetize the federal debt no matter what? If I were Bernanke and I was asked this question, I would respond that it depends on macroeconomic conditions, that the Fed will use all its available to ensure that AD is on track to meet the Feds objectives and that debt monetization is one of those tools. I would add the caveat that current conditions don’t warrant use of this tool and that we don’t expect to have to use it but that we would consider it if our forecast of AD continued to fall short of our goal. And if I were the BoJ trying to demonstrate that I was serious about getting 2% inflation over the medium term I would certainly strongly hint that outright debt monetization would be likely unless AD picked up rapidly.

    It is, after all, the ultimate weapon. Whenever somebody makes the argument that monetary policy is powerless to affect real output and prices (AD) because of the “liquidity trap”, one need only point to the possibility of debt monetization to demonstrate why this is nonsense. So why take it off the table?

  2. Gravatar of Morgan Warstler Morgan Warstler
    2. October 2012 at 05:53

    “hey everybody, let’s stare into my belly button!”

    “keep staring!”

    – Scott Sumner


    The game I invented that no one wanted to play was prescient:

    1. You are Ben, you only get one bite at more QE before election.

    2. When do you drop it if you are trying to get Obama elected?


    We should have consumption taxes to encourage savers!

    We should print money to screw savers and help debtors!


    A FUNDAMENTAL PART of capitalism is the music stops, the tide goes out, and the losers get CRUSHED, and have to sell out their positions for pennies on the dollar. to the winners who held back WAITING for this moment.

    Scott cannot remove this part of capitalism, and in 4 years of him blogging, you can’t find ANYTHING he has written to suggest he accepts this as a fact.

    If he doesn’t accept it, he is not a capitalist.


    And finally, the thing Scott will not answer EVER:

    1. If NGDPLT is so great why doesn’t it work with no catch up?

    2. If it DOES work with no catch up, why won’t Scott explain how?

    Lars is now out there with the subject matter, why won’t Scott get into it?

  3. Gravatar of Saturos Saturos
    2. October 2012 at 07:00

    Hooray for the land down under!

  4. Gravatar of Saturos Saturos
    2. October 2012 at 07:21

    Gregor, there is a good point here. There are other “ultimate weapons” such as forex depreciation and currency reform, but what all these techniques have in common is that they are very unconventional. As Reinhart puts it in the Laurence Ball paper,

    He presents a list of policies that include two that Bernanke previously advocated: currency depreciation and money-financed tax cuts. The list also includes increased discount-window lending, purchases of corporate debt and equity, and reductions in reserve requirements. Lumping all these options together, Reinhart dismisses them:

    You can see why I put this list last. These options would change how we are viewed in financial markets, involve credit judgments of a form we are not used to, perhaps smack of desperation, and pull us into a tighter relationship with other parts of government.

    So it seems this was the speech that made Bernanke change his views about the desirability of very unconventional policy. Since then he adopted the position that such measures would only be adopted to fight outright deflation, not otherwise.

  5. Gravatar of Saturos Saturos
    2. October 2012 at 07:22

    Morgan, what the hell?

  6. Gravatar of Saturos Saturos
    2. October 2012 at 07:22

    forex devaluation, I meant.

  7. Gravatar of Larry Larry
    2. October 2012 at 07:29

    How will the Fed respond if we do head over the cliff? Will BB acknowledge/claim that monetary policy could even partially offset the contraction?

    The accounts of QE3 credit him with extended discussions that eventually brought along (most of) the hawks. I.e., he wasn’t particularly waiting on anything accept their support.

    If QE3 is enough to increase growth in the next couple of months, even with the prospect of the cliff, will that buy him support for bigger action once we’re in free fall?

  8. Gravatar of ChargerCarl ChargerCarl
    2. October 2012 at 09:04

    “Morgan, what the hell?”

