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“Fiscal Policy”

Scott Sumner says this in response to a question from Tom about my model.

Tom, I don’t view fiscal policy as a partisan issue. The GOP loves tax cuts, for instance. Bush did a tax cut in 2008 for AD reasons.

What’s the intuition behind his result? Does he assume monetary policy is ineffective at boosting AD at the zero bound? Obviously it’s not ineffective, but I’m just trying to figure out where that result comes from.

First, I agree that “monetary policy” is effective at the zero bound.  What I am actually trying to say is that monetary policy is required which cannot be carried out by what I assumed was the normal method of setting an interest rate and then creating whatever quantity of liquidity was required.  So my main mistake was using the word “fiscal policy.”  I shouldn’t have done that.  I think of this as an explanation for why what most people call fiscal policy works, but it is a nominal explanation.  So in that respect, I am really talking about monetary policy, just a different kind of monetary policy which may or may not be carried out in the form of government spending.

To see what I have in mind, think of the central government, the central bank, and the banking sector as one entity.  The policy considered in the model was simply setting an interest rate and lending whatever funds are desired at that rate.  But because those funds have to be paid back, and the interest rate is positive, the value of net monetary wealth (money minus debt) is decreasing over time.  But in the face of that, the central authority is trying to create inflation.  This means that they have to keep the money supply increasing.  This means that they have to get people to borrow more and more relative to the value of their monetary wealth which means that they have to keep lowering the nominal (and real) interest rate.

So basically what I’m saying is that this creates a disconnect between expectations about future price levels and the price levels that can be sustained indefinitely through only lending by the CB.  As long as there is slack in the interest rate, they can keep this going, but the longer it goes, the gap between the expected price level next period and what the price level would fall to if the money supply suddenly stopped growing on schedule.

Now the reason the money supply stops growing on schedule could be many things.  It could be that they hit the lower bound and can’t induce enough lending.  It could be that they mistakenly set rates too high.  It could be that for some unexplained reason people decide to stop borrowing (which, of course must also be accompanied by one of the previous two explanations).  But whatever the reason, if the money supply comes up a bit short, all hell could break loose.

This is for many reasons, some of which I have touched on in discussions about the significance of money being backed by debt.  I will talk more about them in the future.  But for now all I want to say is that they can be avoided if the money supply can be kept on track.  The important thing is that once you are at the zero bound this can’t be done by simply inducing more borrowing in the usual way.  You have to do something else to get the money out there.  This could be government spending, funded by fresh money.  For the record, I think that Sumner would say that this has a nominal and a fiscal component and it is the nominal component that I am interested in.  But it could also be buying garbage debt for more than it is worth, or buying pretty much anything for that matter or, for that matter, buying absolutely nothing and just dumping money from helicopters.

This, of course, is the sort of the purest possible conception of “monetary policy.”  But I will call it “unconventional monetary policy” (which, for the record, was also included in the heading of the section next to the words “fiscal policy” if I recall correctly).  This allows me to draw the distinction which I think is important between “conventional monetary policy” which is carried out by expanding credit through borrowing and lending and “unconventional monetary policy” which is carried out by expanding the money supply in some other way which is not connected to any debt (or at least not a private debt).

For the record, there are other types of monetary policy which get a lot of discussion around the zero bound which are considered unconventional but which I see as further attempts to expand credit through borrowing.  For instance, I see QE as an attempt to expand credit by pushing down longer-term interest rates.  The MBS part of QE can be seen as either trying to push down risk premiums and expand credit or a kind of “unconventional” injection to banks in the form of a payment above what those debts are actually worth.  Lowering the interest rate on reserves is essentially equivalent to lowering interest rates in my mind, it just means that you aren’t really at the ZLB.

Now I don’t think that I am saying anything very controversial about how monetary policy works at the ZLB.  The thing I am saying which I think is controversial is that there is a natural tendency toward the ZLB in this system of inflation via credit expansion.

For the record, if the CB pays out all profits from interest payments in the form of a dividend, that also adds a source of additional slack.  I think this will mitigate the issue but not fully fix it but I have to do some more work to be sure about that.

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Categories: Uncategorized
  1. Tom Brown
    July 22, 2014 at 8:03 pm

    I left a link for Sumner, but I think he moved on…

    • Free Radical
      July 23, 2014 at 3:35 am

      Yeah he’s in high demand these days. Appreciate the effort though.

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