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."