Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 6 September 2014

Unconventional Monetary Policy versus fiscal policy

In a previous post I explained why, in a very simple setting, it was best to use lower interest rates to stimulate demand, but that both tax cuts and increases in government consumption could do this job as well, with welfare costs that were minor compared to the cost of inadequate demand. So, to use a bit of jargon, cutting interest rates is first best, but if that first best was not available because nominal rates had hit zero then fiscal policy should be used. If there was a financial constraint on the size of the stimulus, government spending was generally more effective than tax cuts.

What about unconventional monetary policy? There are two main kinds: forward commitment to above target inflation (and a positive output gap) in the future, and printing money to buy various kinds of assets (QE). In each case I want to compare the welfare costs of these policies with the costs of using fiscal policy. However there is also the issue of uncertainty of impact: we need to know how much of a policy measure to apply: this uncertainty issue was not critical in the previous post because we have a lot of evidence about the impact of conventional monetary and fiscal policy. I will consider each type of unconventional monetary policy in turn.

One way of stimulating demand when interest rates are stuck at zero is to promise a combination of higher than ideal inflation and higher than ideal output in the future. (This can be done either explicitly or implicitly by using some form of target in the nominal level of something like nominal GDP. For those not familiar with how this works, see here.) The cost of this policy is clear: higher than ideal future inflation and output. Once again, these costs can be worth it because of the severity of the current recession, which is why nominal rates are stuck at zero. Whether these costs are greater or less than the cost of changing government spending is debatable: a paper by Werning that I discussed here suggests optimal policy may involve both.

One issue that arises with this particular policy is the problem of time inconsistency. The central bank may promise to raise inflation above target in the future to help reduce the recession today, but once the recession is over will it keep to its promise? Will the public let it? If people think it might not then the policy will be less potent, which increases the uncertainty associated with the policy’s effectiveness. This is one reason why it may be useful to hardwire the policy by means of some nominal target. [1]

The other unconventional monetary policy is QE: printing money to buy assets. Now it could be that this policy is doing nothing more than signal forward commitment to lower interest rates in the future, which moves us back to the previous discussion. Suppose it is more than that. I think a largely unresolved problem is how distortionary this policy is.

For example, in one of the most popular models that has explored the effectiveness of QE by Mark Gertler and Peter Karadi, the central bank makes loans or buys government debt. In doing this it reduces a risk premium, which is welfare improving. This raises the obvious question of why QE is not permanent. The authors get around this problem by assuming that the central bank is less efficient than private banks in knowing which assets to buy. However I’m not sure whether anyone, including the authors, has any idea what these efficiency costs might be.

Perhaps these distortions are quite small. However this discussion illustrates a more serious problem with QE, which is that we still have no clear idea of its effectiveness, or indeed whether effects are linear, and what the best markets to operate in are. Announcements about QE clearly influence the market, but that could be because it is acting as a signalling device, as Michael Woodford has argued. Jim Hamilton is also sceptical. This strongly suggests that the uncertainty associated with the impact of QE is far greater than any uncertainty associated with either conventional monetary policy or fiscal policy.

Thinking about it this way, I cannot see why some people insist that unconventional monetary policy is always preferable to fiscal policy. In a comment on a recent Nick Rowe post, Scott Sumner writes “My views is that once the central bank owns the entire stock of global assets, come back to me and we can talk about fiscal stimulus.” What this effectively means is that it is better for one arm of the state (the central bank) to create huge amounts of money to buy up large quantities of assets than to let another arm of the state (the Treasury) advance consumers rather less money to spend or save as they like. This preference just seems rather strange, but maybe Lenin would have approved! 

[1] If a temporary increase in government spending is in fact believed to be permanent, its effectiveness at stimulating the economy largely disappears, but this is not a problem of time inconsistency. Another difference is that governments are increasing and decreasing spending all the time, whereas it is much more unusual for an advanced economy central bank to deliberately create a boom.


  1. "Another difference is that governments are increasing and decreasing spending all the time, whereas it is much more unusual for an advanced economy central bank to deliberately create a boom."

    I think you could find a lot of people who disagree with that assessment, at least based on Fed policy from 2003-2005. Interest rate policy is most effective on the interest rate sensitive parts of the economy, notably housing. If passive fiscal policy is too tight - which seems to be the best explanation of recent economic behaviour - then the central bank has no choice but to over-stimulate housing to make up for it. (Canada has currently fallen into that trap; also probably true for the U.K. and Australia.)

    It's a lot more difficult to control an economy in which half is in a low-level depression and the other half is an overheated casino than it is to control a theoretical economy that consists of a single composite good.

