On the Stupidity of Demand Deficient Stagnation

In my last post I wrote about “why recessions caused by demand deficiency when inflation is below target are such a scandalous waste. It is a problem that can be easily solved, with lots of winners and no losers. The only reason that this is not obvious to more people is that we have created an institutional divorce between monetary and fiscal policy that obscures that truth.” I suspect I often write stuff that is meaningful to me as a write it but appears obtuse to readers. So this post spells out what I meant.

First a preliminary. If you do not understand why economies can suffer from deficient demand, and why this is a needless waste of resources, then to be honest your best bet is to read a few chapters of a popular book on macro, like Tim Harford’s latest. If you have done a macro course and do not believe prolonged demand deficiency is possible, just tell me how you get out of a liquidity trap in a world with inflation targets after reading this post (and maybe this).

Demand deficiency when inflation is persistently below target (the stagnation of the title) should not occur, because it is easy to solve technically. If I was a benevolent dictator in charge of both monetary and fiscal policy instruments, stagnation would never persist in my economy. The way I would ensure this most of the time is by varying interest rates, but if nominal interest rates hit zero (a liquidity trap) I have a whole range of alternative instruments, ranging from cutting various taxes to increasing transfers or raising public spending. I know of no macroeconomic theory on earth which tells me that everyone of these instruments will fail to raise demand.

Whatever instrument I use to raise demand in a liquidity trap, I need to finance it. I can do this by issuing bonds (increasing government debt) or creating money. A higher stock of government debt or money is the only legacy (apart from happier people) of my successful operation to remove demand deficiency. We generally prefer governments to use bond finance, for reasons I will come to. But supposing there is some constraint (real or imagined) on issuing bonds. As a benevolent dictator I can just create money, which we call money financed fiscal stimulus. Money financed fiscal stimulus is a sure way of ending demand deficiency in a liquidity trap.

If that higher stock of money proves too great later on when the economy has recovered, I can reduce it by various means. There will be no subsequent above target inflation. There are no technical problems that I as a benevolent dictator need to worry about here. Of course creating lots of money on a temporary basis is exactly what central banks in the UK, US and Japan have recently done (QE - Quantitative Easing). The problem is that they have not been accompanied by sufficient tax cuts, increased transfers or increased government spending. Creating money to buy financial assets is by comparison to money financed fiscal stimulus an unreliable way of raising demand.

So that is it. Demand deficient stagnation is easy to prevent technically. The huge waste of resources that we see in the long and incomplete US recovery, the even slower UK recovery and the absence of recovery in the Eurozone are all unnecessary, because we know how to fix them. [1]

What stops this happening in the real world is that we have become fixated by the labels ‘monetary’ and ‘fiscal’ policy, and created an independent institution to handle the former. Central banks do monetary policy (varying interest rates and creating money) but are not allowed to give money directly to the people (helicopter money, or John Muellbauer’s QE for the people). Governments run fiscal policy, so can do bond financed fiscal stimulus, but are not allowed to create money. So a self-imposed institutional setup prevents either central banks or governments doing money financed fiscal stimulus alone.

A major reason why this institutional arrangement exists is to discourage non-benevolent governments creating inflation through fiscal profligacy, or more recently in order to increase policy credibility. Of course during a period of stagnation there is no danger of rampant inflation. Unfortunately this institutional arrangement creates a problem when governments – in my view for largely imaginary reasons - put a priority on reducing deficits. Money financed fiscal stimulus is not available to get you out of a liquidity trap. So we get this huge waste of resources.

Within the existing institutional framework, there is plenty to be done to convince fiscal policy makers that reducing deficits should not be a priority in the short term, or in trying to improve the monetary policy framework so liquidity traps happen less often. Yet it would be better still if we had an institutional framework which was a little more robust to failures on either front. We need to regain the possibility of money financed fiscal stimulus in a liquidity trap.

[1] What I say here has a lot in common with the advocates of Modern Monetary Theory. However, it also appears to be perfectly standard macroeconomics to me, so here I will simply commend them for highlighting these aspects of mainstream thought.