end the fed('s dithering)

8/2/2019 End the Fed('s Dithering)

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End the Fed(s Dithering) Word count: 1497

Of the few things which macroeconomists can agree on these days, the one ideathat at least has some acceptance is that the recent recession was the result of a decline inaggregate demand. Macroeconomic theory dictates that in the event of a decline inaggregate demand, there are two channels through which the government can restoreaggregate demand and initiate a recovery: fiscal stimulus, conducted by the federalgovernment through various purchases and transfers, and monetary stimulus, conductedby the central bank primarily through open market operations and occasionally throughother monetary transmission mechanisms. The disappointing pace at which the recoveryhas proceeded has left policymakers with little breathing space; they are now underimmense pressure to find an immediate solution to their economic malaise. However,both stimulus options are loaded with hazards that could exacerbate current economicrisks. Governments have been fighting with the very real issue concerning the size oftheir deficits and their level of debt. Central banks have focused on avoiding the mistakesof the past, like when they had let inflation get too high, let prices fluctuate too much, lettheir credibility decline, or let the financial sector collapse into a heap. Central banks arefurther restricted of course by the dreaded zero bound, meaning that they cannot lowernominal interest rates any further. Finding a solution that is sufficient in scale to bring theeconomy back to full employment while minimizing the threat from these risks may seemlike an impossible task.

I believe however that acceptable solutions exist, and that if central banks (inparticular the Federal Reserve, but also the Bank of Japan and European Central Bank)would adopt decision making processes that focused less on avoiding specific risks, andmore on fulfilling their role as custodian of the economy, the economy would return tonormal at a much faster pace. It is possible, and indeed desirable, to use monetarystimulus to spark an economic recovery.

There are still plenty of stimulus options available to the central bank, in spite ofthe zero bound. This is not a purely academic argument; even Federal Reserve ChairmanBen Bernanke believes this, arguing as recently as January of 2012 that I would notsay that were out of ammunition. No, I think we still have tools, but we need to furtheranalyze and study those tools and try to make comparisons in terms of effectiveness, risks,and the like. [1] Both academic literature and empirical evidence exist that show thatmonetary policy can be effective at the zero bound. The menu of policies that the centralbank can consider at the lower bound include currency depreciation, zero (or negative)interest rates on bank reserves, debt market operations, communication of inflation oroutput gap targets, targeted asset purchases, quantitative easing, and more [2][3][4][5], all

of which remain effective at the zero bound because they allow the central bank tocredibly influence expectations, the key transmission mechanism for monetary policy atthe lower bound [6][7]. It is up for debate as to what the optimal selection should be, butgiven that institutions like the Federal Reserve are entrusted with the dual mandate ofprice stability and full employment, it would do well to consider some of these policies.

Monetary stimulus therefore remains a possible solution to todays economicissues, in spite of the zero bound. Even so, the public discourse today is dominated by the


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debate over fiscal stimulus, and whether governments can and should do more to restorethe economies of the USA and Europe. This debate however ignores the notion thatcentral banks, not government, predominantly determine the direction and pathway ofeconomic growth, thus implying that monetary stimulus from the central bank can be farmore effective in returning the economy to trend than fiscal stimulus.

The debate over the effectiveness of fiscal stimulus focuses mainly on the fiscalmultiplier, defined as the increase in GDP from a $1 increase in government spending.Fiscal stimulus proponents argue that the fiscal multiplier is above one [8], suggestingthat there is a positive return to fiscal stimulus, while fiscal stimulus critics believe that isless than one (or even zero) [9], suggesting that the return on additional governmentspending is little to none. Empirical evidence shows that the size of the fiscal multiplier isactually dependent on the monetary regime. When the central bank is restricted, like it isfor countries with pegged exchange rates, then the fiscal multiplier is high. When thecentral bank is not restricted, then the fiscal multiplier is small because monetary policybecomes much more accommodative [10]. That is, the central bank factors in the effectsof fiscal stimulus, then dampens its effect by adjusting monetary policy accordingly. Thiswould imply that attempts at fiscal stimulus would be made ineffective by the centralbank, and that successful stimulus can only be driven by a central bank that chooses toadopt a looser monetary policy.

