I wanted to expand on the following which derives from the the last blog entry, The ZLB vs the Natural Rate: US Monetary Policy goes Global,
"A more compelling argument can be made that an economy suffering a secular stagnation that arises from perpetually depressed private investment must rely on a greater use of fiscal policy. In such a state of the world, fiscal policy becomes imperative in generating enough aggregate investment and demand to ensure that all available resources, including labor, are put to productive use rather than imprudently sitting idle. This is particularly the case if existing monetary policy tools fail to gain traction in reducing slack in the economy. Unfortunately due to current political realities and ideologies, a more expansionary role for fiscal policy is often dismissed as a political non-starter. If these assumptions prove to be true, then the decision to accept secular stagnation is a political choice made within the confines of a broken political system."
*Although dollar credit markets are more important given their respective size, Fed interest rate policy also impacts equity funding and market prices. With that said, expectations concerning corporate fundamentals and investor sentiment are still operative as earnings and P/E ratios of public corporations are relatively more important than policy rates. Furthermore, if expectations pertaining to the potential profitability of new investments are favorable, in theory elevated equity prices should entice firms to issue equity in order to fund such opportunities. As companies have engaged in share buybacks, this may suggest that they are not very optimistic about future prospects for capex or that hurdle rates are prohibitively high (risk aversion).
"A more compelling argument can be made that an economy suffering a secular stagnation that arises from perpetually depressed private investment must rely on a greater use of fiscal policy. In such a state of the world, fiscal policy becomes imperative in generating enough aggregate investment and demand to ensure that all available resources, including labor, are put to productive use rather than imprudently sitting idle. This is particularly the case if existing monetary policy tools fail to gain traction in reducing slack in the economy. Unfortunately due to current political realities and ideologies, a more expansionary role for fiscal policy is often dismissed as a political non-starter. If these assumptions prove to be true, then the decision to accept secular stagnation is a political choice made within the confines of a broken political system."
As the prior post highlights, monetary policy works by influencing private credit creation* which either funds private investment, consumption, and/or the purchase of existing financial assets. Since the dollar credit markets play a dominant role, whether intended or not, US monetary policy gets transmitted abroad. This isn't to suggest that the Fed is the only player. When possible, foreign central banks and financial regulators that justifiably worry about the destabilizing effects of dollar denominated financial flows should seek to limit the use of dollar credit by their own financial institutions, firms, and households.**
However as has proven to be the case now and in the US during the GFC, prudent financial regulations can be quite difficult to design and administer without endangering the system by creating the incentive to divert greater activity outside of the regulated financial system. Unfortunately, unintended consequences paved by good intentions are part of a human nature that is fundamentally limited by uncertainty. Moreover if financial regulations, which rightfully force financial institutions to rely on a greater degree of equity funding rather than short-term debt finance, results in an economy that continues to produce below trend economic activity, then other policy measures need to play a complementary role. The hope is that policymakers can create a stable financial system in a fast growing economy that fully employs all of the available resources that at the moment remain wastefully underutilized.*** Otherwise using macroprudental or even monetary policy ("leaning against the wind") to reduce the risks of potential financial instability may come at the expense of economic growth.
Therefore, a person that is concerned about financial stability in the private sector should be more supportive of expansionary fiscal policy when dealing with recessions and subsequent recoveries as this would mean less reliance on monetary policy.**** If the financial system and non-financial firms are unable to direct credit toward profitable private investment then public investment funded by the issuance of US treasury securities is necessary until the private sector is ready to fulfill this role again. To use monetary tools to spur private debt financed economic activity is a second best solution in a time when private debt levels are still near historic highs.
