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Why aren’t we using monetary policy to stimulate aggregate demand?

As is often the case, the genesis of this post is a conversation initiated by Edward (Harrison) on the question of why we aren’t using monetary policy to stimulate aggregate demand. That question was posed here by Tyler Cowen at Marginal Revolution.

The short answer that I gave Ed is that you can’t really use monetary policy to stimulate aggregate demand because the impact of monetary policy is much more diffuse and variable. As I’ve said before, for every winner who derives benefits from lower rates, there is a loser in the form of, say, a pensioner, who is deprived of income.  Tyler Cowen also points this out. Monetary policy is a very diffuse instrument – like using a meat cleaver instead of a scalpel for a surgery. I would also note that this dichotomy is of particular interest to people like Ed who worry that concentrating on aggregate demand obscures problems related to an economy’s resource allocation.

Fiscal policy is the only way to deal with both the problem of lack of aggregate demand and resource allocation. In particular, if we want to encourage private sector deleveraging, short of mass default or repudiation, this has to be supported by government spending, which means fiscal policy. This can take the form of direct government spending, but it can also take the form of tax cuts. That is a political/distributional question, as opposed to an economic one.

But for both, the underlying reality is the same: As the private sector withdraws spending (aggregate demand) and starts reducing its debt levels, the only way that GDP can continue growing is if there is an external trade boom (unlikely overall, especially since all countries by definition can’t become net exporters) and/or fiscal support.

Fiscal deficits have to provide the support to demand to keep national income growing to provide the capacity for the private sector to save. It is a basic macroeconomic reality. The paradox of thrift has to be subverted. As we’ve argued before, quantitative easing won’t cut it. Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts. It’s an asset shuffle, plain and simple. It does nothing to enhance aggregate demand, but does penalize savers at the expense of debtors.

The idea that monetary policy can be used to “unblock” credit and hence stimulate additional demand is wrong on so many levels. At the most basic level, most of us would probably agree that we don’t want a return to the status quo ante, whereby growth is overly reliant on private sector credit growth. We want income growth, which means we should be targeting policies needed to generate full employment. Again, this comes back to fiscal policy.

The notion that the evil banks who have received all of this government money but are holding back recovery because of a refusal to lend is ludicrous. Banks are fully capable of making loans at any time, but are unwilling to do so under present circumstances because (a) aggregate demand is so weak that they cannot find creditworthy customers and (b) economic activity is insufficiently robust to engender any confidence among borrowers that the things they might be better off by expanding production (with working capital borrowed from the banks).

Credit follows creditworthiness, not the other way around. Virtually all proponents of “monetary policy uber alles” fail to understand this elementary point.

In other words, today’s ongoing sluggishness reflects a policy misperception at the heart of policy today in both the US and the UK (the euro zone offers separate challenges, due to its institutional structures). Both governments, under the sanction of their respective central banks, have placed inordinate reliance on monetary policy and too little on fiscal policy as the preferred policy response, and, moreover, have encouraged the hysteria surrounding the increasing deficit through their own comments (talking about “exit strategies”, etc). Ed believes this will continue and has suggested a second dip may be coming as a result.

The reason credit is tight in the US at present is because the banks are being very cautious and they do not perceive a strong demand coming from credit worthy customers. Once they assess that there are worthy borrowers they will lend regardless of the central bank expansion of reserves. Additionally, borrowers have minimal capacity or ability to borrow, due to declining incomes which precludes the ability to service existing loans. Credit, as James Galbraith reminds us, is a two-way contract between borrower and lender, not a one-way “credit flow” from banks to borrowers, which can be solved by “unblocking credit” via bank bailouts.

One other point which is seldom made on the virtues of fiscal policy: it actually enhances financial stability. A fiscal policy deployed properly toward generating full employment (say, via a Job Guarantee scheme) means you have growing incomes and, hence, a great ability on the part of the borrower to service his/her existing debts. Debt which is successfully serviced means reduced write-offs for banks and, hence, less impaired balance sheets. In other words, fiscal policy starts the process of financial reform from the bottom-up, rather than top-down. The sooner President Obama and others figure this out, the better will be the outlook for the US economy. But don’t hold your breath. We still seem far away from that.

Marshall Auerback

About 

Marshall Auerback, has 29 years experience in the investment management business, serving as a global portfolio strategist for Madison Street Partners, LLC, a Denver based hedge fund. He also has also worked as an economic consultant to PIMCO, the world’s largest bond fund management group. He is a Fellow at the Economists for Peace and Security, a Research Associate at the Levy Institute, and a non-executive director of Pinetree Capital in Toronto, Ontario, Canada.

10 Comments

  1. Matt Stiles says:

    “Why aren’t we using monetary policy to stimulate aggregate demand?”