There is an argument that at the zero bound the central bank is restricted,suggesting that fiscal stimulus could be effective [11]. We know however that the centralbank still has other options that it can pursue, and that the zero bound is not a hardrestriction on monetary policy [12]. Monetary stimulus would also allow governments toallay fears of rising debt and deficits, concerns over distributional fairness and equity,and worries of a lack of oversight and accountability from Congress, all issues whichwould have to be addressed with a fiscal stimulus package. Any policymaker would have

to give serious consideration to how much more effective monetary policy can be thanfiscal policy. It is worth noting that most of Europes problems stem from their sharedcurrency, a monetary constraint, rather than fiscal profligacy [13][14]. One cannot helpbut wonder if the monetary solution of allowing the Eurozone to break up and allow eachcountry to issue their own currency would be much simpler than implementing any sortof fiscal solution.

Of course, monetary stimulus is not risk free. That being said, it is hard to arguethat the risks to additional monetary stimulus will vastly outweigh its benefits. The mainfears are that it would create too much inflation, that overly easy monetary policy willresult in another asset bubble similar to the housing bubble prior to this crisis, and that

central banks do not have the credibility to convince the public that they can stimulate theeconomy, thereby shorting the key transmission mechanism of expectations managementfor most zero bound policies. Yet, even with these risks in consideration, additionalmonetary stimulus still seems beneficial overall for the economy. Fears of inflation orhyperinflation have not materialized in the last few years in spite of low interest rates[15], and furthermore it is difficult to argue that an inflation rate of 2% and highunemployment is preferable to 4% inflation and falling unemployment. Fears of anotherasset bubble may be valid concerns, but the link between easy monetary policy and asset


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bubbles is not clear. Period of easy money (like the 1960s) did not see housing or stockbubbles, yet periods of exceptionally tight money (1920s, 1980s) did see bubbles [16].This does not mean easy money cannot contribute to a bubble, but direct causation is notimminently obvious. The risk of eroding credibility or confidence in the central bank mayor may not be real; academic evidence does not lend itself to any theory on this issue [17].

The only solace here is that the reactions to recent central bank announcements indicatethat they are still considered credible [18]. Given that these risks seem minimal, moremonetary stimulus would arguably be beneficial.

There is good reason to be pessimistic about the chances of the Federal Reserve,the Bank of Japan or even the European Central Bank actually announcing a monetarystimulus package any time soon. The decision-making processes of these institutionsplace too much weight on avoiding risk, rather than weighing costs over benefits. Boththe Bank of Japan and the European Central Bank have raised interest rates, only to beforced to turn back on their decisions because of the resulting economic misfortune. Thatboth institutions made this exact mistake twice in the last decade on two separateoccasions indicates a problem with each institutions internal processes [19]. The FederalReserve is not guiltless either; their most recent economic estimates suggest that in 2014we will see higher than trend unemployment and lower than trend inflation [20], yet themove for additional stimulus has been cautious thus far. Existing economic models mayalso not provide central banks with enough information to implement the mostappropriate policy. One wonders, for example, if we would have seen larger stimulusefforts over the last three years if initial economic forecasts had estimated the severity ofthe downturn more accurately [21]. Governments and central banks should at least fortifyexisting tools, if not consider new models, analyses, and decision-making processes, inorder to institute more effective monetary policy. This would dramatically increase thechances of monetary stimulus, both now and for future recessions.

References

[1] Federal Reserve. Transcript of Chairman Bernankes Press Conference.http://www.federalreserve.gov. Federal Reserve, 25 Jan. 2012. Web.http://1.usa.gov/wihXN5.

