It has been almost 4 years since the US fell into the Great Recession and we have yet to see a strong recovery. One of the after-effects of the Great Recession has been the increased attentiveness to monetary policy. Attentiveness to monetary policy existed before the Great Recession but not to the degree seen today; since the Federal Reserve took unconventional steps in 2008 to fight the recession, it now seems like every single word or action coming of the Federal Reserve (Fed) is a do or die moment for the markets and the economy.
Well, I got bad news for all those who think monetary policy is the “Holy Grail” to our problems – it’s not. Unfortunately, this reliance on the Fed has diverted attention away from the true matter we need to concentrate on: fiscal policy. Despite what all the supporters of monetary policy say, the Fed is out of bullets. They dropped interest rates to 0% (to make borrowing more affordable), conducted QE1 which calmed markets by providing liquidity (“Credit Easing”), tried QE2 & Operation Twist (which aimed to bring longer-interests rates down) and attempted better communication measures (“Rate Easing”) as they committed to keeping interest rates near zero “at least through late 2014”.
Despite these actions taken by the Fed, we still see high unemployment and weak GDP growth. While parts of the economy are showing strength, the two most important measures of the economy show anything but strength. anything but that. Why can’t we solve our problems if monetary policy worked in the past? Market Monetarists (strong supporters of super aggressive monetary policy) will say that the Fed (and every major Central Bank) has failed to do its job. However, this is just wrong.
The main reason we are in an economic malaise is because we are stuck in a “Balance Sheet Recession” (termed by Richard Koo). This is a rare but deadly type of economic illness in which the private sector (or parts of the private sector) is no longer concerned with maximizing profits, and instead is focused on minimizing debt – even at zero interest rates. The balance sheet recession happens when a nationwide asset bubble pops, and the private sector finds itself overleveraged and underwater as the asset price falls. In the US’s case, this nationwide asset bubble happened to be in the largest asset Americans owned , houses. The popping of the housing bubble left millions of households in debt. Those who could no longer afford to pay down the liability, (the debt) defaulted.
However, many Americans, despite being underwater (liability > asset) rationally chose not to file bankruptcy because they still generated enough cash flow to cover their debt payments. This is what threw the US in the balance-sheet recession; as households were focused on paying down debt, spending and investments fell. And when large populations of people do not spend money, aggregate demand falls, unemployment rises from weaker sales, and GDP contracts.
This is where monetary policy becomes impotent. Monetary policy works through two channels. The first channel is through credit. They can make borrowing cheaper or more expensive. The second channel is through expectations, mainly by altering views of inflation. There are two problems with these channels. People (especially the baby boom generation who experienced the housing collapse) don’t want to borrow as they are in the middle of the deleveraging cycle. The problem with expectations is assuming that actions taken by the Fed are communicated to everyone in the economy and that everyone will act upon it. This isn’t true as most small and medium businesses (which are a major part of the economy), don’t even know what the Fed is, let alone their policies.
Higher inflation is supposed to increase people’s spending and investing habits; however, as we know, that is not the issue here. People and/or companies who have healthy balance sheets are not hoarding/not spending money because they fear deflation, regulation, or any other issue; they are doing it because of one thing: low aggregate demand!
Fiscal policy on the other hand can provide direct stimulus, which not only can alter views (imagine knowing you would be getting a tax cut in 2013 instead of a possible tax increase), but can actually boost the economy right away. Through fiscal stimulus (government spending & tax cuts), the government can increase the total number of net financial assets the private sector holds to the point where it would boost aggregate demand. For example, a full payroll tax holiday will put up to a trillion dollars back in the economy (that is about 5-6% of GDP). A payroll tax holiday would put money back in the pockets of those who need the money. Debt will be paid down faster, and savings & spending will increase thus boosting sales. This will surely boost aggregate demand and would finally close the output gap. An infrastructure stimulus package would bring down unemployment almost immediately, would give a much-needed investment upgrade and would increase sales right away (which is the number one concern for businesses as confirmed by many economic surveys).
One of the main reasons we don’t see strong fiscal policy is because the people who “control the engine” refuse to step on the gas. Instead, they are actually about to hit the breaks and slow the car down even more despite already driving at 20 miles per hour below the legal speed limit! The problem with those in Congress (who controls the checks) is that they are economically ignorant and do not understand the basics and realities of the modern monetary system. This, along with the major focus on monetary policy, shifts the attention away from the main conversation we should be having on fiscal policy. We demand higher aggregate demand!
Jerry Khachoyan
Jerry Khachoyan is currently an intraday equity trader who blogs over at the Stocktwits Network. He is also a student at UCLA. His interests not only include trading and markets, but also macroeconomics.