    1. I disagree with your choice of "over-stimulate" as a phrase and this is where the market monetarists are coming from.

      If the Fed has an NGDP path level target, they wouldn't have been tightening in 2007 as the credit markets were freezing up and NGDP was dropping. A NGDP path level futures market at the time would have been flashing red. Instead if you read the FOMC minutes they were worried about whether inflation would moderate.

      If they kept the pedal to the metal then and steered into the curve and kept it gunning, the downturn wouldn't have been as bad even with the austerity from 2011 onwards. As Wren-Lewis points out in this post there would have been costs, but they would have been less than the damage we've suffered without it.

      It's difficult to do this politically. The Fed suffered a lot of pushback from the Republican half of the establishment when it did QE even though that QE was ad hoc and tentative. They did the minimum necessary to give us the crappy recovery we've had and they tapered as soon as was possible.

    2. It is hard to see what monetary policy would have been able to do in 2007. Financial institutions and consumers were insolvent, and no one in their right mind would lend to them. If the Fed had purchased up all the private sector assets needed to keep the bubble inflated, they would have been well outside their legal mandate. Even if you put aside the legal issues, would it make sense to keep building houses that no one could pay for? In a single-good economic model, all production increases utility, but in the real world, producing things that are useless is a waste of resources.

      The downturn was bad because workers needed to be redeployed from construction to doing something else. In the current economic structure, there is no way for that "something else" to appear fast enough for it to make a difference. Although the violence of the contraction could have been moderated, I doubt that the situation in the real economy would have been much different in the longer term.

    3. Brian,

      If by “single composite good” you mean combining fiscal and monetary policy, then I agree. Having two bodies with a say on stimulus makes as much sense as having a car with two steering wheels controlled by a husband and wife in the middle of a matrimonial breakdown.

    4. It seems like we agree mostly. Longer term problems and issues need deeper fixes. There was a problem in that they needed a bubble to maintain near-full employment. Was that "easy" money? Regulations were "easy."

      But there was a panic and credit crunch. That could have been moderated. As we approach full employment in the next decade, what's the bubble in this time? Credit conditions and regulations seem tighter.

    5. Is Brian Romanchuk's view of financial insolvency the consensus? Analyzing the counterfactual wherein monetary policy maintained the pathway of NGDP, and skipped direct liquidity support of financial institutions, seems outside the scope of modern economics. Similarly, the casual manner in which we use the term "bubble" seems to presume much of current analytical tools. We do know that housing prices crashed. So can we delineate the bubble portion? Is there obviously stationarity in particular valuation measures? Is there a sacrosant trend line? Can we confidently advise residents of Vancouver, Melbourne, London, San Francisco, and Manhattan to divest their landholdings (without the "if only" and "anytime now" caveats)? The consensus language just seems too confident, which makes me suspicious as to whether anything was really learned, or whether the consensus simply adopted new heuristics to guard against the last crisis.

  2. The MMs really don't like government spending.The central bank buying asset classes is the least bad form of this. In other forms of government spending, government is making investment and employment decisions more directly.

    I see it like this. They are conservatives who want the central bank to maintain a NGDP path level target because if the economy falls into a bad recession the government will be given an excuse to intervene with stimulus and spending and increase its presence in the economy. Other types of conservatives don't care and will just fight intervention in the economy by the government by forcing austerity no matter whether or not the economy is in recession or booming.

    In America lately there have been a few (a couple) conservatives who have come out for infrastructure spending - Martin Feldstein (I know) and Glenn Hubbard (I think). Feldstein sees the Fed as overreaching and doing too much. I'd disagree with him there and agree with the MMs. He sounds like progressive, liberal, leftists who are skeptical of QE. I think Japan has shown QE works. Also there's the comparison of the U.S. and Europe. It's better than nothing. The U.S. has had fiscal austerity since 2011 but it's going away now. My preference would be for government spending which I see as most effective and achieving the most bang for the buck.

    I don't thing government is inherently less efficient when making investment and allocation decisions. It can do infrastructure, school building etc easily. Look at how poorly the private sector did with allocation when it came to the housing bubble.

    I'm an Obama fan, but one thing that infuriated me was how when discussing his big ARRA stimulus he would go on and on about how there were no "shovel-ready" projects and it was all so very hard. Baloney. Nonsense. And then he didn't even defend how well his stimulus actually worked. There was a recent U. of Chicago survey of economist and most of them said it worked, despite the constant propaganda against it. Instead he turned to cutting the deficit and now his poll numbers are dismal.

  3. A simple view of QE is that by swapping newly-created money for assets( that people don't view as equivalent to money) then people will spend some of this new money and boost AD.