[2] Bernanke, B. ; Reinhart, V ; Sack, B; Monetary Policy Alternatives at the ZeroBound: An Empirical Assessment, Brookings Papers on Economic Activity 2004:2, pp.1-78.

[3] Svensson, Lars. Monetary policy and Real Stabilization in Rethinking Stabilization

Policy, 261312. Kansas City: Federal Reserve Bank of Kansas City. 2002.

[4] Congdon, T. Monetary policy at the zero bound World Economics, January, Vol 11,No 1, pp 1146. 2010.

[5] Boman, D. ; Gagnon, E. ; Leahy, M. Interest on Excess Reserves as a MonetaryPolicy Instrument: The Experience of Foreign Central Banks. Federal Reserve Board,International Financial Discussion Paper 996. 2010. http://1.usa.gov/yvc57V
http://1.usa.gov/wihXN5http://1.usa.gov/wihXN5http://1.usa.gov/wihXN5


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[6] Friedman, B. ; Svensson, L. [Monetary Policy Alternatives at the Zero Bound: AnEmpirical Assessment] Comments and Discussion Brookings Papers on EconomicActivity , Vol. 2004, No. 2 (2004), pp. 79-100

[7] Eggertsson, G. ; Woodford, M. The Zero Bound on Interest Rates and OptimalMonetary Policy. Brookings Papers on Economic Activity, 2003(1), 139233. 2003

[8] Romer, C. ; Bernstein, J. The job impact of the American recovery and reinvestmentplan, Council of Economic Advisers. January 2009.

[9] Aspects of the Sunset of EGTRAA and JGTRAA, United States Senate, Committeeon Finance Cong. (2010) (testimony of Douglas Holtz-Eakin). Web.http://1.usa.gov/wCmHZe

[10] Ilzetzki, E., Mendoza, E.; Vegh. How Big (Small?) are Fiscal Multipliers?, NBERWorking Paper No. 16479. 2010.

[11] Christiano, L. ; Eichenbaum, M. ; Rebelo, S. When is the Government SpendingMultiplier Large?, Journal of Political Economy, 119, 78121. 2011

[12] Svensson, L. "Monetary Policy and Financial Markets at the Effective LowerBound," Journal of Money, Credit, and Banking 42 (Supplement): 229- 242. 2010.

[13] Mansori, K. What Really Caused the Eurozone Crisis? (Part 1), The Street Light.September, 2012. Web.http://bit.ly/zLletK

[14] Eichengreen, B. European Monetary Integration with Benefit of Hindsight, Journalof Common Market Studies 50 (S1): 123-136. 2010.

[15] Economics by Invitation, Is inflation or deflation a greater threat to the world

economy? The Economist, June 2010, Web.http://econ.st/y4YvNu

[16] Sumner, S. Tight Money causes bubbles. TheMoneyIllusion. January, 2010. Web.http://bit.ly/yHxFWF

[17] Blinder, A. S. et al. Central Bank Communication and Monetary Policy: A Surveyof Theory and Evidence, Journal of Economic Literature, 46 (4), 91045. 2008.

[18] "Swiss Franc: Is The Peg Working? Planet Money : NPR" NPR : National PublicRadio. Web. 19 Feb. 2012.http://n.pr/x80MjN

[19] Sumner, S. "What We Can Learn from the Trichet Debacle?" TheMoneyIllusion.Web. 19 Feb. 2012.http://bit.ly/x4QHaP

[20] "January 25, 2012 Projection Materials." Board of Governors of the Federal ReserveSystem. Web. 19 Feb. 2012.http://1.usa.gov/A6g4N1

[21] CBO's Economic Forecasting Record: 2010 Update. United States Congressional
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Budget Office. 2010. Web.http://1.usa.gov/x66qAn
http://1.usa.gov/x66qAnhttp://1.usa.gov/x66qAnhttp://1.usa.gov/x66qAnhttp://1.usa.gov/x66qAn

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