Generally, there are two broad policy approaches to having the government (or it’s appointed representative, the central bank) manage the macro economy. One, fiscal policy involves deliberate management of the government budget (spending and tax policy) with a view to stimulating or slowing the economy. The other is monetary policy where the central bank (or government if it has retained control over currency) moves interest rates up or down, and buys or sells bonds in order to stimulate or slow the economy. Fiscal policy acts directly on the economy: government spending adds directly to demand for goods and causes those goods to be produced and thus raise employment (assuming there are unemployed people to hire). Taxes directly take money away from households and prevent them from buying goods (assuming they were going to spend anyway – which they may not if very high income or wealth).
Monetary policy however, is very indirect. It’s almost a Rube Goldberg machine in design. The central bank has to buy/sell bonds on the public market and to/from banks in an effort to increase/decrease interest rates by affecting the supply/demand for such bonds. Then, if the central bank is trying to stimulate, it has to hope that the lower interest rates cause busineses and consumers to decide that lower financing costs (lower interest rates) now make some purchases more attractive than before. Then the businesses and consumers have to borrow and then go buy things (typically consumer durables, houses, or business investment). There’s a lot of steps there where the policy could be defeated by folks not cooperating. For example, today lots of businesses are deciding that since they have excess capacity already and not enough people are buying the goods they make now, there’s no sense in borrowing to expand. Likewise, consumers who are scared they may not have a job next year are taking a pass on buying a house or car even though the interest rate is low.
Joe Stiglitz explains the problems we face today with monetary policy in a post at Project Syndicate. Keynes pointed out a long time ago (before the dark ages of macro), that in times of high unemployment, unused capacity, and low interest rates (what is sometimes called a liquidity trap), monetary policy isn’t going to be very effective.
With interest rates near zero, the US Federal Reserve and other central banks are struggling to remain relevant. The last arrow in their quiver is called quantitative easing (QE), and it is likely to be almost as ineffective in reviving the US economy as anything else the Fed has tried in recent years. Worse, QE is likely to cost taxpayers a bundle, while impairing the Fed’s effectiveness for years to come.
John Maynard Keynes argued that monetary policy was ineffective during the Great Depression. Central banks are better at restraining markets’ irrational exuberance in a bubble – restricting the availability of credit or raising interest rates to rein in the economy – than at promoting investment in a recession. That is why good monetary policy aims to prevent bubbles from arising.
But the Fed, captured for more than two decades by market fundamentalists and Wall Street interests, not only failed to impose restraints, but acted as cheerleaders. And, having played a central role in creating the current mess, it is now trying to regain face.
In 2001, lowering interest rates seemed to work, but not the way it was supposed to. Rather than spurring investment in plant and equipment, low interest rates inflated a real-estate bubble. This enabled a consumption binge, which meant that debt was created without a corresponding asset, and encouraged excessive investment in real estate, resulting in excess capacity that will take years to eliminate.
The best that can be said for monetary policy over the last few years is that it prevented the direst outcomes that could have followed Lehman Brothers’ collapse. But no one would claim that lowering short-term interest rates spurred investment. Indeed, business lending – particularly to small businesses – in both the US and Europe remains markedly below pre-crisis levels. The Fed and the European Central Bank have done nothing about this.
They still seem enamored of the standard monetary-policy models, in which all central banks have to do to get the economy going is reduce interest rates. The standard models failed to predict the crisis, but bad ideas die a slow death. So, while bringing down short-term T-bill rates to near zero has failed, the hope is that bringing down longer-term interest rates will spur the economy. The chances of success are near zero.
Large firms are awash with cash, and lowering interest rates slightly won’t make much difference to them. And lowering the rates that government pays has not translated into correspondingly lower interest rates for the many small firms struggling for financing.
More relevant is the availability of loans. With so many banks in the US fragile, lending is likely to remain constrained. Moreover, most small-business loans are collateral-based, but the value of the most common form of collateral, real estate, has plummeted……
…Copyright. Project Syndicate, 2010.
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