Monday, August 30, 2010

What Next for Monetary and Fiscal Policy?

It is now pretty obvious that government policymakers are in a quandary. The economy is not growing the way they had hoped; criticism abounds as does confusion; and usable policy instruments are in short supply. Alan Blinder, a former vice chairman of the Federal Reserve Board, wrote an interesting op-ed for the August 26 Wall Street Journal on the dwindling options the Fed has to deal with the current situation ("The Fed is Running Low on Ammo", subscription required). He states that there are four additional measures available to the Fed.

  1. The Fed could adopt a quantitative easing policy of buying private securities rather than Treasuries. 
  2. The FOMC could change its wording to say that its commitment to a near-zero fed funds rate is even longer than the "an extended period," as it now says.
  3. The Fed could lower the interest rate the Fed pays on bank reserves. It is currently set at 25 basis points.  Blinder suggest that it could be lowered to below zero -- a minus 25 basis points, in order to induce banks not to hold idle reserves. 
  4. Fed bank examiners could ease up on questioning bank loans and indicate "that some modest loan losses are not sinful, but rather a normal part of the lending business."
Blinder concludes: "So that's the menu. The Fed had better study it carefully, for if the economy doesn't perk up, it will soon be time to fire the weak ammunition."

There are obvious problems with these tools. Buying private securities needs to be done carefully to avoid charges of favoritism. Changes in the wording of FOMC statements can have a transitory effect on markets but it is a rather weak tool. Blinder is "dubious that there is much mileage here." A negative rate of interest on reserves or excess reserves is an intriguing idea, but the Fed appears to be leery of what this would do to money markets. Finally, using bank examiners for macroeconomic goals establishes a bad precedent and may not work in any case. (I wrote a post related to this suggestion in February 2009 -- "The Regulators' Dilemma.")

Given the limited ability of the Fed to do much in addition to flooding the economy with money, which may not work and would cause great anxiety in any case, which would not be helpful for either consumer or investor confidence, one presumes that Administration policymakers are considering what fiscal policies they might take. One school of thought is that increased government spending, for example on repairing and improving infrastructure such as water and sewer systems, bridges, roads, and public transportation systems, should be undertaken. According to this school, the current deficit should not be a concern in an economy with unused resources, but the increased spending in the near-term should be coupled with a long-term plan to reduce the budget deficit once the economy recovers. Others argue that tax incentives are a better way to go than than increased government spending.

The fear of deficits and its use in political arguments (by conservatives against increased spending initiatives and by liberals against tax cuts) have appeared to make any changes in fiscal policy for the time being impossible. I do not know if the economy will continue to be weak or deteriorate, but, if the economy does get noticeably worse, the Administration and Congress, regardless of the outcome of the November elections, will face deafening calls to take action. Already, the Tea Party movement, which has no discernible economic prescription to current problems except perhaps to think that reduced taxes and reduces government spending should be the goal, is holding large rallies as the growing economic unease serves to swell its ranks. That must worry politicians, even though it is hard to know how to assuage the Tea Party movement. Most will probably eventually conclude that the best response is to take measures they hope will improve the economy, even if this meets with political criticism from Tea Party activists and others. 

The Administration likely believes that it has no ability to address the current bad economy in any meaningful way before the November elections. They must be hoping that the pessimists are wrong and that the economy will improve, if only slowly. However, if that does not happen and the economy worsens, some sort of fiscal stimulus (by a different name, no doubt) will be enacted. If the Administration and Congress do not do this in response to a bad economy, then U.S. politics has fundamentally changed more than I think it has. 

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