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.

Monetarist vs Fiscalist

Giles Wilkes (ex special advisor to Vince Cable, Business Secretary in the current UK government and LibDem) has a post that compares those he calls ‘fiscalists’ like myself and Jonathan Portes to market monetarists (MM). His post follows some comments and a post by Mark Sadowski responding to an earlier post of mine where Mark took exception to my saying “the major factor behind the second Eurozone recession is not [controversial] : contractionary fiscal policy”. You find much the same debate in this post by Scott Sumner, attacking (mainly) Paul Krugman.

I think Giles Wilkes gets a lot of things right, but I thought it might be useful to set out as clearly as I can how I see the nature of the disagreement. The first, and probably the most important, thing to say is that the disagreement is not about whether fiscal contraction is contractionary, if the monetary authority does nothing. (See, for example, Lars Christensen here.)That is actually what I meant with my statement about the Eurozone recession, which linked to a study that calculated the impact of austerity holding monetary policy ‘constant’. This is so important because, in their enthusiasm to denounce countercyclical fiscal policy, MM often give the impression of thinking otherwise.

The disagreement is over what monetary policy is capable of doing. The second thing to say is that this is all about the particular circumstances of the Zero Lower Bound (ZLB). I do not like the label fiscalist for this reason - it implies a belief that fiscal policy is always better than monetary policy as a means of stabilising the economy. (Giles Wilkes is not the first to use this term - see for example Cardiff Garcia, who includes more protagonists.) Now there may be some economists who think this, but I certainly do not, and nor I believe does Paul Krugman or Jonathan Portes. I described in this article what I called the consensus assignment: that monetary policy should look after stabilising aggregate demand and fiscal policy should be all about debt stabilisation, and there I described recent research (e.g.) which I think strongly supports this assignment. However there has always been a key caveat to that assignment - it does not apply at the ZLB.

Before talking about that, let me illustrate why language can confuse matters. Suppose we had fiscal austerity well away from the ZLB. Suppose further that for some reason the monetary authority did not take measures to offset the impact this had on aggregate demand, and there was a recession as a result. I suspect a MM would tend to say that this recession was caused by monetary policy, even though monetary policy had not ‘done anything’. (In this they follow in the tradition of that great monetarist, Milton Friedman, who liked to say that monetary policy caused the Great Depression.) The reason they would say that is not because fiscal policy has no effect, but because it is the duty of monetary policy to offset shocks like fiscal austerity. That is why fiscal policy multipliers should always be zero, because monetary policy should make them so. So Mark Sadowski got upset with my statement because in his view ECB policy failed to counteract the impact of Eurozone austerity, and could have done so, which meant the  recession in 2012/3 was down to monetary policy, not fiscal policy.

So we come to the heart of the disagreement - the ability of monetary policy to offset fiscal actions at the ZLB. This is all about the effectiveness of unconventional monetary policy (UMP), which is both Quantitative Easing and what I call forward commitment (promising positive output gaps in the future: see David Beckworth here). I do not want to go over these arguments again, partly because I have already written about them elsewhere (e.g. here, here and here). Instead I just want to make an observation about asymmetry.

Economists like Paul Krugman, Jonathan Portes and myself (and there are many others) do not argue against using UMP. Indeed PK pioneered the idea of forward commitment for Japan, and I have been as critical as anyone about ECB policy. We do not argue that fiscal policy will be so effective as to make unconventional monetary policy unnecessary, and so write countless posts criticising those promoting UCM. To take a specific example, I happen to think that the recent ECB moves will have less impact on the Eurozone than continuing fiscal austerity, but I do not say the ECB is wasting its time as a result. They should do more.   

I’m interested in this asymmetry, and where it comes from. Why do MM hate fiscal expansion at the ZLB so much? It could be ideological (see Noah Smith here), but I suspect something else matters. I think it has something to do with monetarism, by which I mean a belief that money is at the heart of issues to do with stabilisation and inflation. MM is not about controlling the money supply as monetarism originally was, but I think many other aspects of monetarism survive. My own view is more Wicksellian (or perhaps Woodfordian), whence the failure to be able to lower interest rates below zero naturally appears central. To those not trained as macroeconomists (and perhaps some that are) these sentences will appear mysterious, so if this idea survives comments I may come back to it later.