Reigniting the Economy
The economy is like a fire burning in a fireplace. There are tools to keep both the economy and the fire running properly. When the flames weaken, poking the logs or adding kindling can restore them. But what happens if the flames get so weak that these ordinary tools no longer bring the fire back to life? Something similar happens with the economy. Monetary policy is the main tool available to keep the economy functioning properly. But is monetary policy enough to stimulate a recovery when the economy becomes severely depressed? Most economists believed that central banks around the world had the necessary tools to solve economic problems. But the recent global financial crisis has shown that it was not as easy as they thought. When interest rates are pushed to the zero bound level, conventional monetary policy is no longer effective. But are there other forms of monetary policy that can be used? In theory, unconventional monetary policy could still work in this situation, but a combination of strong fiscal stimulus and loose monetary policy is a more effective way to stimulate recovery.
Under conventional monetary policy, a central bank controls the interest rate by buying short-term government debt with newly printed money in the open market. Because bonds and money are imperfect substitutes for each other, people hold some money in order to make payments, but they also buy bonds to yield a higher return. When the central bank buys bonds and lowers the interest rate, the return on bonds diminishes, and more people have an incentive to spend money rather than invest in bonds. This is expansionary monetary policy. But when the central bank buys so much debt and pushes interest rates to zero, bonds and money become perfect substitutes, so people hold cash just for its stored value. This limits the usefulness of conventional monetary policy and is known as a liquidity trap (Krugman 2010a).
But there are still unconventional steps a central bank can take to stimulate an economic recovery. Since the central bank has exhausted the effectiveness of the short-term interest rate, it needs to make commitments about future monetary policy in order to promote investment and increase future output (Mankiw 2011). However, this is not a simple task. Paul Krugman argues that the central bank needs to “credibly promise to be irresponsible” and “make a persuasive case that it will permit inflation to occur.” This gets the economy out of a liquidity trap by boosting demand: people will stop holding cash because cash will now have a negative real return (1998).
But is this really possible? Historically, most people have believed that the central bank’s main obligation is price stability. Can the central bank convince people that it will stick to its inflation targets even after signs of inflation inevitably appear? Will the inflation hawks on the board of the central bank allow this to happen? And how will citizens and the elected government respond? In theory, promising inflation allows monetary policy alone to stimulate a recovery, even in a liquidity trap. But it is not easy to accomplish given the reality of political restraints.
Structural reform is another possible tool. This could be deregulation or other measures targeted to improve the supply side. For example, former General Electric chairman Jack Welch said the U.S. government should “freeze all regulations” in order to boost hiring (Little 2011). However, when the economy is suffering from weak aggregate demand, structural reform is unlikely to stimulate a recovery. Structural reform can improve business efficiency and profitability, but it will not boost demand and lead the economy out of a liquidity trap (Krugman 1998).
Given the limits of monetary policy and of structural reform in a liquidity trap, fiscal policy must be used to stimulate a recovery. There is evidence to show that both tax cuts and government purchases are effective forms of fiscal stimulus. Although tax cuts do promote growth, government purchases are more effective since all of that spending goes into the economy, whereas a portion of tax rebates are most likely saved (C. Romer 2011). Therefore, the government should increase its purchases to restore full employment and to make up for the lack of aggregate demand in the private sector. This can be done by building roads and bridges, by aid to state and local governments, or by other projects that put people back to work. Short-term fiscal stimulus should be offset by long-run cuts, but those cuts should not be made until the economy is back to full employment (D. Romer 2011).
The stimulus must be large enough to make up for the shortfall in aggregate demand. The fiscal stimulus that President Obama signed in 2009, the American Recovery and Reinvestment Act, helped the U.S. economy, but it was not large enough to solve the problem (C. Romer 2011). By contrast, World War II is the greatest example of effective fiscal stimulus for the United States. The increased government spending for the war effort made up for the gap in aggregate demand and ended the Great Depression. But many observers feared that when the war ended, the United States would slip back into recession because people would start saving money to prepare for another downturn. Throughout the war and soon after, however, prices increased about 70 percent. This reduced the real value of debt and improved the nation’s balance sheet. The increased output and ensuing inflation together sustained the recovery, and the economy continued to grow after the war (Krugman 2010b).
Though fiscal stimulus has been proven to have positive effects on the economy, many policymakers, such has British Prime Minister David Cameron, former European Central Bank president Jean-Claude Trichet, and U.S. Congressman Paul Ryan, argue that fiscal austerity is expansionary and that governments should cut back on spending. Their rationale is that reducing the deficits will increase confidence and will help spur growth and reduce unemployment. But there is strong evidence to show that fiscal austerity hurts economic growth. Spain, Greece, and Great Britain have started austerity programs to address the current financial crisis, and unemployment has continued to rise in those countries (C. Romer 2011).
By contrast, Keynesian models accurately predicted that a huge rise in the monetary base would not cause inflation, that huge budget deficits would not send interest rates soaring, and that fiscal austerity would slow growth (Krugman 2012). Rather than heeding these models, policymakers from all countries have instead worried about inflation and deficits even though the economy remains depressed with extremely high unemployment. But in such a situation, budget deficits do not crowd out private sector investment. Certainly, fiscal stimulus will increase future debt, but allowing the economy to remain depressed will produce a bigger burden on future generations (Krugman 2009). For example, college students and recent graduates will continue to struggle to find decent starting jobs, and studies show that their lifetime earnings will be less than their peers who graduated in good times (Murray 2009). The financial and emotional toll this inflicts on young people can cause a lifetime of damage.
In conclusion, monetary policy alone could in theory stimulate a recovery even in a severely depressed economy if the central bank committed to allowing future inflation. However, due to the difficulty of accomplishing this, a combination of strong fiscal stimulus and loose monetary policy is a better solution. Sufficient fiscal stimulus will boost aggregate demand to get out of the slump, and loose monetary policy will keep interest rates low to promote investment and allow some inflation that will prevent sliding right back into a recession. This brings us back to the image of a dead fire in a fireplace. Most of the time you can poke the fire and add kindling to keep it burning steadily, but sometimes you have to put on new logs and rebuild it from the bottom up. As with the fire, the economy sometimes needs to be reignited by all the available tools.
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