[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?
READER COMMENTS
MICHAEL PETTENGILL
Mar 15 2020 at 4:50pm
As a Keynesian I should be irate that fiscal policy has changed to inhibit building capital so capital is so scare capital prices are inflating far beyond the labor costs to build capital?
Keynes talked of burying jars of money, not to create more money in the economy, but to get businesses to pay workers to dig up the jars of money.
FDR did what Keynes described in his thought experiment by hiking the price the US Treasury would pay for gold, which quickly doubled the number of gold miners being paid to dig up gold in the US.
But Keynes argued that burying jars of money would create jobs, but it would be better for workers to be paid to build capital assets that would return benefits for decades in the future.
Taxes in the 30s on profits made paying more workers to build capital much more sensible than paying taxes and giving the rest to the rich who owned shares.
To a degree, this promotion of building capital only disrupted the job market faster. A factory owner faced with profits to spend to dodge taxes would pay workers to produce more goods faster and cheaper. Ie, pay workers to learn to operate and maintain equipment, and then have them build better machines that work faster and better. The factory owners who failed to “automate” lost market share and went bankrupt. Dairy farmers who poured their profits into electricity and milking machines and posturing and refrigeration eliminated the need for workers while increasing milk supply, which drove down prices that bankrupted farmers who didn’t, probably because they didn’t live where big government force electric companies to run power lines to rural areas.
While Hoover paid workers the lowest of wages to build the Hoover Dam by the cheapest wage paying construction companies, FDR and Congress funded cheap debt to electric coops which meant farm communities decided who to pay and how much to build power lines to connect every farm and every business and every home for electric service. And farm communities were generally well organized around the Grange, so a political-economic establishment existed to build capital for the benefit of its members.
Other than Elon Musk and Jeff Bezos, who are the big advocates of paying US workers to build capital in the US, ie, factories making cars, electric charging stations, warehouses and fleets of delivery vans, rocket factories, spaceport, solar roofs, home electric storage, tunnels to move around, under private property without impacting those tunneled under.
Read chapter 24 of Keynes opus and you see today’s economy described: scarce capital, monopoly profits, excessive rent seeking. The solution is paying workers to build so much new capital that the price of capital falls to the lowest labor cost of new capital. And the US has so much land in 50 sovereign States which have hundreds of millions acres of vacant land that just needs capital like roads, water and sewer, for building capital like homes and businesses, that are cheaper than the hyper inflated capital prices that are the norm. Bezos and Musk are building lots of capital very quickly on lots of cheap vacant land found all over the US. These places then draw so many workers, new capital must be built prevent homeless workers. Consider the increase in homelessness around Gigafactory Nevada. Or around the new Amazon office going into vacant, underused Virginia office buildings.
But, with low taxes on profits, paying workers means shareholders pay 79% plus of wages instead of the IRS paying up to 90% of wages of new workers in the 30s and 40s, falling toward 50% in the 50s and 60s.
If you invoke Keynes, please understand what he called for.
bill
Mar 15 2020 at 5:44pm
I recall reading that the blast in Halifax was felt in Boston. Wow! (if true)
P Burgos
Mar 15 2020 at 8:26pm
If the restraints on monetary and fiscal policy are political (in the US), doesn’t that just mean that the economy is screwed during the next recession? Maybe people aren’t saying this, but wasn’t the ARRA (the Obama stimulus bill) really difficult to get passed due to partisanship in Congress? I guess where I came down on this is that Congress and the Fed were so dysfunctional that stimulus was still needed almost a decade after the end of the last recession. So why complain about fiscal and monetary stimulus when the economy keeps growing without much inflation? What’s worrying is that it seems that nothing has changed about the political restraints since the last recession, with perhaps the exception being that Trump would likely support the Fed in doing anything stimulative during his re-election campaign.
Scott Sumner
Mar 15 2020 at 9:10pm
Burgos, The economy has been fine in recent years, that’s not the problem. The problem is that the economy is expected to be in bad shape during 2021 and 2022.
I hope I’m wrong.
Don Geddis
Mar 15 2020 at 10:27pm
You note that many people talk about the Fed “running out of ammunition”, and you comment that “monetary policymakers can never actually run out of ammunition”. So people are simply wrong about monetary economics.
But then you try to come up with an alternative theory of “political ammunition”, and propose that the Fed might hypothetically be limited by “not willing to allow its balance sheet to exceed $10 trillion”.
But that’s not what most people are thinking of, I suspect. I’m surprised you didn’t mention the most obvious (albeit wrong) justification for the “out of ammunition” claim: the Zero Lower Bound.
Most people think that monetary policy works by lowering interest rates, which causes increased incentive for consumer borrowing. And that transmission path apparently would “stop working” if interest rates can’t be lowered any more, which happens at the ZLB.
Yes, I know that’s not actually the transmission mechanism of monetary policy. I know QE works just fine for monetary stimulus, even at the ZLB. But I suspect the naive concern about the interest rate channel is the primary reason most people talk about the Fed being “out of ammunition”.
Rajat
Mar 17 2020 at 3:14pm
For what it’s worth, I don’t think most people equal a dollar of ‘monetary ammunition’ (as in scope to make asset purchases) with a dollar of fiscal ammunition (as in direct spending on goods & services). Asset purchases are believed to work in a much more indirect way compared with government purchases – call it a cognitive illusion!
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