Fiscal policy is the only game in town...
This article was originally published on 10/10/2020 for my informal email list. Certain edits were made to this current version. I’m re-posting some of my earlier newsletters here as a gradual process to shift to Substack.
One major theme of my recent emails is that “fiscal policy is the only game in town,” as monetary policy isn’t as relevant at the moment when the Fed is very close to being out of tools. To put things into historical perspective, I’ll make two quick points today:
we’ve really come a long way to our current view of fiscal policy and debt expansion;
but I think this is more because of the surprisingly lack of efficacy in monetary policy rather than the efficacy of new proposals like MMT (Modern Monetary Theory) per se, and monetary policy is facing grave challenges…
The economic orthodoxy on balanced budget has changed dramatically relative to the time of the 2008 financial crisis, when the European sovereign debt crises and Reinhart and Rogoff’s influential paper “Growth in a Time of Debt” convinced policymakers to adopt austerity measures and tight fiscal policies.
This orthodoxy, however, has long been fraying, as exemplified by the dramatic build-up of deficits in advanced economies with few noticeable consequences and the growing popularity of Modern Monetary Theory that aims to upend the existing economic paradigm. The Covid-19 pandemic seems to have delivered the final blow – even the IMF recently reversed advice from a decade ago and announced that most developed countries do not need to cut public spending or raise taxes to restore public finances after the pandemic (see here and here).
It’s extremely puzzling why monetary policy is not achieving its intended efficacy. Europe and Japan have been in historically low interest rates for years, but we still see no sign of inflation. The conventional view that “inflation is a monetary policy phenomenon” (determined largely through interest rate setting and inflation targeting) largely stopped working since 2012 or so.
The current zero lower bound for interest rates and the low inflation make full employment less likely to achieve, while household and government debt and central bank balance sheet sizes are at all-time peaks. All such signs would likely lead to the policy consensus that structurally high deficits should be encouraged to spur economic growth, at least for the foreseeable future.
The fears for high deficit from 2010-2012 have been replaced by policymakers’ willingness to consider more expansionary fiscal policy, making it seem like fiscal policy is "the only game in town.” What should be the future of fiscal-monetary interaction? Should central banks play a more activist role in monetizing debt and pushing for progressive legislations, as Modern Monetary Theory economists have proposed? Should fiscal authorities consult with central banks on matters of financial stability and the disconnect between financial and real assets before rolling out expansionary fiscal packages? These are important questions that ought to be reasoned through.
I don’t think most central bankers have a definitive answer to this puzzle. I think everyone in the monetary policy research community is working extra hard to “salvage” it, or else we may end up in a world where I keep meeting guys in the gym who tell me “bro how is the Fed printing money gonna affect my life… I told you MMT is gonna save us…”