End of central banking as we have known it?

Greg Ip has a very nice article on the emerging world of constrained central banking and monetary policy.

Since World War II, every recovery was ushered in with lower rates as the Fed moved to stimulate growth. Every recession was preceded by higher interest rates as the Fed sought to contain inflation. But with interest rates now stuck around zero, central banks are left without their principal lever over the business cycle... The Fed typically cuts short-term interest rates by 5 percentage points in a recession... yet that is impossible now with rates below 2%. Workers, companies, investors and politicians might need to prepare for a world where the business cycle rises and falls largely without the influence of central banks... In November, Fed Chairman Jerome Powell warned Congress that “the new normal now is lower interest rates, lower inflation, probably lower growth…all over the world.”... Central banks are calling on elected officials to employ taxes, spending and deficits to combat recessions. “It’s high time I think for fiscal policy to take charge,” Mario Draghi said in September, shortly before stepping down as ECB president.

This description of the causes of business cycles,

The causes of business cycles were diverse, Wesley Clair Mitchell, an NBER founder, wrote in 1927. They included “the weather, the uncertainty which beclouds all plans that stretch into the future, the emotional aberrations to which business decisions are subject, the innovations characteristic of modern society, the ‘progressive’ character of our age, the magnitude of savings, the construction of industrial equipment, ‘generalized overproduction,’ the operations of banks, the flow of money incomes, and the conduct of business for profits.” He didn’t mention monetary or fiscal policy because, for all practical purposes, they didn’t exist. Until 1913, the U.S. hadn’t had a central bank, except for two brief periods. As for fiscal policy, U.S. federal spending and taxation were too small to matter.

On the nature of business cycles,

From 1854 to 1913, the U.S. had 15 recessions, according to the National Bureau of Economic Research, the academic research group that dates business cycles. Many were severe. One slump lasted from 1873 to 1879, and some historians argue it lingered until 1896... U.S. recessions were more frequent before the Federal Reserve took control over interest rates, using them as a lever to slow inflation or boost the economy.

On the origins of monetary and fiscal policies,

When central banks were established, they didn’t engage in monetary policy, which means adjusting interest rates to counter recession or rein in inflation. Many countries were on the gold standard which, by tying the supply of currency to the stock of gold, prevented sustained inflation. The Fed was established in 1913 to act as lender of last resort, supplying funds to commercial banks that were short of cash, not to manage inflation or unemployment. Not until the Great Depression did that change. In 1933, Franklin D. Roosevelt took the U.S. off the gold standard, giving the Fed much more discretion over interest rates and the money supply. Two years later, Congress centralized Fed decision-making in Washington, better equipping it to manage the broader economy... John Maynard Keynes... showed how individuals and firms, acting rationally, could together spend too little to keep everyone employed. In those circumstances, monetary or fiscal policy could generate more demand for a nation’s goods and services, Mr. Keynes argued... The Employment Act of 1946 committed the U.S. to the idea of using fiscal and monetary policy to maintain full employment and low rates of inflation.

This is a nice summary of the history of monetary policy,

The next quarter-century followed a textbook script. In postwar America, rapid economic growth and falling unemployment yielded rising inflation. The Fed responded by raising interest rates, reducing investment in buildings, equipment and houses. The economy would slide into recession, and inflation would fall. The Fed then lowered interest rates, investment would recover, and growth would resume. The textbook model began to fray at the end of the 1960s. Economists thought low interest rates and budget deficits could permanently reduce unemployment in exchange for only a modest uptick in inflation. Instead, inflation accelerated, and the Fed induced several deep and painful recessions to get it back down.

By the late 1990s, new challenges emerged. One was at first a good thing. Inflation became both low and unusually stable, barely fluctuating in response to economic growth and unemployment. The second change was less beneficial. Regular prices were more stable, but asset prices became less so. The recessions of 2001 and 2008 weren’t caused by the Fed raising rates. They resulted from a boom and bust in asset prices, first in technology stocks, then in house prices and mortgage debt.

After the last bust, the Fed kept interest rates near zero from 2008 until 2015. The central bank also purchased government bonds with newly created money—a new monetary tool dubbed quantitative easing—to push down long-term interest rates. Despite such aggressive stimulus, economic growth has been slow. Unemployment has fallen to a 50-year low, but inflation has persistently run below the 2% target the Fed set. A similar situation prevails abroad. In Japan, Britain and Germany, unemployment is down to historic lows. But despite short-and long-term interest rates near and sometimes below zero, growth has been muted. Since 2009, inflation has averaged 0.3% in Japan and 1.3% in the eurozone. The textbook model of monetary policy is barely operating, and economists have spent the last decade puzzling why.

This about the asymmetric nature of monetary policy effectiveness,

A central bank can always raise rates enough to slow growth in pursuit of lower inflation; but it can’t always lower them enough to ensure faster growth and higher inflation.

On why interest rates transmission in the US may be weaker today,

The economy has changed in ways that weaken its response to interest-rate cuts, they wrote. The economy’s two most interest-sensitive sectors, durable goods manufacturing, such as autos, and construction, fell to 10% of national output in 2018 from 20% in 1967, in part because America’s aging population spends less on houses and cars. Over the same period, financial and professional services, education and health care, all far less interest sensitive, grew to 47% from 26%... the response of employment to interest rates has fallen by a third, meaning it is harder for the Fed to generate a boom.

My one quibble with this narrative is on an issue of attribution. How do we know that monetary policy was responsible for all these trends being attributed to it? How much role did central banking play in ushering in the Great Moderation and sustaining it for nearly a quarter century? How do we separate monetary policy's impact from the numerous other forces that converged at the same time? How do we know that the quantitative easing monetary policy since the crisis has been more beneficial than costly? In fact, how do we refute the criticism that the extended monetary accommodation has entrenched the existing elite power, widened economic inequality, and ripened popular discontent? In other words, how can we claim that the positives associated with monetary policy are causation and not mere correlation?

Interpreting Keynes - restoring market confidence

The 'neo-classical synthesis' of Keynesianism and classical microeconomics holds that the economy is Keynesian in the short-run because wages and prices are "sticky" (as initially interepreted by John Hicks in England and Alvin Hansen in the US), while it is classical in the long-run when prices have found their right level. It implies that, to restore full employment, we simply need to realign nominal prices with nominal demand, either with monetary policy to stimulate private spending or with fiscal policy to replace private spending with public spending. Opponents of the Keynesian fiscal policy to stimulate aggregate demand, led by the likes of Robert Barro and Eugene Fama, invoke Ricardian equivalence to argue that government spending will crowd out private expenditure.

UCLA Professor Roger Farmer, in a series of recent working papers and articles, while conceding the usefulness of fiscal policy he argues that the fiscal stimulus induced government spending multiplier is smaller than claimed and presents an alternative approach to address such deep economic crisis. He argues that orthodox Keynesian interpretations of the General Theory misses the story and offers an alternative reconciliation of Keynes with microeconomics that does not rely on sticky prices.

About the problem with fiscal policy, he writes,

Keynes said three things in the General Theory. First: the labour market is not cleared by demand and supply and, as a consequence, very high unemployment can persist forever. Second: the beliefs of market participants independently influence the unemployment rate. Third: It is the responsibility of government to maintain full employment. He was right on all three counts. But he was wrong about something else.