    In this simple view it really doesn't matter what assets are bought as long as they are not seen as money-equivalents. No matter how temporary people think this new money is there will always be people at the margin who are ready to swap asset's for new money and spend some of it.

    What is wrong with this simple view ?

    1. They are exchanging one form of wealth (their asset) for another (money). So how much would they spend? Why not simply give people money instead - we know they will spend some of this.

    2. This comment has been removed by the author.

    3. yes, they are exchanging one form of wealth (their asset) for another (money). but they will now have more money relative to other things (assets and other goods) after the exchange so they will spend some of it and start a process that will drive a change in AD.

      Of course giving people money will have the same effect achieved in a perhaps more direct way - but as Nick Rowe points out the real complexities and distortions come into play when the monetary authorities have to reverse out the policy via higher taxes later rather than just selling the assets they have bought.

      Obviously if QE doesn't work (fails to boost AD) then fiscal policy is the only show in town - but my question really was - why wouldn't QE work ? If my simple view is correct then how could it not work ?

    4. They may spend some of it, but we have no idea how much. Good policy instruments need to have predictable effects.

    5. MF. QE is not being used to increase aggregate demand. It is intended for major investment and pension funds to go out and chase higher returns from investing in the "supply side" of the economy (NOT the demand side). The commercial banks are only intermediaries in this game, holding the new cash on deposit. Those deposits will be balanced by an equivalent increase in the commercial banks "reserves" (supplied by the BoE), to cover the banks new deposit liability; and, banks don't lend reserves in the retail market. There are no new "financial assets" being added to the economy they are just being swapped.

      Holding Treasury Gilts at 3 - 4% is safe. Swapping those Gilts for cash means no income stream so the BoE is making those funds get out there and invest in the guy who is going to invent the next Google or such like. Unfortunately, those funds are not keen on playing that game of risk. That's why they bought the Gilts in the first place.

  4. Another very good post Simon! It forces me to think.

    1. I think the Leninist point is a good one. That is why I think Milton Friedman's Optimum Quantity of Money argument is deeply flawed. Because it would mean the central bank would end up owning everything, to bring i down to 0%. Milton Friedman was a crypto commie! And I think that is why we should not have too low an inflation target (or NGDP growth target) for the long run. Does that same argument apply in the short run too? Hmmm.

    2. "What this effectively means is that it is better for one arm of the state (the central bank) to create huge amounts of money to buy up large quantities of assets than to let another arm of the state (the Treasury) advance consumers rather less money to spend or save as they like."

    But when the Treasury "advances" money to consumers, to deal with a temporary fall in AD, it will need to *tax* it back in future, when the shock goes away, using distorting taxes. If the central bank "advances" (i.e. lends) money to consumers, it can "tax" it back from those same individual with lump-sum taxes (they repay the loans).

    1. All the inter-temporal budget constraint says is that government debt does not explode relative to nominal discount rates. If those discount rates are less than nominal GDP growth rates - which is what we typically see in practice - the fiscal authority doesn't need to do much of anything. And since tax rates are what matters, not the amount of taxes paid, they can be left unchanged. Higher nominal GDP growth implies that there will be a passive tightening with unchanged rates. Since the "distortion" is more a function of rates than the amount of taxes paid, why should anyone care?

    2. Nick - when the central bank gives people money, it takes their assets, so we have very little idea of how much - if any - more they will spend. So yes, a tax cut will increase the cost of tax distortions, but at least we have some idea of the impact it will have.

    3. Nick,

      Re your No.1, you’re attributing ideas to Friedman which I don’t think he advocated. At least in his 1948 paper “A Monetary and Fiscal Framework….” he very definitely did not advocate having the state print money and buy up assets, which is what Market Monetarists advocate. He advocated having the state print money and spend it on the normal public sector items (education, roads, etc) – and/or cut taxes.

      Second I don’t agree with your claim that taxes are, as you put it, “distorting”. Obviously taxes CAN BE distortionary: e.g. a tax on red cars but not cars with a different color. But a flat percentage tax on everyone’s income would be almost completely distortion free.

    4. the only truly non-distortionary tax is a poll tax; it has absolutely no influence on your behavior except perhaps to make you want to earn a bit more money.

    5. and there is something to be said, during times of inadequate demand, to just send checks to every citizen, which would again do very little to distort incentives.

    6. I wonder if Margaret Thatcher would have agreed about poll taxes having absolutely no influence on people's behavior

    7. Of course poll taxes are distorionary, rob - you're just not looking at the right margin. They lower the utility of the living without lowering the utility of the dead, and hence make living less attractive relative to dying.

