End the Fed(s Dithering)

Word count: 1497

Of the few things which macroeconomists can agree on these days, the one idea that at least has some acceptance is that the recent recession was the result of a decline in aggregate demand. Macroeconomic theory dictates that in the event of a decline in aggregate demand, there are two channels through which the government can restore aggregate demand and initiate a recovery: fiscal stimulus, conducted by the federal government through various purchases and transfers, and monetary stimulus, conducted by the central bank primarily through open market operations and occasionally through other monetary transmission mechanisms. The disappointing pace at which the recovery has proceeded has left policymakers with little breathing space; they are now under immense pressure to find an immediate solution to their economic malaise. However, both stimulus options are loaded with hazards that could exacerbate current economic risks. Governments have been fighting with the very real issue concerning the size of their deficits and their level of debt. Central banks have focused on avoiding the mistakes of the past, like when they had let inflation get too high, let prices fluctuate too much, let their credibility decline, or let the financial sector collapse into a heap. Central banks are further restricted of course by the dreaded zero bound, meaning that they cannot lower nominal interest rates any further. Finding a solution that is sufficient in scale to bring the economy back to full employment while minimizing the threat from these risks may seem like an impossible task. I believe however that acceptable solutions exist, and that if central banks (in particular the Federal Reserve, but also the Bank of Japan and European Central Bank) would adopt decision making processes that focused less on avoiding specific risks, and more on fulfilling their role as custodian of the economy, the economy would return to normal at a much faster pace. It is possible, and indeed desirable, to use monetary stimulus to spark an economic recovery. There are still plenty of stimulus options available to the central bank, in spite of the zero bound. This is not a purely academic argument; even Federal Reserve Chairman Ben Bernanke believes this, arguing as recently as January of 2012 that I would not say that were out of ammunition. No, I think we still have tools, but we need to further analyze and study those tools and try to make comparisons in terms of effectiveness, risks, and the like. [1] Both academic literature and empirical evidence exist that show that monetary policy can be effective at the zero bound. The menu of policies that the central bank can consider at the lower bound include currency depreciation, zero (or negative) interest rates on bank reserves, debt market operations, communication of inflation or output gap targets, targeted asset purchases, quantitative easing, and more [2][3][4][5], all of which remain effective at the zero bound because they allow the central bank to credibly influence expectations, the key transmission mechanism for monetary policy at the lower bound [6][7]. It is up for debate as to what the optimal selection should be, but given that institutions like the Federal Reserve are entrusted with the dual mandate of price stability and full employment, it would do well to consider some of these policies. Monetary stimulus therefore remains a possible solution to todays economic issues, in spite of the zero bound. Even so, the public discourse today is dominated by the

debate over fiscal stimulus, and whether governments can and should do more to restore the economies of the USA and Europe. This debate however ignores the notion that central banks, not government, predominantly determine the direction and pathway of economic growth, thus implying that monetary stimulus from the central bank can be far more effective in returning the economy to trend than fiscal stimulus. The debate over the effectiveness of fiscal stimulus focuses mainly on the fiscal multiplier, defined as the increase in GDP from a $1 increase in government spending. Fiscal stimulus proponents argue that the fiscal multiplier is above one [8], suggesting that there is a positive return to fiscal stimulus, while fiscal stimulus critics believe that is less than one (or even zero) [9], suggesting that the return on additional government spending is little to none. Empirical evidence shows that the size of the fiscal multiplier is actually dependent on the monetary regime. When the central bank is restricted, like it is for countries with pegged exchange rates, then the fiscal multiplier is high. When the central bank is not restricted, then the fiscal multiplier is small because monetary policy becomes much more accommodative [10]. That is, the central bank factors in the effects of fiscal stimulus, then dampens its effect by adjusting monetary policy accordingly. This would imply that attempts at fiscal stimulus would be made ineffective by the central bank, and that successful stimulus can only be driven by a central bank that chooses to adopt a looser monetary policy. There is an argument that at the zero bound the central bank is restricted, suggesting that fiscal stimulus could be effective [11]. We know however that the central bank still has other options that it can pursue, and that the zero bound is not a hard restriction on monetary policy [12]. Monetary stimulus would also allow governments to allay fears of rising debt and deficits, concerns over distributional fairness and equity, and worries of a lack of oversight and accountability from Congress, all issues which would have to be addressed with a fiscal stimulus package. Any policymaker would have to give serious consideration to how much more effective monetary policy can be than fiscal policy. It is worth noting that most of Europes problems stem from their shared currency, a monetary constraint, rather than fiscal profligacy [13][14]. One cannot help but wonder if the monetary solution of allowing the Eurozone to break up and allow each country to issue their own currency would be much simpler than implementing any sort of fiscal solution. Of course, monetary stimulus is not risk free. That being said, it is hard to argue that the risks to additional monetary stimulus will vastly outweigh its benefits. The main fears are that it would create too much inflation, that overly easy monetary policy will result in another asset bubble similar to the housing bubble prior to this crisis, and that central banks do not have the credibility to convince the public that they can stimulate the economy, thereby shorting the key transmission mechanism of expectations management for most zero bound policies. Yet, even with these risks in consideration, additional monetary stimulus still seems beneficial overall for the economy. Fears of inflation or hyperinflation have not materialized in the last few years in spite of low interest rates [15], and furthermore it is difficult to argue that an inflation rate of 2% and high unemployment is preferable to 4% inflation and falling unemployment. Fears of another asset bubble may be valid concerns, but the link between easy monetary policy and asset

