Friday, 10 May 2013

The farce that is monetary policy.

First, I do like this chart which shows the – er – amazing benefits of the 2009 cut in base rates in the UK. More specifically, the base rate plunged, and the result? Rates charged by commercial banks, etc to borrowers went up.

Re the chart, hat tip to
Next, Brad DeLong and Laura Tyson give five reasons why it used to be thought that monetary policy alone could deal with recessions.
All five reasons are thoroughly defective. The reasons copied straight from their paper are as follows (in brown), followed by my comments in black.
1. The problem of legislative confusion: Legislatures that were told that  expansionary policies which led to cyclical deficits in downturns were  good might have difficulty retaining the other important lesson that  structural deficits which led to perpetually rising debt-to-GDP ratios were  bad. Better, it was thought, to keep the legislative process focused on  “classical” considerations of the benefits and costs of spending programs and taxation levels.
No doubt most of us agree that the legislature should concentrate on the strictly political matters, like what proportion of GDP should be allocated to public spending and how that should be split between education, defence and so on. But that doesn’t preclude fiscal stimulus: the degree of fiscal stimulus can be decided by a fiscal council or some other independent committee of economists, while the above mentioned “political matters” remain untouched. E.g. if a fiscal council cuts taxes and raises public spending by the same proportion and with a view to imparting stimulus, then the proportion of GDP allocated to public spending remains untouched.
Moreover, it is easy to build in an element of variability into sales taxes for example: indeed, VAT has been altered three times in the last five years in the UK without a full vote in the House of Commons. Likewise an element of variability could easily be built into social security benefits, payroll taxes, etc.
2. The problem of legislative process: Legislatures are, by design,  institutions that find it very difficult to make decisions quickly. Central  banks, by contrast, can move asset prices in an hour. Fiscal policies that  take effect this year as a result of decisions made by a legislature last year based on information from two or three years ago would seem to  guarantee sub-optimal economic outcomes. 
Total confusion here.
First, even assuming that central banks can take decisions quicker by a few weeks or months AND ASSUMING that fast acting fiscal councils are not possible, the “in an hour” point is irrelevant. The IMPORTANT question is the TOTAL LAG as between the decision to act and the eventual effect. And in that lag for both fiscal and monetary policies seems to be around a year. So if it takes a fiscal council a month longer to act than a central bank, that is near irrelevant.
Next, whence the assumption that decisions on fiscal stimulus are based on “information from two or three years ago” but decisions on monetary stimulus are based on more recent information? The “information” will be EXACTLY THE SAME in each case: the most important pieces of information being whether unemployment is rising or falling and ditto for inflation.
3. The problem of implementation: Public bureaucracies have limited  capacities to ramp-up or ramp-down their spending levels quickly without  incurring substantial waste. The larger the fiscal-policy intervention to  balance aggregate demand, the less likely the intervention would be well timed, well designed and well executed. 
Obviously there are areas where “ramping up or down” involves waste. A classic example is one of the most popular proposed forms of anti-recessionary spending, that is infrastructure. It’s normally impossible to get infrastructure projects going quickly, plus if anti recessionary spending is concentrated on just one area (infrastructure or whatever), the requisite skilled labour probably won’t be available.
However, there shouldn’t be any of the above waste if stimulus is spread over the entire economy or a large portion of it, as occurs when taxes or benefits are adjusted.
Moreover, adjusting interest rates suffers from exactly the problem mentioned above: namely concentrating stimulus on one or two narrow areas of the economy. That is, cutting interest rates concentrates stimulus on capital expenditure (assuming interest rate cuts work as they are supposed to, which looks doubtful if the above chart is any guide). As mentioned above, big increases in demand for PARTICULAR PRODUCTS care likely t o run into the above mentioned shortage of skilled labour problem.
4. The problem of rent-seeking: In a world where we fear that the  structure of government already leads to policies favoring too-many  politically-powerful winners at the expense of politically-weak losers, an  additional excuse to undertake fiscal projects and programs that would  not meet conventional societal benefit-cost tests is not welcome. 
Rent seeking is a problem that occurs where corporations can bribe politicians into allocating government spending to PARTICULAR projects or forms of spending. In contrast, fiscal committees or similar are NOT CONCERNED with specific projects or similar. Fiscal committees are concerned with changes to tax or spending which do not impinge to any great extent on one project or area of the economy.
5. The problem of superfluity: Monetary policy was strong enough to do  the job. Fiscal policy was simply not necessary.
The fact that something is “strong enough to do a job” is not a good reason for supposing it’s the BEST TOOL for the job. In particular, monetary policy is DISTORTIONARY (as mentioned above) in that it concentrates stimulus on capital spending.
An Abrams tank is “strong enough” to plough a field. But it’s not the best tool for the job, is it?
And to cap it all, monetary policy, as DeLong and Tyson correctly point out becomes a feeble implement at the zero bound.

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