Does anyone actually care about monetary and fiscal "ammunition"?
By Scott Sumner
[This post was written a month ago, before it became apparent that a recession is likely in the near future. This doesn’t change my analysis.]
There’s a lot of discussion about what would happen if there were another recession. The media is fully of stories speculating on what fiscal and monetary policymakers might do to prop up the economy. But something important is missing from this discussion.
A good place to start is with the concept of “ammunition”. The media tends to use this term in reference to monetary policy, not fiscal policy. And yet “running out of ammunition” is actually much more likely to occur with fiscal policy. Indeed in a technical sense, monetary policymakers can never actually run out of ammunition.
One counterargument is that there may be political barriers to monetary stimulus, upper limits on how much monetary stimulus is politically acceptable. Thus in the US, it might be the case that negative interest rates are politically unacceptable, creating a zero lower bound. As far as QE, some have argued that the Fed would be reluctant to increase their balance sheet too much, as they would be exposed to the risk that the value of their portfolio might decline in a bear market for bonds.
Similarly, it might be argued that fiscal stimulus is limited by the fact that Congress would be reluctant to increase the budget deficit beyond a certain point. This was even a problem in 2009, despite a unified government. The next recession will likely occur under divided government, making it even more difficult to rapidly approve a large fiscal stimulus measure.
Let’s illustrate this idea by assuming the following political limits on monetary and fiscal stimulus. (The exact numbers are not important; I’m interest in the general concept.):
1. Assume the Fed is not willing to allow its balance sheet to exceed $10 trillion.
2. Assume Congress is not willing to approve a budget deficit greater than $1.5 trillion.
Monetary ammunition is the gap between the maximum balance sheet, and the size of the Fed’s current balance sheet. Fed assets are currently about $4.2 trillion, which leaves $5.8 trillion in “ammunition”.
Fiscal ammunition is the difference between the current budget deficit and the maximum budget deficit. The current budget deficit is about $1.0 trillion, leaving $500 billion in “ammunition”.
BTW, although I believe the Fed has more ammo than does Congress, these figures do not show that. The monetary figures are a stock variable and the fiscal figures are a flow variable. Thus it’s an “apples and oranges” comparison.
In recent years, policymakers have greatly reduced both fiscal and monetary ammunition, for no good reason. The budget deficit has swelled from under $500 billion to over $1.0 trillion, despite the fact that the economy has been booming and doesn’t need fiscal stimulus. And even if you think it does need fiscal stimulus, the Fed (which moves last) offset the effect with nine interest rate increases during 2015-18. The fiscal stimulus did no good.
The Fed has also burned lots of ammunition, by allowing its balance sheet to balloon from just over $800 billion before the Great Recession, to nearly $4.2 trillion today. That was caused by:
1. Low inflation and low interest rates boosting the demand for currency.
2. Interest on reserves boosting the demand for bank reserves.
3. Regulators pressuring banks to hold more reserves, instead of equally safe assets such as T-bills.
4. The Treasury dramatically boosting its deposits at the Fed.
In fairness, the IOR probably doesn’t reduce ammunition, as the loss of ammunition from a larger balance sheet is offset by a gain in ammunition from having an IOR that can be reduced in a recession. The other three sources of the bloated balance sheet are “unforced errors” that reduce ammunition.
Here’s what I don’t get. The media and other economists seem much more worried about this ammunition issue than I am. I actually think the Fed has plenty of ammo, if they use it wisely. But I’m in the minority. Meanwhile, the people that are worried about ammunition don’t seem to talk much about the issues I’ve raised here. If ammunition is likely to be badly needed in the next recession, then why aren’t we screaming at our monetary and fiscal policymakers for the biggest waste of ammunition since the SS Mont-Blanc blew up in Halifax harbor in 1917?
Keynesians should be irate about the fact that the recent fiscal stimulus has dramatically reduced the amount of ammunition available for the next recession. They should also be upset with the Fed’s bloated balance sheet, which also reduces the ammunition available.
Maybe the explanation is that while people talk a lot about ammunition, they don’t really believe in the concept. After all, what limits the Fed’s balance sheet to $10 trillion? Why couldn’t the Fed buy $20 trillion in bonds, or $30 trillion? If you aren’t worried because you believe that in an emergency the Fed could blow by the $10 trillion limit, and Congress could enact a vastly larger than $1.5 trillion deficit, then perhaps you don’t really believe in the concept of “ammunition”.
My view is that the concept of ammunition does not apply to monetary policy, in a technical sense, because monetary stimulus is not costly, but does apply to fiscal stimulus, because fiscal stimulus is costly.
PS. Many Americans are not familiar with the terrible tragedy that hit Halifax on December 6, 1917, when the French ammunition ship exploded in Halifax harbor. The 2.9-kiloton explosion (the largest manmade explosion in history up until that time), killed about 2000 people.
If ammunition is the problem that many people assume it is, then the current policies of our government are effectively making the next recession far worse than it needs to be. Where’s the outrage?