Keynes thought that consumption depends on income... Consumption, and this is two thirds of the economy, depends not on income but on wealth... the theory of the (government spending) multiplier and the implication that fiscal policy can get us out of the current crisis rests on exactly this point... but if income depends on wealth then fiscal policy may be less effective than the Keynesians claim... fiscal policy cannot provide a permanent fix to the problem of high unemployment.

Prof Farmer raises doubts on the Ricardian equivalence claim since its logic "requires that rational forward looking households fully internalize the future tax burden of current fiscal profligacy", an unlikely fact since human "lives are short and not everyone cares for their descendents".

In the first paper, Prof Farmer claims that the equilibrium business cycle theory is flawed and presents an "alternative paradigm that retains the main message of Keynes’ General Theory and which reconciles that message with Walrasian economics". He argues that unemployment will remain trapped at a high level due to two labor market failures - arising from a lemons problem and an externality. The aforementioned two market failures makes it difficult and costly to match unemployed workers with vacant jobs, by not providing "the necessary price signals to ensure that a given number of jobs is filled in the right way". This results in economically and socially inefficient multiple "equilibria in which the unemployment rate is determined by the self-fulfilling beliefs of stock market participants". He writes,

"Firms decide how many workers to hire based on the demand for the goods that they produce. The demand for goods depends on wealth. Every different equilibrium unemployment rate is associated with a different set of prices for factories and machines and the value of these physical assets depends on what market participants think they will be worth in the future. The world economy is currently headed rapidly towards a high unemployment, low wealth equilibrium which was triggered by a loss of confidence in the value of assets, backed by mortgages in the US subprime mortgage market. The inability to value these assets has since led to an amplification of the crisis as panic hit the global financial markets. Even though the US stock market is appropriately valued based on historical price earnings ratios — investors are worried that the value of stocks could fall further... (any further) drop may prove to be self-fulfilling...".

In another working paper, he draws attention to a less costly and more effective alternative to fiscal policy. He feels that the "current financial crisis is an example of a shift to a high unemployment equilibrium, induced by the self-fulfilling beliefs of market participants about asset prices". His arguement is summed up as - "informational asymmetries cause missing markets, missing markets lead to the existence of multiple equilibria, and psychology, in the form of self-fulfilling prophecies, becomes an additional fundamental that selects an equilibrium".

Under such circumstances, a better "alternative might be for the Fed to intervene in the asset markets through purchases and sales of a broad index fund of stocks". He writes, "We need a new approach that directly attacks a lack of confidence in the asset markets by putting a floor and a ceiling on the value of the stock market through direct central bank intervention".

Great Depression Vs Great Recession

Barry Eichengreen and Kevin O' Rourke find evidence to show that the world economy is faring worse than even the Great Depression of 1929-30. Consider these graphics

1. World Industrial Output



2. World Stock Markets



In contrast, the decline in US equity markets have been less steep in comparison to the global markets.




3. Volume of world trade



4. Central Bank discount rates (GDP-weighted average of central bank discount rates for 7 countries) - In both crises there was a lag of five or six months before discount rates responded to the passing of the peak, although in the present crisis rates have been cut more rapidly and from a lower level.



5. Money supplies (GDP-weighted average of 19 countries accounting for more than half of world GDP) - Monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, and the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.



6. Government budget surpluses (for 24 countries) - Though fiscal deficits expanded after 1929, it did so only modestly, whereas the willingness to run deficits today is considerably greater.



The comparison with Great Depression is appropriate since similar to the triggers now, the Great Depression was induced by an unsustainable real estate boom (centred in Florida), lax supervision and regulation, and global imbalances (known then as 'the transfer problem').

Update 1
Price Fishback lays out the stats to show why the current recession is far from being similar to the Great Depression.

Update 2
Great Depression in perspective, with respect to the decline in GDP.



Update 3
Barry Eichengreen and Kevin O'Rourke have an update on the Great Depression Vs Great Recession debate. And their conclusion is - today's crisis is at least as bad as the Great Depression! They show that manufacturing production, exports and equity prices have fallen much steeply in Europe than in the US. Further, they also point to the important differences in monetary and fiscal policy responses during the two crises.

Update 4
And Economix compares with the 1982 recession on job losses. And Mark Thoma points to Menzie Chinn on the comparison with the 1982 recession.

Update 5
Martin Wolf too weighs in.

Update 6
In the latest edition (August 2009) of the comparison of the present crisis with the Great Depression, Eichengreen and Rourke find that though the world industrial production, trade, and stock markets are now showing signs of recovery, the ongoing crisis is dramatic even by the standards of the Great Depression.

Update 7
Greg Mankiw has this nice post which examines as to what should be the yardstick for evaluating the extent of a recession.

Update 8
Barry Eichengreen and Kevin O' Rourke have the September 2009 update of the Great Recession compared with the Great Depression.

Update 9
Carlo Favero proposes a new, historically comparable measure of economic uncertainty to compare the Great Recession and Great Depression and finds that the evolution of uncertainty in this crisis has been much less dramatic than in the 1930s.

His measure of uncertainty is the spread between Moody's Seasoned Baa Corporate Bond Yield and Moody's Seasoned Aaa Corporate Bond Yield, available via the FRED database and the Federal Reserve Bank of St-Louis. The spread between bonds with the same maturity issued by firms with different credit ratings measures directly the premium that uncertainty commands in the bond market.

Update 10 (15/3/2010)
Barry Eichengreen and Kevin O'Rourke update their comparisons based on data from February 2010 and find that while situation has improved there is no room for complacency. They find that global industrial production now shows clear signs of recovering; though global stock markets have mounted a sharp recovery since the beginning of the year, the proportionate decline in stock market wealth remains even greater than at the comparable stage of the Great Depression; though the downward spiral in global trade volumes has abated, and the most recent month for which we have data (June) shows a modest uptick, the collapse of global trade, even now, remains dramatic by the standards of the Great Depression.

Update 11 (26/3/2010)
Minneapolis Fed assesses the present recession in comparison to the previous ones.

Mundell on who and what caused the crisis and the way out

Dani Rodrik points attention to an excellent and informative presentation given by Robert Mundell on the financial crisis and the international monetary system. Prof Mundell touches on several interesting and controversial issues like the role of soaring dollar, decision to let Lehman fail, dated spending vouchers, nationalization, euro-dollar currency system, a global lender of last resort, global currency etc.

1. The soaring dollar (the dollar appreciation overvalued US dollar assets including all fixed income securities and mortgages, tipping Lehman Bros and other banks over the edge) and falling gold price in August-September 2008, were symptoms of a shortage of tight money (despite the low interest rates) and dollar liquidity. "Had the FED recognized this shortage and bought foreign exchange to prevent the appreciation, there would probably have been no financial crisis in the fall. The Federal Reserve cut off the economic recovery in 2008(2) and tipped the economy into recession and financial crisis".

2. He claims that there was a recovery in the second half of 2008 in the US, with growth of 2.8%, which was nipped off by the policies of the government and the Fed. The decision to let Lehman fail exacerbated the crisis, greatly increasing the demand for money further, creating the casualties that followed. The failire to effectively intervene to stem the rise of dollar exacerbated the liquidity squeeze.