      More seriously and generally, the whole idea that lum sum transfers cannot affect behaviour has always seemd dubious to me. Real life people just don't think like that - they have these funny notions of "rights" and "just desserts" which lead to irrational notions of retribution, for a start.

    8. Nick Rowe: "But when the Treasury "advances" money to consumers, to deal with a temporary fall in AD, it will need to *tax* it back in future". Not really in a depressionary / liquidity trap / zero interest environment. You print money to reduce taxes and increase demand. As demand goes back to normality, interest rates go up to prevent economy's overheating. No need to tax money back.

  5. Simon,

    You say, “One way of stimulating demand when interest rates are stuck at zero is to promise a combination of higher than ideal inflation and higher than ideal output in the future.” So why should anyone believe that promise? They’ll believe it if the authorities implement excessive stimulus, but that excessive stimulus ITSELF solves the problem: excess unemployment. Ergo the “promise” is irrelevant.

    Re your reference to Scott Sumner’s ideas as “rather strange”, I’d use much more abusive language, but that’s my style...:-)

  6. "So, to use a bit of jargon, cutting interest rates is first best, but if that first best was not available because nominal rates had hit zero then fiscal policy should be used."

    Maybe the opposite is true: fiscal policy should be used first.

    The idea that government involvement in the economy should be limited to a last resort is a cultural bias. The field of macroeconomics over the past 30 years has been strongly influenced by neoliberal doctrine, which also influenced the Keynesian schools. Economic students end up being indoctrinated with this cultural bias. But it is not founded on anything remotely resembling a scientific theory supported with hard evidence.

    If one compares economic indicators from the "inefficient" post-war Keynesian era — GDP growth, inequality, government debt, private debt, real wages and benefits — to the "efficient" neoliberal era of the past 30 years, the Keynesian era was obviously much more successful on all fronts.

    So it could be quite possible that the economic models being used today are woefully inadequate — like J.J. Thomson trying to model the atom based on classical theory when quantum theory was required. This would explain why the "inefficient" Keynesian era turned out to be much more efficient.

    So related to stimulus to increase aggregate demand: the fact is monetary policy is pretty far removed from the average person who needs to spend more to boost the economy. Lowering interest rates and purchasing corporate bonds takes a while to trickle down to the little people.

    Direct government spending on infrastructure and perhaps an increased VAT rebate, could very well not only be more effective, but have a similar lag time given how indirect monetary policy is.

    (On the supply side: Stiglitz demonstrates in "Freefall" that the financial sector is woefully inadequate in allocating capital in the real economy, despite loose monetary policy. Capital is invested in synthetic assets which are so complex banks don't know their own positions, let alone those of other banks, which causes interest rates to be higher. Money is not adequately used to finance business expansion and innovation that create sustainable GDP, jobs and productivity growth.)

    The idea that central banks are run by independent technocrats is also a fallacy. The 2% inflation target, e.g., is entirely arbitrary. An institution not governed by science and not democratically accountable will be governed by some other political agenda. The 2% inflation target appears to be more inclined to protect the wealth of the well off than the economic interests of the average person. Central banks have also used monetary policy in the past to "moderate" wages. But what forces determine how "moderate" they should be? Not science. Not democracy. Some unaccountable political agenda.

  7. .
    Perhaps a guaranteed national income is a type of stimulus whose time has come.

    Time seems to have inured us to the extraordinary nature of the zero lower bound.

    The zero lower bound may be a symptom of globalization and secular stagnation. The 90% of the population are no longer sharing in the GDP gains and thus causing a lack of demand.

    A guaranteed national income, equal to perhaps 5% of GDP, split among all citizens and paid out from fiscal funds, would go a long way to reducing inequality and increasing demand.

    QE, essentially stealth monetization, has been shown to not increase inflation in depressed economies and should be the other shoe of the policy, as long as inflation and demand are subdued.

    The treatment depends upon the malady.

    As a side note, one of the things that make social policy and economics difficult is a society with a fragmented self image. Judging from the rise of UKIP and the many apoplectic comments I see in UK media, there seems to be a bit of us versus them mentality in the UK. That sort of division makes it very hard to propose a policy that helps everyone.

  8. I disagree that monetary policy is the best first response. Political agreement is that rapid automatic fiscal stimulus in the form of unemployment benefits (fiscal policy) is always the first & best immediate response to a recession. Every developed country has a robust unemployment insurance program because the work and are effective stimulus targeted to those with the greatest needs. Expansion of automatic stabilizers such as infrastructure banks would be another form of fiscal stimulus that is rapid, automatic and targeted to parts of the economy that most need help. Expansion of automatic stabilizers could smooth out the unemployment spikes that carry high social costs to an economy. At the other end, higher taxes are a better way to remove money from an overheated economy than high interest rates.