    -My response to every Morgan post ever

  9. Gravatar of mpowell mpowell
    2. October 2012 at 09:08

    The problem in the linked post is the assumption that there is such a thing as a credible long term fiscal path. The entire concept is a steaming pile of bullshit in the current political environment because the Republicans certainly won’t keep any promises. If you need to cut SS benefits in the future, just do it. It would be nicer to move to chained CPI today, but it’s not going to make that much difference and if you move to chained CPI that opens the risk that the Republicans will just cut taxes more today or in the near future. You can’t keep them out of office indefinitely.

    The only thing that really matters for the long term is stuff like the cost control reforms in the ACA (and healthy economic growth of course). It takes time to find a price path that actually makes sense since the appropriate level of cuts or price growth restraint is certainly not uniform. It would be a lot harder to just cut medicare reimbursement rates by a large amount in 2020 than it would be to increase taxes or cut SS benefits. The best policy under the circumstances is just to not worry about fiscal balance until such time as it is actually needed.

  10. Gravatar of Morgan Warstler Morgan Warstler
    2. October 2012 at 10:44

    Charger, you are invited tot he same $10 Applebee’s gift certificate!

    Just show where Scott has answered this:

    1. If NGDPLT is so great why doesn’t it work with no catch up?

    2. If it DOES work with no catch up, why won’t Scott explain how?

  11. Gravatar of ssumner ssumner
    2. October 2012 at 10:58

    Gregor, You asked:

    “Do you think it’s unhelpful that central banks (the Fed, ECB, BoJ, BoC) go out of their way to insist that they won’t ever monetize the federal debt no matter what?”

    The Fed should do as it’s told. It’s currently being told to stabilize prices and employment, so it should do so. If Congress later tells it to monetize the debt, it should do so.


  12. Gravatar of Morgan Warstler Morgan Warstler
    2. October 2012 at 11:22

    Scott, you’ve read about the formation of the fed, right?

    Where exactly do you think the assumption of Fed independence comes from?

  13. Gravatar of PrometheeFeu PrometheeFeu
    2. October 2012 at 14:02

    If they go off the fiscal cliff, I want to see Ben Bernanke in a Peter Pan outfit dropping bills out of helicopters. (I’m assuming the Fed can buy a Peter Pan outfit within hours) For real. If you are right (and I think you are) problem is solved. If not, we all get one last good laugh.

  14. Gravatar of Major_Freedom Major_Freedom
    3. October 2012 at 07:38

    Stop asking if the Fed is enabling an excessively stimulative fiscal policy by being too easy, and start asking whether the Fed is forcing Congress to run up excessive deficits because NGDP isn’t growing fast enough.

    While there are many factors that may encourage the Treasury to borrow and spend more, the Treasury couldn’t actually do this if interest rates on government debt were higher such that interest expense took up too much of the fiscal budget.

    When I look at this chart of federal debt:

    I see a spectacular acceleration starting around 2001, and continuing to this day. According to Sumner, I should ask whether the Fed is forcing the Treasury to run up this large debt because NGDP isn’t growing fast enough. OK, I asked that question, and my answer is no, because I would have to believe that NGDP hasn’t been growing fast enough all the way back since 2001, which presumably implies that if the Fed put NGDP higher (by being more inflationary, by buying more federal debt, thus putting even more upward pressure on treasury prices and hence putting more downward pressure on interest rates), that the Treasury wouldn’t have borrowed as much.

    As an analogy, it would be like saying you borrow and spend more when your income falls and the cost of borrowing does not fall, not when your costs of borrowing falls and your income remains the same.

    It is much more likely that borrowing skyrocketed starting in 2001 in order to pay for the middle east invasion, and the Fed obliged by lowering rates.

    If I instead asked the question whether or not the Fed is enabling government debt expansion by being too easy (defined for our purpose here as lowering interest rate costs on government debt), then my answer is that this is a necessary condition for borrowing and spending more, because if interest costs didn’t fall, then it would take up a larger and larger portion of the federal budget, such that the Treasury simply couldn’t afford to borrow more at such a high pace. The bond vigilantes would have put pressure on the Treasury without the Fed there to buy the debt.

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