3. The five goats that caused the crisis
a) Lewis Ranieri - the bond trader who is credited to be the "father of securitized mortgages"
b) Bill Clinton - for repealing the Glass-Steagal Act, "prompting the era of the superbank and primed the sub-prime pump" and liberalizing the norms for mortgage lending.
c) Alan Greenspan - for keeping interest rates too low, dollar too weak, for too long, leading the housing bubble to develop; supporting sub-prime lending and variable rate mortgages; and defending derivatives.
d) Maurice Greenberg (AIG founder) - for conducting vast business in credit default
swaps (CDS) and mass multiples of derivatives.
e) Ben Bernanake - for allowing dollar to soar as the euro fell from above $1.60 in June to below $1.30 in October 08 and failing to appreciate that this appreciation would freeze the credit markets causing extreme shortage of dollar liquidity.
f) Hank Paulson - for letting Lehman fail and failing to recognize the consequences of dollar appreciation.

4. The five "trouble makers" were - securitization of mortgages (cut link between issuers and holders); derivatives (created new systemic risks);Credit-Default-Swaps (enabled insurance without ownership); Mark-to-Market Accounting Rules (created intertemporal instability in balance sheets); and Variable Rate Mortgages

5. He gives six prescriptions for the crisis
a) Issue $500 bn Dated Spending Vouchers (to expire in 3 months) to increase effective demand. Retailers would use the executed vouchers as tax credits.
b) Cut corporation tax rates from 35% to 15% to allow recapitalization of corporations and increase competitiveness.
c) Government takeover and restructuring of insolvent banks for subsequent privatization to rehabilitate the banking system.
d) Stabilize dollar-euro rate with the euro fixed at limits between $1.20 and $1.40 to avoid beggar-thy-neighbor exchange rate opportunism. The stabilization can be done gradually by creating a band of fluctuation at the margins of which the banks intervene and then narrow the band as the FRB and ECB get more comfortable at coordinating monetary policies. The dollar-euro rate to be the new anchor for the international monetary system around which an international currency can be based.
e) Establish an International Macroeconomic Advisory Council as a global version of the Volcker-Chaired Obama Advisory Council to deal with the coordination of international macroeconomic policies.
f) Issue 1 Trillion SDRS to IMF members in proportion to quotas or according to a new formula introduced to distribute the seigniorage more equitably. This would provide public money to especially the smaller countries who do not have a lender of last resort. It would also prevent the collapse of the banking systems in the rest of the world.

6. He advocates a global currency, if need be among the Asian economies, as the long run goal. He also prefers a single unit for quoting prices on major commodities, a common unit for denominating debts, a common rate of inflation for participating countries, a common interest rate on risk-free assets, and a global business cycle.

"Balance sheet deflation" and the need for fiscal expansion

Martin Wolf draws attention to the analysis of the Japanese deflation of the nineties by Richard Koo of Nomura Securities who argues that a combination of falling asset prices with high indebtedness forces the private sector to stop borrowing and pay down debt, and the government then inevitably emerges as borrower and spender of last resort.

He describes this a "balance sheet deflation" (and here), where the values of assets purchased with debt plunges, driving the economy into virtual bankruptcy as borrowers start defaulting. When faced with a massive fall in asset prices, companies typically jettison the conventional goal of profit maximization ("yang") and move to minimize debt ("yin") in order to restore their credit ratings. He feels that when faced with "yin" phase of the business cycle, fiscal policy alone will be of any utility.

The situation is made even worse when interest rates are close to zero, thereby rendering conventional monetary policy irrelevant. This happened in Japan and is now happening in the US, though the learnings from Japan appear to have been misinterpreted.

The figures show that US is in a much worse macroeconomic situation that Japan, despite the much larger destruction of wealth there, and the stuttering world economy is in no position to bailout the US economy by volunteering to buy up American exports. Total outstanding consumer credit has risen from $1.7 trillion in 2000 to $2.6 trillion now, residential mortgages rose from $5.6 trillion in 2000 to $12 trillion by end of 2008, and national debt increased from $5.7 trillion to $10.8 trillion in the same period. To top it all, US has both massive public debt (internal) and current account deficit (external) problems.





This means that the US economy will have to emerge out of the present crisis without any external support (Paul Krugman emphasizes this point while drawing on its role in pulling Japan out of its slump) and with the expected long period of suppressed private sector - both households and financial and non-financial businesses - consumption and investment. This leaves the ball squarely in the court of the Government, which despite its own indebtedness, is left with no choice but to engage in fiscal pump-priming in an unprecedentedly massive scale. And government spending too not in the form of tax cuts, which invariably will end up being saved or used to pay off debts.

Wolf points to the inevitable twin challenges for the US economy - reduce private sector debt and current account deficits. He opines that the former can be achieved with relatively lesser pain by forced write downs of bad assets in the financial sector and either more fiscal recapitalisation or debt-for-equity swaps and also mass bankruptcy of insolvent households and forced write downs of home mortgages. This, while increasing public debt, will usher in a slimmer and better-capitalized financial system and a healthier non-financial private-sector balance sheet in reasonable time, and will be better than a decade or more of continuous "deleveraging", with running fiscal deficits, and sustained pain. Addressing the current account deficit will be more a challenge of global economic diplomacy and co-ordinated action by the major economic powers, so as to remedy the grossly unsustainable structural imbalances in the world economy.

Wolf also spotlights on Koo's claim that contrary to the widespread misconception, Japan emerged out of the nineties thanks to the massive fiscal deficits, which prevented the economy slipping into a full fledged depression. In fact, Japan emerged out of the bad decade of nineties in the 2003-07 period, before the present crisis started taking its toll. However, like the US now, Japan too had problems in swiftly responding to the failing banks with their distressed assets and let the zombie banks continue functioning for a decade. The "public hostility to bankers rendered it impossible to inject government money on a large scale, and the power of bankers made it impossible to nationalize insolvent institutions".

Interestingly, Richard Koo finds that the Indian economy is in the yang phase, with the economy healthy, the private sector regaining its vigor, and confidence back.

Update 1
Awkward Corner sums up the balance sheet deflation debate here.

Update 2
Mostly Economics points "to an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis."

Update 3
Paul Krugman says Koo's theory of balance sheet deflation is similar to John Hicks' "non-linear" theory of the business cycle with its emphasis on the unstable short run nature of the economy - "an economic boom causes rising investment spending, which further feeds the boom, and so on, while a slump depresses investment spending, deepening the slump, etc". Krugman says that Hicks’s big contribution was to add limits to the boom and slump: a "ceiling" set by the economy’s capacity, a "floor" set by the fact that investment can’t go negative.

Update 4 (26/12/2010)

Mark Thoma writes about the way out of such balance sheet recessions - "use the federal government’s balance sheet as a means of offsetting the deterioration in the private sector’s financial position".

Depression Vs Recession

Another addition to the list of semantic debates at these bleak economic times has been about the difference between recession and depression. There is no dispute in that both refer to periods of economic slowdowns. The NBER has a formal definition of recession as generally two consecutive quarters of declining economic output.

The Economist distinguishes between the two by drawing attention to two popular definitions of depression - a decline in real GDP that exceeds 10%, or one that lasts more than three years. By this definition, only one developed country has suffered a Depression since the War (Finland, in the aftermath of the collapse of erstwhile USSR), whereas there hae been thirteen instances of depressions in developing economies in the past thirty years.



Another distinction is made based on the cause of the downturn - recession usually follows a period of tight monetary policy, but a depression is the result of a bursting asset and credit bubble, a contraction in credit, and a decline in the general price level (deflation). Therefore both demand separate policy responses. A recession can be cured by lower interest rates, but fiscal policy tends to be less effective because of the lags involved. By contrast, in a depression conventional monetary policy is much less potent than fiscal policy.

