Monetary offset: Why is it so difficult to understand?
By Scott Sumner
In this post I’m going to ask for your advice. I’d like to know why the public, and even the more sophisticated pundits, have so much trouble understanding monetary offset.
Stephen Kirchner sent me a Bloomberg piece discussing the sudden interest in fiscal stimulus:
Monetary policy has done the heavy lifting to date, boosting asset values in the stock market and driving down borrowing costs in the bond markets to record lows for both companies and governments. But the law of diminishing returns seems to be neutralizing central-bank efforts to do anything more than stop the global economy from cratering; never-ending interest-rate cuts and expanded quantitative easing halted the economic slide, but don’t seem able to generate robust growth.
Hence, there’s increasing chatter about the prospect of fiscal action from governments, which is shorthand for borrowing money to spend on infrastructure projects, thereby creating jobs, boosting growth and investing in the future. The U.S., the U.K., Japan and the euro zone are all being urged to ease up on austerity and open their pocketbooks.
The chatter, though, has become a roar — which raises the uncomfortable prospect that speculation about fiscal action will lead to disappointment. Here’s a chart showing how the hubbub has become louder and louder in recent weeks:
There are so many fallacies here one hardly knows where to begin. The central banks have not done any “heavy lifting”. They can print money at virtually zero cost and their massive portfolio of bonds is generating enormous profits, more than twice as large as before the recession.
Interest rates have fallen to low levels because of slow NGDP growth, not easy money. If policy were actually expansionary, we’d see increasing inflation/NGDP growth.
There are no “diminishing returns” in monetary stimulus, as Joe Gagnon showed in his recent study of QE.
The unemployment rate in the US has fallen back below 5%. That’s all monetary policy is supposed to do, and all it can do. If we have sluggish growth due to productivity, there is nothing that monetary policy can or should do about that. We need supply-side reforms.
Of course the biggest mistake has to do with monetary offset. If fiscal policy becomes more expansionary, central banks will simply offset it. Already there is chatter that the ECB may not ease policy at its next meeting, as had been expected. Why not? Because the post-Brexit economic slump does not (yet) seem to be materializing. When growth is stronger, money becomes tighter. Now it’s very possible that the ECB is making a mistake in not easing—inflation is far below their target—but that has no bearing on whether monetary offset occurs.
Let me head off one possible misconception. It’s not possible to do fiscal stimulus in both good times and bad. There is a long run budget constraint. Years when the national debt is rising as a share of GDP need to be offset by years where the national debt is falling as a share of GDP. If the fiscal policymakers do more stimulus at a time when unemployment is 4.8%, they will not be able to do as much the next time it is 8% or 10%.
I’m also being to see murmurs in the pundit class that Britain might not fall into recession after all. Gee, do you think it’s possible they forgot about monetary offset?
Have people already forgotten that Japan’s earlier experiment in fiscal stimulus, including lots of bridges to nowhere, did absolutely nothing for aggregate demand? In fact, Japan is one of the few fiat money countries to ever experience a two-decade fall in NGDP, from 1993 to 2013. Have people forgotten that growth in the US picked up during the austerity of 2013, when 350 Keynesian economists warned that austerity risked a double dip recession?
Even Paul Krugman used to remind his readers that monetary offset applied when interest rates were being controlled by the central bank. This is not rocket science, so why is it so hard for pundits to understand? I’m genuinely perplexed.
PS. Alex Tabarrok linked to an excellent Scott Alexander post that exposes the progressive tendency to respond to every failure of regulation with a call for more regulation. I see an analogy with fiscal stimulus. Instead of asking central banks to do more (the obvious solution) they propose dubious schemes to try to use fiscal policy to make up for the failures of monetary policy.
PPS. David Henderson’s new post links to another great example. Instead of responding the the 2008 banking crisis by unwinding the regulations that did so much to contribute to the crisis, they left them in place and added many more, each of will have dozens of unexpected side effects.