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Friday, March 16, 2012

The Insufficiencies of Monetary Policy in a Severe Financial Crisis

As we talked about last time, monetary policy is practical and useful even when interest rates near zero, thanks to unconventional tools such as quantitative easing. But in spite of this, I believe that monetary policy alone isn’t sufficient in the current financial crisis. In this entry, I'll argue that fiscal policy is needed to complement monetary policy due to the following three reasons.

Low Investment due to a Lack of Confidence in Consumer Demand 

First, since consumers are busy paying back debt, firms lack the confidence to employ more staff and expand production even if they have the resources and the ability to do so. Firms need to observe an increase in aggregate demand before they have the confidence to invest.

The situation is similar to the prisoner’s dilemma. A desirable outcome can be attained if all firms invest more when the economy is far below its equilibrium output. However, every firm is waiting for other firms to invest first, and in the end nobody invests and a bad outcome is reached. The only player with the authority to solve this coordination problem is the government. Hence, in a severe financial crisis, public spending restores confidence and stimulates private investment and spending. The crowding out effect is absent. 

The Marked Slowdown in Credit Creation

Second, a financial crisis is different from a typical mild recession, because in a financial crisis the money multiplier falls dramatically. Monetary policy is ineffective because the central bank will find it hard to increase the money supply despite efforts to expand the monetary base.

As Reinhart and Rogoff point out in This Time will be Different: Eight Centuries of Financial Folly, the economy takes longer to recover after a financial crisis because banks have to consolidate their balance sheets. They’ll hold more reserves to maintain financial health and lend out less money. Banks cut lending also because they’re worried about the creditworthiness of borrowers.

For example, as shown in Friedman’s and Schwartz’s The Monetary History of the United States, 1867-1960, while the monetary base was stable in the Great Depression, M1 (a measure of money supply, which includes currency in circulation plus demand deposits) fell by about 30% in the crisis. The culprit for such a drastic fall was a decrease in the money multiplier, and this problem has arisen again in the current financial crisis. In the United States, the monetary base has tripled since the start of the crisis but M2 (a measure of money supply that economists use most often, which includes M1 plus savings deposits and small time deposits) has gone up by 30% only.

In comparison, fiscal policy may be a lot more effective, especially given the lack of empirical evidence for Ricardian equivalence. Besides, tax increases are shown to have a highly contractionary impact on the economy, which suggests fiscal policy is more effective than economists previously thought. 

The Risk of Financial Bubbles

Third, a prolonged zero interest rate and rounds of quantitative easing are likely to fuel speculation and create financial bubbles. Given the drastically lower money multiplier, a lot of the money pumped into the economy is trapped in the investment and commercial banks. When optimism returns to the market and banks start to speculate and make more loans, asset price bubbles will easily follow. Hence, a central bank can’t use monetary expansion for too long because otherwise it risks over-inflating asset prices and causing another bubble before the real economic recovery has come. 

Fiscal Expansion as a Necessary Complement to Monetary Policy 

A low interest rate doesn’t help if consumers have little desire or confidence to spend even at zero interest rate. From Japans lost decade, we know that more liquidity doesn’t help if total factor productivity grows too slowly. Monetary policy is powerful, but it alone can’t stimulate economic recovery. 

Governments should boost the economy by taking the lead to spend. Austerity measures aimed to reduce public debt will only further contract the economy. Not only can public spending stimulate investment from the private sector, it benefits the economy by providing the infrastructure and public goods necessary to enhance productivity and growth in the future.

Government spending makes sense especially for countries like the United States, which can finance its public expenditure at a low, sustainable borrowing rate (as shown in the 10-year Treasury note yield, which is at 2%, compared to over 5% for Spanish and Italian bonds of the same maturity). It is a pity for austerity measures to take hold in the United States.

(Entry 4 of 4 in the An Introduction to Monetary Policy series) 

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