Policy prescriptions for the crisis

The ongoing global financial crisis turned economic recession is fast turning into a stag-deflation, where banks have turned off their credit taps, consumers have pulled back on consumption and businesses have responded by postponing their investments. Uncertainty and fear have unleashed a self-fulfilling cycle of psychological shocks among the major economic actors, paralyzing all normal economic activity.

As was discussed in an earlier post, "the specific economic and financial market conditions that created the crisis, bad as they are, have been overtaken by the psychological apprehensions and fears of the market participants. The increasingly entrenched rational expectations of the investors and lenders, consumers and businesses about themselves, others and future prospects, have brought all normal financial and economic activity to a virtual standstill. The challenge is to break this grid-lock and get economic normalcy restored".

Now, in a neat summary of the debate on the prescriptions for immediate action, the Chief Economist of IMF, Olivier Blanchard, draws the distinction between "subjective" (unknown unknowns) and "objective" (known unknowns) uncertainty, and claims that in the present economic environment the former rules, leaving investors, consumers and firms paralyzed. The result has been a flight from all forms of assets perceived as even slightly risky, including the emerging markets. His prescription

1. Reduce uncertainty, by removing tail risks, and the perception of tail risks, by - establishing atleast a floor price on distressed assets, ring fencing them and taking them off bank balance sheets; commit to do now and in future, whatever it will take to avoid a Depression, from fiscal stimulus to quantitative easing. The responses should be clear, decisive, immediate, and large.
2. Stabilize the financial markets by helping recycle the funds towards risky assets, through recapitalization etc. The governments should intervene aggressively with capital injections into the domestic financial markets and the emerging economies, which have been facing massive exodus by foreign portfolio investments.
3. Break the wait-and-see attitude of consumers and firms by incentivizing them to spend and invest now rather than later - temporary subsidies etc. Government infrastructure spending and other stimulus measures, tailored and communicated well, can not only stimulate and replace private demand, but also reassure consumers and firms.

Alberto Alesina cautions against any unlimited, blank-cheque monetary and fiscal stimulus, and points to the need to keep the budgetary constraints, especially for the future, in mind. He also finds fault with the unprioritized and "throw everything you have at the economy" approach advocated by Blanchard. More specifically, he advocates temporary incentives to make banks lend and investors borrow and invest - public insurance against defaulting borrowers for banks who lend; fiscal incentives to encourage private investors to invest this year rather than next (easily done with depreciation allowances); fiscal protection against stockmarket losses, using temporal variation in capital-gains taxes and loss deductions etc.

Robert Shiller draws attention to the importance of "confidence multiplier", as against the conventional "economic multiplier", which would improve economic agents' level of trust in other people and businesses, and thereby break the "wait-and-see" gridlock. He therefore advocates that the "focus has to get off of 'what fraction of this stimulus will be spent' to 'how does this stimulus affect confidence." Since "different kinds of stimulus have different effects on confidence, depending on how they are viewed and interpreted by the public", we need to keep this in mind while structuring the fiscal stimulus .

Mark Thoma argues that given the uncertainty about the sources of the problems, and about which remedies will be effective, we should "do the equivalent of throwing a full spectrum antibiotic at the problems and hope this somehow manages to work" - a "portfolio of policies", which are "too much rather than too little". He also underlines the need to reassure consumers, lenders, and businesses by "rebuilding and restructuring of these markets to insulate them against future problems — including regulatory changes".

Eswar Prasad draws attention to the importance of coordinated fiscal stimulus in major economies, which if "suitably trumpeted and implemented on a massive scale, could deliver a much bigger bang for the buck than uncoordinated policies". He also warns of the harmful effects of protectionist rhetoric, especially on businesses and investments.

Tyler Cowen is right in arguing that the policy solutions have to go beyond merely stimulating aggregate demand, and seek to restore confidence and dispel fears. He therefore advocates the use of placebo policies (placebos often wor as much as drugs!) - initiatives which appear bold and have great symbolic value, but which don't necessarily cost us very much. He points to the importance of making the "painful adjustment to lower levels of spending and debt", which requires "reallocation of resources out of construction, finance, and debt-financed consumption", all of which will be made harder by boosting aggregate demand.

Ricardo Caballero fears that the plummeting asset values and consequent de-leveraging could quickly wipe out equity capital values of financial institutions with with strict capital requirements (banks, insurance companies, and monolines), and simultaneously close their option to raise new capital. Further, "forcing them to raise capital, be it private or public, at panic-driven fire-sale prices threatens enormous dilutions to already shell-shocked shareholders, further exacerbating uncertainty and fueling the downward spiral".

While his analysis is a partial explanation, the prescriptions can be disputed. He proposes the replacement of the "two functions of bank capital — a buffer for negative shocks and an incentive device to reduce risk-shifting — by the provision of a comprehensive public insurance, and by strict government supervision while this insurance is in place". Arguing against nationalization, he advocates a comprehensive insurance backstop for banks, after removing their rotten assets and recapitalising them on terms that are not penal to existing shareholders. He also feels that the government should become the explicit insurer for generalised, extreme, panic-driven risk, as opposed to the microeconomic risk and moderate aggregate shocks.

Free Exchange, proposes "contingent policies", widely known in advance, that are triggered when a predetermined bad state of the economy is reached. Such policies would reassure households, investors, and businesses that tail risks are less likely to be realised, and they should become more willing to spend or invest, further reducing those tail risks. Apart from conventional contingent policies like deposit insurance and Taylor rule, anc automatic stabilizers like health care subsidies and unemployment insurance, there is scope for others like Central Banks becoming lenders and insurers of last resort.

Update 1
Brad De Long (and here) analyses the four policy options to combat a depression - inflation, monetary policy, credit policy and fiscal policy. And he feels that only the last two are effective now, and we need to try both at the same time.

Real business cycle theory rebutted

Joseph Schumpeter had argued that a "perennial gale of creative destruction" is an inevitable requirement for any advance in human condition and this in turn can take place only in the context of a cycle of boom and bust. New technologies and inventions arouses a wave of optimism and entrepreneurial spirit, leading to over-investments, funded by credit made available by banks eager to partake of a share in the boom. Then reality dawns and the bubble bursts, leading to banks exiting in the same irrational manner, which only exacerbates the crisis. But the reality of such a "creative destruction", with its attendant bad times, is an inevitable fact of such cycles. This in turn calls for government intervention to to smooth the rough edges of the "destruction" arising from the replacement of the old capital.

Robert Skidelsky takes up arguement against the contemporary "real business cycle" theories which claims that efficient markets, which always clear, will smooth over and minimize the "destructiveness" of the "creation" in any boom and bust, and therefore any government intervention will be counter-productive. He rejects their contention that the markets will clear by themselves, and argues that the non-intervention arguements of the "real business cycle" theorists is misplaced. However, he argues that unlike even the dot-com bubble, this time there was no positive technological shock and the easy credit financed only a massive house of financial innovation built on shaky and often illusory foundations.

Fiscal Vs Monetary Policy

This (and the next) is a longish (and often rambling) post... an attempt at rehearsing the story so far in one of the most fascinating economics debates of our times! It is also an attempt at linking up the relevant sources, so as to serve as a resource for future reference. So, either skip this, or bear with me!

Whoever said economics is a dismal science and for ivory tower academicians, should themselves step out of their ivory towers and open their computers and follow some of the popular economics blogs on the Internet for a day or two! We are surely living in an age of real-time academic opinion-making, if not policy-making, in economics atleast!