Hence, this type of fiscal policy is a consequence of weak private investment and high private debt levels and not a call for "big government" which it's often made out to be. Fiscal policy can always be conducted in a way that empowers the private sector especially households by directly transferring them the financial resources necessary to boost their purchasing power. This not only would augment aggregate demand, but also provides households the liberty and ability to use such transfers to fund private investments in whichever way they decide. This isn't to say that fiscal spending on risky, large scale projections such as infrastructure, education, R&D***** shouldn't be supported. In cases where the disaggregated private sector cannot or is unwilling to direct investment into projects which prove to be too risky or where returns are only felt in the very long term, a competent government should be able to do so on behalf of their citizenry. Importantly, having both sectors of the economy working in greater unity would significantly ensure that everyone would be able to experience a substantial improvement in their living standards as technological advancements are made. Maybe this is expecting too much given the current political paralysis, but if so we should be calling for major changes in our public as well as private institutions.
As for those claiming that an expended role for fiscal policy would actually cause financial and economic instability, the bright minds participating in the financial markets have yet to show signs of this being the case (see Japan as another example). Whenever times of crisis actually manifest themselves, treasury securities have been fiercely bid up. This is especially the case in situations where once highly rated private securities (AAA-rated paper) are no long perceived to be safe creating a safe asset shortage in the process. Thus even in the most acute of panics, the US treasury market is seen as a safe haven. Therefore adherents of market fundamentalism should pay attention to the price signals sent by the markets themselves.
In a way, fiscal authorities can be seen as providers of insurance****** in the form of treasury securities. By doing so, the private sector's net worth is safely augmented which may very well foster a return to risk taking in the form of real investments. As for the household sector, direct transfers along with counter-cyclical policy measures (social security, unemployment insurance etc.) can minimize their exposure to economic and financial volatility which they are vulnerable to but powerless to guard against. Individual households alone, especially the poorest, are not very well equip to handle or anticipate large macroeconomic changes that prove disruptive to their lives.
Ironically by instituting such policies, this could mean that less "government intervention" is required in the future. It would also likely reduce the need for a monetary policy exhibited by persistently low interest rates. Without a greater role for fiscal policy, less dependence on monetary policy may not be possible. Therefore, a world where policy interest rates are continuously at risk of hitting the zero lower bound is one where fiscal policy is overly restrictive. It also problematically suggests the Fed has been overly reactive to an inflation target (ceiling) that in hindsight has been likely set too low (explored here). Improved fiscal policy coupled with a higher inflation target (or NGDP level target) may be what is needed to create a pace of financially stable economic growth that ensures economic security for as many households as possible.
Hence, this type of fiscal policy is a consequence of weak private investment and high private debt levels and not a call for "big government" which it's often made out to be. Fiscal policy can always be conducted in a way that empowers the private sector especially households by directly transferring them the financial resources necessary to boost their purchasing power. This not only would augment aggregate demand, but also provides households the liberty and ability to use such transfers to fund private investments in whichever way they decide. This isn't to say that fiscal spending on risky, large scale projections such as infrastructure, education, R&D***** shouldn't be supported. In cases where the disaggregated private sector cannot or is unwilling to direct investment into projects which prove to be too risky or where returns are only felt in the very long term, a competent government should be able to do so on behalf of their citizenry. Importantly, having both sectors of the economy working in greater unity would significantly ensure that everyone would be able to experience a substantial improvement in their living standards as technological advancements are made. Maybe this is expecting too much given the current political paralysis, but if so we should be calling for major changes in our public as well as private institutions.
As for those claiming that an expended role for fiscal policy would actually cause financial and economic instability, the bright minds participating in the financial markets have yet to show signs of this being the case (see Japan as another example). Whenever times of crisis actually manifest themselves, treasury securities have been fiercely bid up. This is especially the case in situations where once highly rated private securities (AAA-rated paper) are no long perceived to be safe creating a safe asset shortage in the process. Thus even in the most acute of panics, the US treasury market is seen as a safe haven. Therefore adherents of market fundamentalism should pay attention to the price signals sent by the markets themselves.
In a way, fiscal authorities can be seen as providers of insurance****** in the form of treasury securities. By doing so, the private sector's net worth is safely augmented which may very well foster a return to risk taking in the form of real investments. As for the household sector, direct transfers along with counter-cyclical policy measures (social security, unemployment insurance etc.) can minimize their exposure to economic and financial volatility which they are vulnerable to but powerless to guard against. Individual households alone, especially the poorest, are not very well equip to handle or anticipate large macroeconomic changes that prove disruptive to their lives.