    Monetary policy to fight inflation does so at the expense of workers who suffer through unemployment. It is not without social costs. Monetary policy through QE as is currently practiced increases money in the hands of bankers and investors who already sit on piles of savings. QE is not being channeled in a way that increases the use of otherwise unproductive labor. It could be, but it would need to be coordinated with fiscal policy. Monetary policy targeted to fund public goods and services would be far more effective than untargeted efforts that put too much money where it is not needed and may even make matters worse if it leaks out of the domestic economy into foreign investments that offshore jobs or is invested in replacing labor with capital that we have seen in the latest recession.

    Monetary policy is governed by bankers and elites whose mission is to protect the banking system. The fascination with monetary policy is in part that it depends on a technocratic elite that supposedly can be persuaded to act for the common good. This is opposed to fiscal policy which is under the control of Yahoos elected from the rabble who may have little understanding of economics. Intellectuals can be more comfortable interacting with like minded elites than tangling with the messy sausage of politics. Monetary elites have a primary mission to protect the banking system (mostly from itself) and political constraints limit acceptable actions. Fiscal policy may be enacted by Yahoos, but the policies are generated behind the scenes at policy institutes, many funded by elite special interests. Monetary policy is mostly important in the finer nuances of guiding an economy. There are few big impacts of good monetary policy. The big impacts come from fiscal and regulatory policy. Even the best monetary cannot compensate for misguided or inadequate fiscal and regulatory policy.
    -jonny bakho

  9. What you want to cause private investment in new projects. Thus you can analyze the various measures by how they effect expected ROI. Expected inflation in combination with low rates is terrific. GDP growth is terrific. Anything that looks to increase numerator cash flows and while suppressing denominator discount rates is a good idea. QE and variants is less good. All it does is free up idle funds that could be reinvested in new projects, but probably won't because the equations are unchanged. Or nearly so.

    Cash is king. New cash by people who will spend it dominates ROI.

  10. Simon, effective monetary policy is not about *doing* anything, ... like adjusting rates, or QE, etc, it's about a state of mind. For example, I'm going to ease monetary policy right now ...

    [[[[... concentrating ...]]]]

    There! Did you feel it? Did you feel it ease a bit? ...No?... well don't get discouraged: you'll get the hang of it eventually. It takes some practice... even to just feel a change when it happens. And don't worry, I won't leave it all loose like this... I'll tighten it back up the way it was again before I go. :D

    1. hmmm ... must have been drunk when I wrote this.

  11. Suppose one day all the money was hoarded by one big American corporate job creator in an offshore bank (not invested in the U.S.) -- what would happen to the M-1 supply? If fiat currency isn't being circulated throughout the U.S. creating economic activity (because the hoarders control the promise of future goods and services with their cash holdings), how could the economy exist? Imagine it wasn't paper money (or digital dollars in a computer database) that they hold, but piles of gold. The Fed can't mine gold whenever their paper dollars disappear under someone's mattress, but they can print money.

    National and Household Debt - Apples and Oranges

  12. I don't understand why liberals want to make government spending hostage to demand and supply shocks. Should we cut spending just because inflation got too high? If not, why would we increase spending because of say the Arab oil embargo?

    Why not have the government spend whatever money the public is willing to pay in taxes to do what only it can do?

    As long as monetary policy is able to address such shocks, why wouldn't we use it to do so?

    The Fed was NOT at ZLB in 2008 when things really started to go bad. It could have acted much more aggressively when NGDP started to slump. That's a counterfactual I'd love to have lived through.

    Am I too cynical to believe that those who love fiscal policy see it mostly as a way to spend more money (how many of them are willing to cut it when times change?)

    1. On your last question, yes. It seems to me that most macroeconomists are pretty clear that fiscal stimulus is only useful at the ZLB under flex rates. Those who advocate it for members of a currency union do so symmetrically.

      What is much more difficult to explain are those who insist that monetary policy is all you need even at the ZLB. As Tony Yates has suggested, extreme antagonism to fiscal policy is almost a defining characteristic of market monetarists:

      The point of the these two posts was to show that this is pretty irrational.

    2. While I agree that MMs are indeed hostile to FP, they tell a good story behind that belief.NGDP can be protected regardless of ZLB. At some point, the "buy the world" strategy will have the desired effect. More likely forward guidance (or better, an NGDP futures market target) eliminates the need for such moves. Efficacy established, the only question then is whether monetary policy has downsides ("financial instability"?) that are underweighted.

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