Economic Recovery and the Fed

by William Margeson

In his book The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, intended to inform economic policy in the wake of the Great Recession, economist Richard Koo writes:  “…the current recession is the result of the private sector saving more at a time when there are not enough borrowers to go around.”  Writing with Robin Wells in the New York Review of Books, Paul Krugman endorses Koo’s interpretation, “In our view, Koo makes a persuasive case. Unfortunately, it’s not a case currently making any headway in American politics. In particular, at this point there is zero chance of getting any significant stimulus through the US Congress…”

There are at least two apposite policy responses:  (1) the government increases spending financed by borrowing; or (2) the Federal Reserve aggressively pursues a strategy to induce the private sector to spend.

While it is mathematically impossible to assign a lower probability than zero to the possibility that Congress will pass further stimulus, today’s elections will almost certainly increase the level of confidence one can have in that estimate.  Given the cataplexy of Congress, therefore, the forthcoming November statement of the Federal Reserve Open Market Committee is of acute importance to the prospect of economic recovery.

It is widely expected that the Federal Reserve will announce a plan to pursue a second round of quantitative easing, QE2 as it has been dubbed, in which the Fed will purchase some quantity of government debt in order to increase the money supply.  This strategy is intended to lower the long-term interest rate and raise expectations of inflation, which should induce the private sector to substitute toward current spending.  Ultimately, QE2 should translate into reduced unemployment.

In an interview with Ezra Klein, Nobel laureate Joseph Stiglitz argued that QE2 is a poor strategy for promoting recovery because the recession has adversely affected “the various channels through which monetary policy will operate,” thus diminishing its expected value.  Stiglitz contends that fiscal policy is optimal.

I have no reason to doubt that Stiglitz is correct.  However, that fiscal policy is the optimal route to recovery does not necessarily entail that monetary policy should not be pursued, especially considering that the odds of a sufficient fiscal policy response are comparable to those that all Americans will opt for a tofu turkey this Thanksgiving out of concern for the environment.  Although the effect of further quantitative easing is likely to be significantly weaker than the effect of aggressive fiscal stimulus, it is probably better than nothing.  Despite Krugman’s prognosis that QE2 will amount to “a mild mitigation at best,” Krugman and Wells argue in the NYRB essay cited above:  “…monetary expansion should be pursued through every route possible—yes, it’s uncertain how effective any given measure would be, but that’s no reason not to try.”

Ideally, both fiscal and monetary policy would be deployed to stimulate the economy, but, as in so many instances, the policy response that is feasible is not the one that is optimal.  That doesn’t mean it should be rejected, however.  In compliance with its charter, the Fed should pursue further monetary policy to stimulate the economy and reduce unemployment.  Second, it has been argued that because Bernanke wields particular influence among Republicans, he should make an unequivocal and public case for fiscal stimulus.  Considering that Republicans are almost assured a majority in the House, Bernanke’s strong vocal support for fiscal stimulus is of pressing importance.  But as Sewell Chan reported in the New York Times last week, his reticence and timidity might undermine his policy objectives.


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