Since economics became to be appreciated as a formal branch of the social sciences, macroeconomic policy making during economic crisis, has been one of the most contentious issues in the subject, so far not amenable to any settled, single and widely accepted theory. The present economic crisis has re-opened the debate with an intensity and spread rarely witnessed, thanks to the ability of blogs to let the top economists and the world engage in a series of fascinating, real-time debates (and happily there seems to be no dearth of willing volunteers!).

The debate essentially has two main plots - fiscal policy Vs monetary policy, and government spending Vs tax cuts. We will examine each of the two and also a few sub-plots. We will first cover the first one in this post and the second in the next post.

Fiscal Vs Monetary Policy

Even as the sub-prime mortgage bubble burst and the economic crisis dawned, the Central Banks across the world, after some initial hesitation, were quickly off the blocks and resorted to aggressive monetary policy actions - lowering rates to almost zero bound, direct cash injections into financial institutions, purchases of troubled or distressed assets, liquidity infusions through auctions and Central Bank lending windows, relaxation of collateral standards for lending, blanket insurance on deposits etc. In the US alone, the balance sheet of the Federal Reserve has burgeoned from $900 bn to nearly $3 trillion in the space of a few months.

However, all these have had limited effect in reining in the steep slide downwards. There are ofcourse, those who claim that without these aggressive monetary loosening, the results would have been worse still. Even if this is true (and it surely is), it is a small consolation. The apparent ineffectiveness of the monetary policy in preventing a slide into an economic recession, set in motion calls for a fiscal stimulus package to bail out the economy and its various sections.

Central to the debate on fiscal and monetary policies has been a 1994 NBER Working Paper by David and Christina Romer, which examined the evidence from post-war recessions and claimed that monetary policy appeared to be more influential in economic recoveries atleast in the initial stages. The authors' claim is based on the finding that Central Banks step in early and adequately with their rate cuts, whereas policy makers take time (often well past the trough) to cobble up a politically consensual fiscal policy which often ends up being too little too late. A discussion on the Romers' position is available here.

Apart from the views against fiscal policy expounded by the Romers, the other major arguements against the utility of fiscal stimuluses include its supposed inherent lags (often more than the duration of the recession), its allocative problem (the strong possibility of pork barrel and inefficient use), and its "crowding out" of private investments. Mark Thoma (here and here), Robert Skidelsky, and Paul Krugman have made persuasive cases against all these arguements.

There are very strong arguements against the contention that infrastructure projects suffer from implementation lag and hence public investments on infrastructure may not be money well spent. Since it has now become abundantly clear that the recession and the potential-output gap will persist well into the next decade, in addition to the "shovel-ready" projects, newer projects, which take time to come on-stream, also become effective stimulus options. Econbrowser has an excellent graphical illustration of this for the US economy.

Alan Blinder has one of the best articles against the blanket critics of discretionary fiscal policy. He makes the distinction between government interventions to stabilize the economy during normal and abnormal times. Whereas monetary policy is superior to fiscal policy under normal circumstances, fiscal policy assumes much greater significance during "occasional abnormal circumstances — such as when recessions are extremely long and/or extremely deep, when nominal interest rates approach zero, or when significant weakness in aggregate demand arises abruptly".

Mark Thoma, with a similar position as Alan Blinder, argues that macroeconomic policy effects are dependent on the state of the economy - monetary policy is much less effective in recessions than at full employment, and with fiscal policy it is vice-versa. He writes, "I have a J. of Econometrics paper that finds state dependency for monetary policy (it's much less effective in recessions than at full employment), and as I've noted here many times over the last few years, I believe fiscal policy is similarly dependent on the state of the economy, though I would expect - consistent with basic Keynesian theory - that the effects run in the opposite direction. That is, unlike monetary policy, fiscal policy is most likely to be effective when the economy is sputtering (one reason is that crowding out, the main factor that undercuts fiscal policy effectiveness, will be small or non-existent), and least effective at full employment."

The different fiscal policy prescriptions have been presented by IMF, Martin Feldstein, Paul Krugman. Economix blog of the NYT has this exhaustive list of fiscal stimulus policy proposals by a number of leading economists. It also has this list of opposing view against fiscal stimulus measures. Paul Krugman makes another excellent case in favour of expansionary fiscal policies.

Amidst all this, the old, debunked and forgotten "Treasury View", that "that nothing could boost employment: not government spending, not tax cuts, not private business decisions to expand their capacity, not irrational exuberance on the part of entrepreneurs - for the unemployment rate was what it was", also got dusted up from the woodworks by no less an economist than Eugene Fama. This view works on the same "crowding out" logic - Government spending doesn’t increase aggregate demand; it only transfers spending power from one party to another by borrowing from or taxing the public; the resultant government debt (or increased taxes) absorbs private and corporate savings, which means private investment goes down by the same amount. Similarly, stimulus by lower taxes leads to lower government revenues, and hence increased government borrowing.

Montagu Norman provided a clear and stinging burial by showing how Fama made a fundamental misinterpretation of the national income accounting equaltion. In this context, a more intutive explanation for Fama's contention that stimulus expenditures "displaces other current uses of the same funds", is two-fold
1. the "current users" are "under certain extraordinary circumstances" not willing to spend the savings pool available, in which case, the money gets merely saved, without contributing to expanding the aggregate demand
2. in any case, public goods will be under-supplied (or not supplied) by the private sector, and the government has to make the required investments in them. Therefore the "displacement", is only of that share of the savings that had to be displaced to make a normal economy function.

Actually, it was Caroline Baum who had invoked it earlier in the crisis, only to be put in its place by Paul Krugman. Mark Thoma too has an excellent explanation, using the parable of a town devastated by a windstorm.

The next post will explore the other important debate, that between two different fiscal policy options - government spending and tax cuts.

Update 1
Paul Krugman uses the zero-bound and the graphic below to claim that conventional monetary policy is useless, and the need of the hour is fiscal expansionary and unconventional monetary policies.



Update 2
A primer on monetary policy is available here (pdf here).

Update 3
Economix blog draws attention to a debate on health care spending as a fiscal stimulus. Casey Mulligan argues against it, while Lawrence Summers, Dean Baker and Raj Chetty favours the Keynesian perspective.

Update 4
John Cochrane follows his Chicago School colleague Eugene Fama in resurrecting the "Treasury View" (ie. stimulus plans do not add to current resources in use but just move resources from one use (private spending) to another (government spending)). Brad De Long and Paul Krugman respond with exasperation. As Krugman says, the Savings=Investments accounting identity always holds, but "any discrepancy between desired savings and desired investment causes something to happen - GDP to fall (or rise) - that brings the two in line".

Update 5
Robert Barro sees the decline in private spending during the World War II as evidence that government expenditure (on the war) "crowds out" private spending. Paul Krugman responded here and here. He writes, "there was a war on. Consumer goods were rationed; people were urged to restrain their spending to make resources available for the war effort."

Update 6
Martin Feldstein is the most prominent conservative economist to support fiscal stimulus, saying that the current recession is much deeper than and different from previous downturns.

Update 7
Megan McArdle debates the stimulus options.

Update 8
NYT has this excellent article on the Japanese fiscal stimulus spending, espcially on public infrastructure, which saw Japan spend $6.3 trillion on construction-related public investment between 1991 and September 2008 ($2.1 trillion on public works between 1991-95 in the early part of the recovery, which led to growth touching 3% in 1996, before premature spending cuts and tax increases snuffed out growth), leading to Japan amssing public debt equivalent to 180% of its $5.5 trillion economy.

