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


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.