bubbles is not clear. Period of easy money (like the 1960s) did not see housing or stock bubbles, yet periods of exceptionally tight money (1920s, 1980s) did see bubbles [16]. This does not mean easy money cannot contribute to a bubble, but direct causation is not imminently obvious. The risk of eroding credibility or confidence in the central bank may or may not be real; academic evidence does not lend itself to any theory on this issue [17]. The only solace here is that the reactions to recent central bank announcements indicate that they are still considered credible [18]. Given that these risks seem minimal, more monetary stimulus would arguably be beneficial. There is good reason to be pessimistic about the chances of the Federal Reserve, the Bank of Japan or even the European Central Bank actually announcing a monetary stimulus package any time soon. The decision-making processes of these institutions place too much weight on avoiding risk, rather than weighing costs over benefits. Both the Bank of Japan and the European Central Bank have raised interest rates, only to be forced to turn back on their decisions because of the resulting economic misfortune. That both institutions made this exact mistake twice in the last decade on two separate occasions indicates a problem with each institutions internal processes [19]. The Federal Reserve is not guiltless either; their most recent economic estimates suggest that in 2014 we will see higher than trend unemployment and lower than trend inflation [20], yet the move for additional stimulus has been cautious thus far. Existing economic models may also not provide central banks with enough information to implement the most appropriate policy. One wonders, for example, if we would have seen larger stimulus efforts over the last three years if initial economic forecasts had estimated the severity of the downturn more accurately [21]. Governments and central banks should at least fortify existing tools, if not consider new models, analyses, and decision-making processes, in order to institute more effective monetary policy. This would dramatically increase the chances of monetary stimulus, both now and for future recessions. References [1] Federal Reserve. Transcript of Chairman Bernankes Press Conference. http://www.federalreserve.gov. Federal Reserve, 25 Jan. 2012. Web. http://1.usa.gov/wihXN5. [2] Bernanke, B. ; Reinhart, V ; Sack, B; Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment, Brookings Papers on Economic Activity 2004:2, pp. 1-78. [3] Svensson, Lars. Monetary policy and Real Stabilization in Rethinking Stabilization Policy, 261312. Kansas City: Federal Reserve Bank of Kansas City. 2002. [4] Congdon, T. Monetary policy at the zero bound World Economics, January, Vol 11, No 1, pp 1146. 2010. [5] Boman, D. ; Gagnon, E. ; Leahy, M. Interest on Excess Reserves as a Monetary Policy Instrument: The Experience of Foreign Central Banks. Federal Reserve Board, International Financial Discussion Paper 996. 2010. http://1.usa.gov/yvc57V

[6] Friedman, B. ; Svensson, L. [Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment] Comments and Discussion Brookings Papers on Economic Activity , Vol. 2004, No. 2 (2004), pp. 79-100 [7] Eggertsson, G. ; Woodford, M. The Zero Bound on Interest Rates and Optimal Monetary Policy. Brookings Papers on Economic Activity, 2003(1), 139233. 2003 [8] Romer, C. ; Bernstein, J. The job impact of the American recovery and reinvestment plan, Council of Economic Advisers. January 2009. [9] Aspects of the Sunset of EGTRAA and JGTRAA, United States Senate, Committee on Finance Cong. (2010) (testimony of Douglas Holtz-Eakin). Web. http://1.usa.gov/wCmHZe [10] Ilzetzki, E., Mendoza, E.; Vegh. How Big (Small?) are Fiscal Multipliers?, NBER Working Paper No. 16479. 2010. [11] Christiano, L. ; Eichenbaum, M. ; Rebelo, S. When is the Government Spending Multiplier Large?, Journal of Political Economy, 119, 78121. 2011 [12] Svensson, L. "Monetary Policy and Financial Markets at the Effective Lower Bound," Journal of Money, Credit, and Banking 42 (Supplement): 229- 242. 2010. [13] Mansori, K. What Really Caused the Eurozone Crisis? (Part 1), The Street Light. September, 2012. Web. http://bit.ly/zLletK [14] Eichengreen, B. European Monetary Integration with Benefit of Hindsight, Journal of Common Market Studies 50 (S1): 123-136. 2010. [15] Economics by Invitation, Is inflation or deflation a greater threat to the world economy? The Economist, June 2010, Web. http://econ.st/y4YvNu [16] Sumner, S. Tight Money causes bubbles. TheMoneyIllusion. January, 2010. Web. http://bit.ly/yHxFWF [17] Blinder, A. S. et al. Central Bank Communication and Monetary Policy: A Survey of Theory and Evidence, Journal of Economic Literature, 46 (4), 91045. 2008. [18] "Swiss Franc: Is The Peg Working? Planet Money : NPR" NPR : National Public Radio. Web. 19 Feb. 2012. http://n.pr/x80MjN [19] Sumner, S. "What We Can Learn from the Trichet Debacle?" TheMoneyIllusion. Web. 19 Feb. 2012. http://bit.ly/x4QHaP [20] "January 25, 2012 Projection Materials." Board of Governors of the Federal Reserve System. Web. 19 Feb. 2012. http://1.usa.gov/A6g4N1 [21] CBO's Economic Forecasting Record: 2010 Update. United States Congressional

Budget Office. 2010. Web. http://1.usa.gov/x66qAn