Update 9
Eugene Fama and John Cochrane take on Krugman and De Long on fiscal stimulus. Kevin Murphy and Chicago economists discuss the fiscal stimulus.

Update 10
Gary Becker and Kevin Murphy feel that the multiplier from any direct spending fiscal stimulus could be small. They also feel there will be problems in rolling them back once the crisis is over and could lead to higher taxes in the future.

Update 11
Mark Thoma brilliantly demolishes the arguement that stimulus borrowings constitute inter-generational theft. But as he rightly says, it is beneficial only if the spending is on good and useful assets, instead of being wasted on pork. In other words, the returns from the assets created should be greater than the cost of the capital.

Update 12
Alan Auerbach has this working paper on designing fiscal policies. Martin Feldstein too writes on re-thinking the role of fiscal policy. Federic Mishkin on the utility of monetary policy, especially in the initial statges of a financial crisis in counter-acting adverse feed back loops.

Update 13
Christina Romer makes the case for fiscal stimulus here.

Update 14
Richard Clarida feels that fiscal stimuluses may be a case of little bang for lots of bucks. Brad De Long feels that we need not fear about large fiscal stimuluses despite genuine concerns about bottleneck-driven inflation, capital flight-driven inflation, crowding-out of investment spending, nor reaching the limits of debt capacity.

He writes, "In all of these cases, that the stimulus is going to go wrong becomes very visible in advance. If the stimulus is going to be ineffective because it generates bottleneck-driven inflation, we can identify that problem as the price or wage of the bottleneck good or service spikes. If the stimulus is going to fail because of capital flight-driven inflation, we will see the value of the dollar collapse as foreign-exchange speculators front-run the capital flight – and then we will see import prices spike and put upward pressure on prices in the rest of the economy. If the stimulus is going to fail by crowding out private investment, we first will see the medium-term corporate interest rates relevant to financing plant expansion spike. And if it is going to impose a crushing debt repayment burden, we will see long-term Treasury bond interest rates spike instead. Right now, however, we see none of these things. No signs of bottleneck-driven or wage-push inflation gathering force. No signs of approaching rapid dollar depreciation. No signs that the stimulus is pushing up medium-term interest rates on corporate borrowing. No signs that the stimulus is pushing up long-term interest rates on government bonds."

Update 15
Brad De Long outlines the four policy options when economies are faced with recessions - fiscal policy, credit policy, monetary policy, and inflation.

Update 16 (21/3/2010)

Laurence S. Seidman and Kenneth A. Lewis finds, in the context of the stimulus spending during the Great Recession in the US, that fiscal stimulus effectively mitigates the recession and that debt as a percentage of GDP is only slightly greater with the fiscal stimulus than it would be without the stimulus.

Update 17 (27/7/2010)

Greg Mankiw has this essay examining the challenge government economists face during recessions in deciding policy - fiscal or monetary - responses. Free Exchange tries to explian the conditions when fiscal stimulus works.

Recessions and macroeconomic policy making

In the previous post, I had tried to put in perspective the challenge facing the world economy today. This post seeks to scan the landscape of macro-economic theory and conventional wisdom and see what specific policies (if any) are relevant for such times.

The challenge is to break the gridlock formed from a triple coincidence of banks refusing to lend, consumers refraining from shopping, and businesses postponing investments, all of which in turn reinforcing each other's expectations. The problem is that nobody is sure about what to do under such circumstances, as there are no specific and universally accepted theoretical principles for macroeconomic policy making during such times. The Chicago School of economists have for some time now been advocated that monetary policy acts faster and is more effective in smoothing over economic contractions than demand management policies. But as the present crisis has evolved, the limitations of this approach has been badly exposed, leaving fiscal policy as the preferred macroeconomic policy option.

Even when there is unanimity on the application of fiscal policy, there is raging controversy on what specific fiscal policy strategies to adopt. The knowledge from previous brushes with economic recessions appears to be of limited relevance as the results have been mixed and each crisis has its own unique features requiring situation-specific prescriptions.

While academics have from hindsight, gleefully dissected past crises, prescribed their versions of policy suggestions and blamed policy makers for failing to implement them, there appears to be nothing settled or certain about their prescriptions now. The old adage about the one-handed economist is more relevant now than ever. The fact remains that standard economic theories, while providing some form of loose and broad guiding framework, are of only limited utility in specific policy making during crises.

When the going is good, macroeconomic policy making has a ring of inevitability about it and the economic success appears to lend credence to beautifully constructed theories. It is therefore no surprise that the post-War neo-classical monetarist theories that emerged, to displace pre-War Keynesianism, during the golden age of capitalism, assumed a sacrosanct status (atleast, for a brief period of time in the eighties and nineties). This was more a case of co-relation equals causation, owed to an accident of history than arising out of any noteworthy successes in the real world.

Even during the good times, monetarism offers limited guidance on issues like how and when to prick speculative bubbles! Experience from even the recent examples of Central Bank interventions (or lack of it) during times of asset price inflation leading to bubbles, give little conclusive knowledge about monetary policy during the good times. For every example of a Greenspan "put" that created the conditions for speculative asset bubbles - first in equity and then in real estate - to develop, there is a contrarian example of a Bank of Japan conciously pricking a rapidly growing property market bubble in the nineties. The results were same in both cases - the equity markets crashed and recession followed.

The fact there is atleast some unanimity about the need for demand management through a fiscal stimulus is the surest indicator that Keynesianism remains the closest we have yet to a "theory of economic crisis"! However, a more comprehensive and complete theory of policy making during an economic crisis is still a work in progress...

Update 1
NYT has this article which captures the debate about macroeconomic policymaking challenges facing the incoming Obama administration. Every body agrees that "the goal ... is to jump-start economic activity by getting as much money as possible as quickly as possible into the hands of consumers and businesses, trying to make up for the falling demand in the private sector that is leading to higher unemployment". But how this can be done, with the lowest cost or the highest bang for the buck, is the issue.

At the end, the only consensus that emerges is that whatever support is provided, it should be so massive as to wash away all the troubles, something similar to using a steroid to cure a common cold!

The challenge facing the world economy

The US treasury and the Fed have effectively pumped in more than a trillion dollars over the past three months, even as the Fed's balance sheet has ballooned to nearly $3 trillion from below $1 trillion. Central Banks have indulged in monetary easing on an unprecedented scale, so much so that interest rates are staring against the zero rate bound in many of the developed economies. The Reserve Bank of India (RBI) alone has injected liquidity of more than Rs 300,000 Cr into the banking system over the same period. Fiscal stimuluses have come in all shapes across the world. None of these dramatic fire fighting measures, many of them last resort efforts, appear to have had any effect in reining in the terminal decline towards a deep economic recession across the world. What is the problem?

The bursting of the sub-prime mortgage bubble has left the financial institutions with large and unknown quantities of assets of dubious quality or troubled assets. The inability of the market and its institutions to locate, quantify, and price risk has unleashed a massive problem of information asymmetry with attendant adverse selection issues. Uncertainty about the quality of their own assets, wariness of counter-party risks in their prospective borrowers, and entrenched expectations of a deep economic recession looming have forced lending institutions to instinctively shut their lending taps and sit tight by investing their surpluses in the safety and liquidity of Government securities.