    Two reasons:

    1) Because more “aggregate demand” is not the most desirable route for many people. Many people do not have adequate savings for their retirements, so for them less consumption and more savings is the answer. There is no paradox here. The consumer feels he has a higher value of “capital later” than “capital now”. The more people like this there are, the more others benefit by having a lower cost of choosing “capital now” vs. “capital later”. Once these people see sufficient evidence (via lower costs of other resources) that this will yield them a better long-term situation, the system turns back the other way. It is a system that oscilates between levels of instability, but always tending toward the healthy medium. It is not a “bottomless spiral”.

    Asset prices have swung too far in one direction to convince people that they should borrow money to buy them and turn them into other “value-added” assets. The answer is to let them fall until this other extreme is found; until it makes sense for seemingly everyone to do this.

    Lower demand for things is a good thing. Underneath the “aggregate” changes will occur within the structure of production. Not only for different goods (home renos vs. high-tech educations perhaps), but also for different durations of goods (drilling for deep-sea oil [1 year] vs. building a state-of-the-art nuclear plant [15 years]).

    Constantly focusing on the aggregates ignores the fundamental mechanisms of change.

    2) Because government is an inefficient allocator of capital.

    While government spending may be able to boost the aggregates, it cannot allocate resources effectively. It is not only about providing incomes to other people who then “recycle” it back. It is about providing incomes to the correct people: to those who can, in turn, invest the capital back into resources that will most likely be needed in the more distant future (and so on and so on).

    By indiscriminately allocating capital dictatorially – based on whatever political end motivates them – government skews the process of resource allocation. Resources are wasted. This waste builds up in an economy, it builds itself a bureaucracy to perpetuate its existence, and serves as a drag on the economy until eliminated. These resources could be best otherwise spent researching for the cure for cancer or building a new, efficient water desalinizer. Instead they’re being consumed shuffling paper, using energy, land, and other resources for an end that benefits nobody.

    What is the ultimate end that we all strive for? Nominal wealth? Or the achievement of as many of our own individual desires? I’m at the point where the maintenance of a healthy environment, clean drinking water and a stable food source is high on my list of desires. But the necessary investment to ensure this is not happening because inflated asset prices make this investment uneconomic. Instead we “stimulate aggregate demand” for near-term goods, sending signals to markets that we should drill more offshore oil wells and build infrastructure for the wrong modes of transportation.

    What we’re going to get with fiscal stimulus is a lower quality of living 10 and 20 years from now than we currently expect ourselves to achieve.

  2. DavidLazarusUK says:

    @Matt

    An interesting but delusional vision of the world.

    Yes there will be an increase in savings because people have been exposed as swimming naked now that the tide has turned to paraphrase George Soros.

    Whether governments are efficient allocators of capital or not is irrelevant. If they create a frame work for business such as a green energy policy with carbon taxes then businesses will operate to maximise profits in that framework. The government do not have to spend any money to change this.

    For the last twenty or more years the Big Three auto makers campaigned against higher fuel efficiency standards. So when the oil price hit $147 per barrel US vehicles were prohibitively expensive to run. Whereas Europe and Japan coped much better to the price spike. Then they struggled to sell any vehicles which lead to their demise. They campaigned for their own demise. Everyone could tell that oil was going to rise eventually and they were simply ill prepared for that eventuality.

    Also who are the “correct people” that governments should be giving money to? To provide investment capital to? Trickle down economics has never been proved to work. Also if it were the correct policy why have median US mens wages stagnated for the best part of twenty years? What you could do on a single persons wages in the seventies takes two or more wages now. That is not the sign of a vibrant economy.

    Also many are not suggesting stimulus for oil exploration. There are a number of economists recommending a drive for green energy. This would have a number of benefits. It would significantly reduce the dependance of the US on dodgy overseas oil supply. That would also reduce the US trade deficit, reducing the supply of dollars out there in the world.

    If the US had a $1 a gallon fuel tax then it would simultaneously raise hundreds of billions in tax to clear the deficit, and drive the market to use more efficient vehicles. Then rather than hold on to the tax revenues it could spend them to support the economy in a number of ways. Then as the economy recovers cut that support to clear the deficit.

    The basis of any stimulus is to keep people working and earning so that they can clear their debts. If not they will default leaving the banks nursing bigger losses. Once someone feels confident with their level of savings and debts they can resume spending when necessary. One of the biggest failures of monetary policy over the last thirty years has been the destruction of the domestic savings market. Low interest rates make it less of an incentive to save, and more to spend and borrow. Consequently the US and many western economies are now suffering more because of the Paradox of Thrift. It is in the best interest of individuals to rebuild their savings, but collectively it is disastrous for the economy as a whole.

    Higher interest rates would encourage savings and simultaneously deter speculative investment. It would hold down property prices as the cost of property would be commensurately higher.

    As for lower quality of living 10 or 20 years from now. Have you not noticed that the standard of living for the majority of US citizens has been falling for the last decade?