Ironically by instituting such policies, this could mean that less "government intervention" is required in the future. It would also likely reduce the need for a monetary policy exhibited by persistently low interest rates. Without a greater role for fiscal policy, less dependence on monetary policy may not be possible. Therefore, a world where policy interest rates are continuously at risk of hitting the zero lower bound is one where fiscal policy is overly restrictive. It also problematically suggests the Fed has been overly reactive to an inflation target (ceiling) that in hindsight has been likely set too low (explored here). Improved fiscal policy coupled with a higher inflation target (or NGDP level target) may be what is needed to create a pace of financially stable economic growth that ensures economic security for as many households as possible.
*Although dollar credit markets are more important given their respective size, Fed interest rate policy also impacts equity funding and market prices. With that said, expectations concerning corporate fundamentals and investor sentiment are still operative as earnings and P/E ratios of public corporations are relatively more important than policy rates. Furthermore, if expectations pertaining to the potential profitability of new investments are favorable, in theory elevated equity prices should entice firms to issue equity in order to fund such opportunities. As companies have engaged in share buybacks, this may suggest that they are not very optimistic about future prospects for capex or that hurdle rates are prohibitively high (risk aversion).
**Foreign regulators who have financial stability concerns should especially try to limit the issuance of foreign denominated debt by their financial institutions, firms, and households. This would not only work to address potential issues having to do with the use of too much debt over equity but also problems that stem from balance sheet positions that exhibit a great deal of currency mismatch.
***Idle resource in an economy producing below full potential is as much a misallocation of labor and capital as a situation where these inputs were used mistakenly or imprudently. During times of crisis, it's often lamented that the incentives within the economic and financial systems are geared toward pushing the private sector to use credit in order to drive unsustainable economic activity. However, during weak recoveries I don't think it's stressed enough that wasteful unemployment and underemployment stemming from deficient investment and consumption are just as heedless.
****Once at the zero lower bound, the effectiveness of monetary policy particularly balance sheet expansion has come into question. Unlike fiscal policy, the Fed cannot buy goods or services from the private sector. Neither is the central bank able to engage in direct transfers to those with the highest marginal propensity to spend. Fed LSAPs (QE) has very inaccurately been termed "money printing" when in reality the Fed has only swapped one type of government debt (reserves) for another (t-bonds). This is functionally the same as if the government had financed itself by issuing T-bills in the first place.
*****Delaying or suspending fiscal investment spending on infrastructure, education, and R&D creates a real burden on current and future generations. If these assets are allowed to deteriorate, either living standards will be at risk of declining or future generations will be forced to direct future resources toward their repair. Thus, the misplaced fear of nominal government debt levels creates actual risks. To only focus on the level of government debt held by the public while ignoring the asset side of the balance sheet is a grave mistake.
*******See the Holland Principle which states the the US government can be viewed as a gigantic insurance company with an army.
****Once at the zero lower bound, the effectiveness of monetary policy particularly balance sheet expansion has come into question. Unlike fiscal policy, the Fed cannot buy goods or services from the private sector. Neither is the central bank able to engage in direct transfers to those with the highest marginal propensity to spend. Fed LSAPs (QE) has very inaccurately been termed "money printing" when in reality the Fed has only swapped one type of government debt (reserves) for another (t-bonds). This is functionally the same as if the government had financed itself by issuing T-bills in the first place.
*****Delaying or suspending fiscal investment spending on infrastructure, education, and R&D creates a real burden on current and future generations. If these assets are allowed to deteriorate, either living standards will be at risk of declining or future generations will be forced to direct future resources toward their repair. Thus, the misplaced fear of nominal government debt levels creates actual risks. To only focus on the level of government debt held by the public while ignoring the asset side of the balance sheet is a grave mistake.
*******See the Holland Principle which states the the US government can be viewed as a gigantic insurance company with an army.
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