The beating taken by asset markets - equity, debt and real estate - and increased debt service burdens has resulted in a negative wealth effect (more so in the developed economies, with their low savings and income effect driven consumption) on consumers, who have abruptly reined in their consumption. The fast emerging deflation scenario and rational expectations of a deep recession have magnified this fear in consumers, who now prefer to adopt a wait-and-see approach.

When consumers shut shop and the credit markets freeze, the businesses are invariably affected. Businesses have been battered from both supply and demand side. Throw in the bleak economic prospects and they need no more signals to cancel or postpone their investment decisions. The economy gets trapped in a vicious cycle.

In many respects the specific economic and financial market conditions that created the crisis, bad as they are, have been overtaken by the psychological apprehensions and fears of the market participants. The increasingly entrenched rational expectations of the investors and lenders, consumers and businesses about themselves, others and future prospects, have brought all normal financial and economic activity to a virtual standstill. The challenge is to break this grid-lock and get economic normalcy restored. The next post will explore what the prevalent macroeconomic theories tell us about the road ahead.

Sub-prime crisis - History repeats itself!

Starting from early last year, in a series of magisterial working papers, comparing an exhaustive list of financial and banking crises across both developed and developing countries, Professors Carmen Reinhart and Kenneth Rogoff have been arguing that the ongoing sub-prime mortgage bubble induced financial crisis is no different from what has been continuosly and repeatedly happening throughout history, in both developed and developing countries. There are fairly conclusive lessons to be learnt from the impact of surges in cross-border capital inflows and equity and property market bubbles on fiscal conditions and economic growth across countries.

Further, based on a historical comparison of how 22 economies, including emerging economies, came out from a major financial crisis, Professors Carmen Reinhart and Kenneth Rogoff claim that the American economy may be in for a long haul back to normalcy.

They find that unemployment rises by 7% on average after a severe financial crisis and doesn’t peak until four years after the crisis; housing prices fall 35% and downturns last six years; output falls 9% from peak to trough over two years; stock-price declines last three and a half years and total 55%; and government debt reaches 86% of GDP. If these are taken as broad indicators, the US unemployment rate will increase to touch 11% by 2011, housing market will not start recovery till 2011, GDP will decline by 4-5% in 2010-11, Dow Jones Industrial Average (DJIA) will fall to 6500, and public debt will touch $12 trillion!



In another paper studying banking crises across history in high and middle-to-low income countries, the same two authors find striking similarities in its impact. They claim that such crises dramatically weakens fiscal positions everywhere - government revenues invariably contract and fiscal expenditures often expand sharply. They find that the fiscal burden of banking crisis arises more from fall in tax revenues due to economic contraction and increased expenditure on fiscal stimulus, than from the cost of bailouts. They also find that systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike.

Comparing the US sub-prime mortgage crisis, Prof Reinhart and Rogoff find striking similarities with banking crises in 18 industrialized countries. Their analysis squares up with the existing financial crisis literature that for countries experiencing large capital inflows, equity and housing prices stand out as the best leading indicators.

In a panaoramic analysis of financial crisis, dating from England's fourteenth century default to America's current sub-prime bubble, the same authors confirm the conventional opinion, that crises frequently emanate from the financial centers with transmission through interest rate shocks and commodity price collapses. Their data also documents that "most of these crises accompany default: including inflation, exchange rate crashes, banking crises, and currency debasements". In a grim reminder to emerging economies, they find that periodically spaced "serial defaults are a nearly universal phenomenon as countries struggle to transform themselves from emerging markets to advanced economies".

Examining the history of surges in international capital flows, Prof Carmen and Vince Reinhart finds that in line with earlier studies, "global factors, such as commodity prices, international interest rates, and growth in the world's largest economies, have a systematic effect on the global capital flow cycle". They also find that capital inflow "bonanzas are no blessing for advanced or emerging market economies". In the case of the latter, such bonanzas are associated with "a higher likelihood of economic crises (debt defaults, banking, inflation and currency crashes) and with procyclical fiscal policies and attempts to curb or avoid an exchange rate appreciation - very likely contributing to economic vulnerability". For the advanced economies, though not as adverse, bonanzas are associated with more volatile macroeconomic outcomes for GDP growth, inflation, and the external accounts. Slower economic growth and sustained declines in equity and housing prices follow at the end of the inflow episode.

Update 1
Economix blog has this post about the Reinhart-Rogoff study on how much worse it can get for the US economy.

Update 2
Bradley Shiller puts the US economic situation in historical perspective here and feels that the ongoing recession is not as bad as the previous big recessions.

Fiscal policy debates

The economic crisis has initated an intense debate (Conservatives Vs Liberals, Monetarists Vs Keynesians) about whether monetary or fiscal policy are of greater significance during times of such turmoil. It has also re-kindled the old debate about the relative importance of the various fiscal policy options, especially the respective economic multipliers of tax cuts and government spending.

Mark Thoma and Robert Skidelsky weigh in on the importance of government spending led fiscal policy over tax cuts and monetary expansion. Paul Krugman writes that we have reached a world in which monetary policy, both in US and soon in Europe, has little or no traction, and therefore fiscal policy is the only option left. James Galbraith too appears to agree.

Greg Mankiw, invoking studies by Christina and David Romer, Bob Hall and Susan Woodward, and Valerie A Ramey, argues that the tax cuts offer a higher multiplier than government spending. He claims that unlike the later which works through increases in disposable income and consumption demand, the former also incentivizes more investment demand from businesses. However, Martin Feldstein, a doyen among conservative economists, broke ranks and declared that the $168 bn tax cut dominated US fiscal stimulus of February 2008 failed because people actually ended up saving and paying off debts instead of spending it on consumption.

Mark Thoma sums up the debate about the relative utilities of the various fiscal policy options, mainly between tax cuts and government spending. Catherine Rampell in the Economix blog of NYT has the recommendations of an exhaustive list of distinguished economists.

Update 1
Marginal Revolution draws attention to a recent NBER paper by Andrew Mountford and Harald Uhlig which finds that of the three fiscal policy options - deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion - deficit financed tax cuts have the highest multiplier on the GDP. Free Exchange is not impressed and takes up issue here.

Update 2
The always insightful Mark Thoma has an excellent parable explaining how fiscal policy works during economic downturns and depressions. The commonest criticism against fiscal policy that it crowds out private investment may not apply to downturns and depressions, since at such times there are idle resources that are involuntarily unemployed and private investors are in any case unwilling to make any additional investments. So Paul Krugman is spot on in claiming that normal rules do not apply when the world is in depression.

Update 3
The most definitive proof that monetary policy can save the economy in times of economic slowdown comes from the present crisis. Unlike the Great Depression, nobody can accuse the Central Banks across the world, individually and collectively, of not doing enough and quickly at that. We have seen the Fed and others summon all the monetary policy levers - lower rates aggressively to the zero bound; capitalize banks and financial institutions with the most liberal terms; inject liquidity through their discount windows by relaxing all lending standards; act as a market maker of last resort by purchasing troubled assets and commercial papers; and provide blanket guarantees to deposits. The amounts involved have been mind boggling - more than $1.3 trillion in the US alone, and counting!

Apart from a few hours (in a few cases, a couple of days) of market rally, the financial markets and the economy appears to have hardly acknowledged these interventions. If anything, Central Banks, and not the Governments, have been the primary players in the drama so far.

However, despite the overwhelming proof, apologists of Monetarism, will surely claim that had the Central Banks not intervened so aggressively, the situation could have been much worse!

