Thursday, January 14, 2010

More debate on effectiveness of monetary policy now

The slowness of economic recovery and continued weakness in the job market coupled with a burgeoning public debt in the US appears to be re-igninting the debate on whether the government should attempt to trigger some level of inflation to both create conditions for economic recovery and reduce the debt burden.

Advocates of more aggressive monetary policy actions point to the firmly anchored nature of inflationary expectations and the anemic trend of employment generation, and argue that the Fed should indulge in even more balance sheet expansion to specifically target expanding money supply and lowering the real interest rate so as to make a serious dent on the unemployment rate. They reject the commonly held fears, often expressed by Bernanke himself, about carry-trade (borrow dollar and lend in other currencies), new asset bubbles, and problems in ultimately exiting by unwinding purchases, as overblown and feel that the "economic crisis has been so severe that it will take time to rebalance, rebuild and perhaps repent".

However, this line of argument may be over-simplifying the profoundity of challenges faced by the economy in the US and many other developed economies. I have blogged earlier on the limitations of monetary policy actions at zero-bound in boosting aggregate demand. Apart from the fact that nominal interest rates are touching zero-bound and deflationary pressures loom large (thereby backstopping real interest rates from coming down), the dismal economic prospects also means that the economy is suffering from the debilitating twin problems of weak consumer demand and business investment.

Any monetary policy action involving expanding the balance sheet to increase money supply and lower rates will work only when the twin-spiral is triggered off - consumers should start buying and businesses should start investing. In its absence, the expansionary policies will only create more money without boosting the aggregate demand. It cannot be denied that given the depth of unemployment now and bleakness of economic prospects, the pace of employment generation has to be increased manifold if the economy is not to suffer a long-drawn out and painful recovery process.

The solution, as Mark Thoma writes and I have blogged earlier, would appear to lie in policy actions that have more direct impact on aggregate demand, which are mostly fiscal in nature. Mark Thoma points to the success of the cash for clunkers program and the inducements given for new home buyers as evidence for more similarly targetted and direct fiscal policy actions. Such policies include tax credits, transfers to state and local governments, and government spending on goods, services and hiring labor.

In any case, even if the longer-term inflationary expectations get unhinged, there may be a silver-lining in so far as it would erode the value of the buregeoning US public debt, a large share of which is held by foreigners. A recent NBER working paper by Joshua Aizenman and Nancy Marion (pdf here) finds that in the years ahead, despite the fact that shorter debt maturities reduce the temptation to inflate while the larger share held by foreigners increases it, public debt in America is likely to be offset by inflation. They write about impact of a large nominal debt overhang on the temptation to inflate,

"When economic growth is stalled, the US debt overhang may trigger an increase in inflation of about 5 percent for several years. This additional inflation would significantly reduce the debt ratio, even with some shortening of debt maturities... a moderate inflation of 6 percent could reduce the debt/GDP ratio by 20 percent within 4 years."


Anonymous said...

I like this piece. Here are a few specific comments and thoughts.

"the twin-spiral is triggered off - consumers should start buying and businesses should start investing."...
....Banks are not lending to businesses and are making it extremely difficult to borrow. I have seen evidence of the same myself. Requirement for collaterals is increasing and banks are not willing to assess projects and lend on their strength. What are the consumers not buying? What buying are we trying to promote? Should we encourage across the board consumption increase or should we direct it to the extent possible.

"policy actions that have more direct impact on aggregate demand, which are mostly fiscal in nature"....
..I think this is close to Garibi Hatao movement of Mrs.Gandhi. We need to assess the degree of directness possible with different programs closely before increasing the spend on them...

"public debt in America is likely to be offset by inflation."..
...Might be very poor compensation for the country as the savings of folks would be worth nothing down the line. Older folks would be on the streets. This would move investment into non depreciable assets. Is there sufficient and infinitely elastic supply of non-depreciable etc..??

gulzar said...

thanks for the comments

banks are making it difficult to borrow because having seen the events of the past few months, they are vary of counter-party risks (or should we say "uncertainty"!). the bigger problem with the financial market turmoil has been the crisis confidence (and not the crisis of credit markets) that it has unleashed. it will take time for market confidence to return and only then will lending become normal.

as it is getting the macro-details (tax cuts, infra spending, unemployment insurance, food rations, work programs etc) of a fiscal stimulus is difficult. getting into the micro-details of consumption, whether useful or not, may not be practical. just imagine the political difficulty (and resultant corruption and pork-barrel) of designing policies that promote the use of one type of commodity/good over others. across the broad consumption increase may be more easier and practical, unless we have policies that can direct consumption in specific sectors like the cash for clunkers for automobiles in the US and Europe.

NREGA is a classic example of putting incomes directly in the hands of people who are likey to spend (instead of save) it. smaller infrastructure works, like village roads and drains, minor irrigation structures, small school and PHC buildings, are also works which can quickly get off the gorund and provide employment and incomes to people and generate an immediate spending multiplier on the economy.

yes, inflation has its costs and poor peole bear the brunt. automatic stabilizers and mitigatory policies have to be put in palce to cushion them

we are not talking about hyper-inflation, but inflation in the range of 3-6%, even more. i do not think this would have any depressive effects on investments in capital assets. in any case, the transmission mechanism is far too complex for higher inflation to simply channel investments in non-depreciable assets. need a longer post to elaborate on it.