The dangerous game of monetary policy primacy


There is a growing trend, particularly among US economic commentators and bloggers, to stress the importance of the policy choices facing central bankers. While monetary policymakers will undoubtedly be crucial in achieving and sustaining an economic recovery, ignoring the impact of fiscal policy choices on fear-driven economies is wrongheaded.

Of course, many will argue that it was ever thus. Writing on the CrookedTimber blog, John Quiggin explains (emphasis mine):

“Clearly there was a consensus as of early 2008. The differences between “saltwater” (former New Keynesian) and “freshwater” (former New Classical/Real Business Cycle) economists had blurred to the point of invisibility. Everyone agreed that the core business of macroeconomic management should be handled by central banks using interest rate adjustments to meet inflation targets. In the background, central banks were assumed to use a Taylor rule to keep both inflation rates and the growth rate of output near their target levels. There was no role for active fiscal policy such as stimulus to counter recessions, but it was generally assumed that, with stable policy settings, fiscal policy would have some automatic stabilizing effects (for example, by paying out more in unemployment insurance, and taking less in taxes, during recessions)… This broad consensus was destroyed by the Global Financial Crisis and the Great Recession, but it wasn’t replaced by anything resembling a real debate.”[1]

That is to say mainstream economic models assumed that the role of fiscal policy during a recession was to act as a stabilising force as increased spending on social welfare acted to mitigate falling economic activity. Monetary policymakers could then use their interest rate levers to lower borrowing costs, push interest down on savings (decreasing the incentive to hoard capital) and improve growth expectations.

As Quiggin suggests, however, these traditional policy channels proved insufficient to cope with the impact of the Global Financial Crisis and its aftermath. Instead a combination of massive fiscal stimulus alongside a range of new monetary policy tools, including large-scale central bank asset purchases and looser inflation targets, were brought in to counter systemic threats to the financial system.

Whether these new tools have proven successful is the subject of much debate. What is increasingly apparent though is that subsequently central bankers have proven far more responsive to changing circumstances than politicians on both sides of the Atlantic.

Given the political gridlock in America and austerian fervour across the European Union it is understandable that focus has been driven towards areas where meaningful policy decisions can still be achieved (i.e. the Federal Reserve and the Bank of England). Yet while central bank policy loosening (even the unorthodox variety) undoubtedly has an impact, it is being diluted by the threat of fiscal tightening hanging over developed economies.

This point could prove crucial. If the West is facing a period of persistent demand weakness with current output significantly below potential (see Roger Bootle[2] and Gavyn Davies[3]) then the private sector has little reason to invest in trying to grow their businesses, and a large incentive to hoard capital. Indeed this is what we have seen.

Slate’s Matthew Yglesias says that the best way in which to shake these reserves loose is through leaning on monetary policy measures. He writes (emphasis mine):

“That's why a real strategy for bringing corporate cash off the sidelines doesn't have anything to do with tax reform (though tax reform might be nice), it has to do with monetary policy. Specifically an NGDP targeting strategy or an "Evans Rule" strategy would work on both of these dimensions. That's because both the Evans Rule or a reasonable NGDP target amount to a promise that either real growth will be faster-than-expected or else inflation will be faster-than-expected or else both. That doesn't give you "certainty" about the future, but it gives you a rational basis for shifting assets at the margin out of low-yield high-liquidity strategies and into more aggressive ones. That more aggressive business investment posture should, in turn, produce both more real output and somewhat higher prices thus creating a credible virtuous circle.”[4]

I think Yglesias is missing something here. I agree with him that profitable firms must decide what to do with their excess cash. Yet when faced with existential threats, such as a eurozone collapse, or the prospect of wilful demand destruction carried out by governments they have good reason to seek insurance in “safe assets” like sovereign debt rather than put capital at risk.

Looked at another way the US debt ceiling debate – much as the fiscal cliff debate before it – is not really about a threat of sovereign default but about the future of fiscal policy. If the Republicans succeed in exacting harsh spending cuts then the country could quickly find itself in a similar position to the UK – with a government wedded to both upfront cuts to spending (including slashing investment) and reducing countercyclical benefit payments.

You need only look at Britain’s recent economic performance to illustrate just how successful those policies have been.

That Obama appears sympathetic to the argument that his administration needs to rein in spending[5] should be a concern. As Jonathan Portes, director of the National Institute of Economic and Social Research, has suggested[6] the danger with this type of thinking is that it risks self-fulfilling pessimism even as debt markets are effectively paying governments to borrow.

I would not argue against the point that there are a number of necessary reforms to put both Britain and the US onto sustainable fiscal trajectories, including dealing with contentious issues such as healthcare and pensions. But lumping these in with short-term efforts to reduce the deficit, as the Coalition is doing and as the GOP are threatening, looks increasingly counterproductive.

Denying the need for fiscal and monetary policy coordination simply because the political classes have become dysfunctional rather lets politicians (and their economic advisers) off the hook. We should instead be vocal in pointing out their folly in the hope, if not the expectation, that they will realise there is still time to change course.


[1] http://crookedtimber.org/2013/01/01/the-failed-state-of-macroeconomics/
[2] http://www.telegraph.co.uk/finance/comment/9701668/OBRs-supply-pessimism-could-be-the-ruin-of-this-government.html
[3] http://blogs.ft.com/gavyndavies/2013/01/13/how-much-spare-capacity-does-the-world-have-left/
[4] http://www.slate.com/blogs/moneybox/2012/12/11/cash_on_the_sidelines_has_nothing_to_do_with_uncertainty.html
[5] http://www.washingtonpost.com/blogs/wonkblog/wp/2013/01/14/obama-wants-1-5-trillion-in-deficit-reduction-what-about-the-gop/
[6] http://www.publications.parliament.uk/pa/cm201012/cmselect/cmtreasy/uc1691-i/uc169101.htm

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