Update 4
Gary Becker takes a historical perspective, of the past fifty years, and restrains any knee-jerk aggressive government regulatory interventions that may have adverse long term consequences.

Update 5
Paul Krugman draws attention to the work of Adam Posen who finds evidence that the Japanese fiscal stimulus in 1995 did actually work and increase economic growth rate. However, Tyler Cowen debates the reliability of the Japanese example, given other factors involved.

Update 6
Paul Krugman gets to the basics of Eco 101 in favour of stimulus in the form of infrastructure spending and providing public goods, as opposed to stimulus in the form of tax cuts. A marginal dollar spent on public goods is worth more than a marginal dollar spent on private consumption, because in any case these are goods that a functioning society and market requires and will be under-supplied by the private sector.

Update 7
Bloomberg has this excellent article tracing the roots of the Monetarist take-over of economic policy making since the seventies. And Barry Ritholtz writes the obituary for Chicago School.

Update 8
Paul Krugman uses numbers to prove that the multiplier is much higher for public spending, by way of the increase in taxes ploughed back to the economy. The net stimulus is therefore smaller, or there is more bang for the buck.

Update 9
Daniel Gross sums up the debate between fiscal and monetary policy and favours using both in such extraordinary times.

Update 10
Here is the famous NBER working paper of 1994, at the center of debate now, by David and Christina Romer that claims that in post-war recessions, monetary policy has been more effective in the early stage of recoveries. They write, "We find that the Federal Reserve typically responds to downturns with prompt and large reductions in interest rates. Discretionary fiscal policy, in contrast, rarely reacts before the trough in economic activity, and even then the responses are usually small. Simulations using multipliers from both simple regressions and a large macroeconomic model show that the interest rate falls account for nearly all of the above-average growth that occurs early in recoveries."

Update 11
Eugene Fama opposes fiscal stimulus on grounds that government debt only transfers burden from one generation to another.

Update 12
Brad Delong writes about the eclipse of the Chicago School.

Are the bailouts and stimuluses only postponing the inevitable?

I am concerned about the turn the economic debate is taking. First it was bailout of the financial markets, then came the fiscal stimulus for the real economy, and now comes the corporate sector. Even the most ardent adovcates of free market would not dispute that all the major financial institutions and the bleagured Big Three Detroit automakers have been guilty of greed, reckless investment decisions, and above all bad management. A worrying impression is gaining ground that such interventions can actually save the economy and its agents from facing upto the consequences of their sins, and can be a substitute for real belt-tightening.

The central dilemma facing policy makers and administrators across the world about what to do next, arises from the legacy of the Great Depression and the lost-growth decade of Japan in the nineties. It is felt that if Government is not aggressive enough in its interventions - bailouts, recapitalizations, and fiscal stimuluses - there is a very strong chance that the economy will slip into a long and protracted depression or stag-deflation or liquidity trap. Now the fundamental issue is who knows how much intervention is "enough"?

The moral hazard created by the consequences of the Lehman bailout and the "too-big-to-fail" arguements are being dusted up from the wood-works to justify these interventions. Paul Krugman feels that nothing could be worse than failing to do what's necessary out of fear that acting to save the financial system is somehow "socialist".

Having become used to living off bubbles, a generation is now unwilling to accept the inevitability of a downturn. So every downturn has to be hurriedly compressed and rolled into the smallest possible period, as opposed to be ameliorated or cushioned, through Government backed financial market interventions and economic re-engineering. Quick-fixes and band-aid solutions become the order of the day. When the going is good, Government is a paraiah and regulations are seen as detrimental to innovation and economic growth. However, at the slightest indication of a slowdown, Government gets re-incarnated as the saviour and the search for a new bubble starts.

Consumers and businesses do not have the patience or faith in systemic solutions. Nobody wants to face upto the reality that you cannot live on booster doses of steriods forever. The ailing economy, like the patient, needs treatment to clean off the excesses and distortions that have built up during the years of "irrational exuberance". Bailouts, rate cuts and stimuluses can at best be analgesics to attenuate the pain and downturn.

Over-leveraged financial institutions, insolvent banks, investors left with illiquid investments worth virtually nothing, homeowners with negative equities (mortgages exceeding home values), businesses with pension and other liabilities papered over by the illusion of comfort provided by Mark-to-Market (MTM) accounting, consumers with massive consumption debts, citizens with negative savings, and an economy relying on foreigners to finance itself, cannot be saved with mere stimuluses and bailouts. The "mother of all Ponzi schemes" has to be carefully dismantled. It does not require any great wisdom to know that all the losses will have to get squared up on each (and all) of the balance sheets for normalcy to be restored.

A period of belt tightening is necessary to re-build the foundations for a sustained period of future growth. A crash landing is inevitable, and the quest should be to make it as soft as possible! The extent and degree of downturn can be controlled, to atleast some extent, by appropriate Government intervention. Such interventions should invariably seek to minimize incentive distortions and keep the costs to the taxpayers at a minimum.

In markets characterized by information assymetry and beset with problems in locating and pricing risks, any selective (as opposed to universal, which is impossibel, given the costs involved) bailout is likely to fail. Such bailouts, especially in the maddeningly compex financial markets, are most certainly likely to be gamed by the same enterprising and greedy investors and borrowers, whose buccaneering spirit brought about the crisis in the first place. Further, the moral hazard ramifications of such bailouts, especially given the importance of "rational expectations" in financial markets, can be catastrophic for long-term good of the economy.

With bailout and stimulus calls flying in all directions, Ken Rogoff cautions us about the need to not lose sight of the underlying problems and advocates a systemic solution which revolves around a moderate dose of inflation to unwind the "epic debt morass". He is spot on in writing, "Securitisation, structured finance and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time". Despite the potential consequences and the probelms inherent in escaping an inflation spiral, moderate inflation (6% for two years, in his opinion), by debasing the currency reduces the real debt burden and values of real estate, can help weed out some of the excesses built up during the bubble years. He feels that fear of inflation, when viewed in the context of a possible global depression, is like "worrying about getting the measles when one is in danger of getting the plague".

Many of the contentions of the aggressive inerventionists have a circular ring to it. It is argued that the need of the hour is to sustain consumption and therefore any effort to increase savings will be counter-productive. It is hoped that the economy will soon recover (on the back of another bubble!), and then we can start saving again...! Similar logic is used to oppose any attempts to initiate efforts to regulate the financial markets now. "Let us do it after the economy stabilizes", goes the arguement. The proponents of this line of logic says that any effort to act tough now, will only upset the apple-cart, distort expectations and force the economy into even deeper turmoil.

I am not, for one moment, arguing against all forms of bailouts and stimuluses. Nor am I in favor of letting the market evolve out a solution to the crisis. Nor should we ignore the importance of market expectations. But we should not indulge in knee-jerk reactions that oscillate to the other extreme of suffocating regulations and excessive thrift. I am only suggesting that the government interventions to fix the failures can at best be palliatives, a long and painful period of convalescence is inevitable, reforms and restructuring should start now in gradual and phased manner, and systemic as opposed to selective solutions are the better (among all uncertain) remedies.

When the going was good everyone threw caution to winds, and lived well beyond their means in the mistaken belief that the good-times would last forever! The high-testosterone growth days are over and the pay-back time has come, and we need to face upto this reality! The fundamental tenet of life - anything that goes up has to come down - cannot be wished away. The spectacular growth of the past two decades are being balanced out by equally spectacular declines of today.