The Impasse of Monetary Policy - Part 6 : Conclusions

Why The Fed, by itself, cannot deliver a sustainable recovery?

                                                              

Part 6 :   Conclusions from the Impasse

 

3.3      The undesirable impact of Monetary Policy on Fiscal Policy

One of the least understood aspects of monetary policy is the indirect impact it has on fiscal policy. Yet the penalty on a government and its taxpayers of lax monetary policy which has been managed for “inevitable” instability – instead of optimized stability – is enormous.

Let’s start by acknowledging the obvious:  the Great Recession greatly reduced tax revenues and caused large US government deficits. Although recessions typically result in lower tax revenues and higher fiscal deficits in every nation, the severity with which it happens underlines the discord between its monetary and fiscal policies. America was a noticeably bad exception in that regard after the Great Recession.

Historically, a balanced budget has been the hallmark of a strong economy and a strong currency. But when the economy slows down, governments have two radically different options: decrease taxes to stimulate consumption (the supply-side economics doctrine) or increase public-sector spending to stimulate employment (Keynesian stimulus thinking).  With either option, the government deliberately increases its short-term deficit with the hope that if the economy does improve, it will then have an opportunity to compensate.

It was foolish when the US entered the Great Recession of 2008 that both mechanisms were operating together: tax-cuts enacted by the previous Administration, and mandatory spending-hikes triggered by the surge in unemployment premiums behind huge job losses. Those, combined with reduced tax revenues associated with the unemployed, created an avalanche effect for the deficit which topped $1.4 trillion -- or 9% of GDP -- in 2009.

Clearly, the toll the Great Recession took on US public debt cannot be understated. Six years later, only Greece and Ireland had done worse, comparatively, for the additional government debt accumulation when normalized relative to country GDP. (see Fig 2)

        FIGURE 2

Because of these trillion dollar deficits, the USA ended up accumulating gross government debt exceeding 105% of its GDP by 2013. What is most striking is that, while US private-sector indebtedness went down by some $8 trillion in the six years following the crisis, the public sector went adversely in the opposite direction by about the same amount, leaving the combined national debt burden still over a treacherous 350% of the GDP. (see Fig. 1)

Six years later, it is clear that expansionary fiscal policies (spending in excess of tax revenues) have not revived the economy as anticipated. Even if for six consecutive years the deficit has shrunk -- and is projected to come under 3% by the CBO for 2014 -- gross public debt still stands at levels last seen during The Great Depression,

To be sure, government deficits are tolerated to a point by global watchdogs like the IMF, as long as the underlying economy has growth potential. This is why fiscal policy is usually paired with monetary policy to sustain higher levels of employment, price stability, and economic growth. The most effective way to coordinate them is a “push-pull” approach where, when the economy is strong, governments run budget surpluses and not deficits by ensuring adequate tax revenues. At least, that is what conventional economic theory says.

But when theory met practice, that pairing in the US has been problematic. Instead of one counterbalancing the effects of the other, with both policies simultaneously harping on the “trickle-down economics” lever – for distributing money toward the most affluent and hope that it would tickle down to all others – the net result is grim: stagnating employment incomes, a lackluster job-market and future taxpayers left to shoulder past policy missteps

 3.4       An undeniable truism amidst a few misguided expectations. 

 

Over the last 20 years the US ended up being excessively dependent on the Fed and its monetary policies. Fiscal and trade policies were comparatively left on the sidelines, as they were politically harder and less expedient to pursue among lawmakers with pronounced ideological differences. To get the Fed to do the heavy lifting was an easier way out.

Alas, coming out from the disruptive Tech Crash of 2001 or the Great Recession of 2008 it seems the Fed itself drew no useful lessons. It continued to be guided by certain convictions which now appear seriously questionable. The first one is that lax monetary policy (i.e. cheap credit) is a helpful remedy in recovering from recessions. The second one is that abundant credit levels the playing field in a way that everyone benefits equally well. To-date, neither of these two beliefs has been validated.


With the first one there are those who think that it is exactly the opposite, i.e. that easy money leads to financial “bubbles” whose inevitable bursting precipitate recessions instead. William White, formerly form the Bank of International Settlements (a.k.a. the bank of the world’s central banks) sums it up like this: “If you have all these underlying problems of too much debt and a broken banking system, to say that we can use monetary policy to deal with underlying real structural problems is a dangerous illusion.”
 

As to the second conviction that low-cost credit helps everyone equally well, it’s getting farther and farther away from veracity: most economists now concur that extreme disparities with income distribution are widened by cheap credit, thus creating more – not less – macroeconomic instability.

A few economists are unequivocal about these issues. First, US Nobel laureate Joseph Stiglitz, had long warned about that unintended consequence of lax monetary policy along with the improbable benefits of “trickle-down economics”. Also, Thomas Piketty, the MIT-trained French economist, went to become a global bestseller with his book “Capital in the Twenty-First Century” for showing how extreme income distribution disparities can chip away at economic growth and overall predictability.

Finally, to exemplify the gravity of the issue, in 2011 the OECD ranked the U.S. in the bottom three of its 28 member countries, only better than Turkey and Chile, with respect to the Gini coefficient. The latter measures the severity of income distribution disparity in the developed world.

Lastly, there is one large public-policy misstep: embracing debt to preserve living-standards, While it is now generally accepted that the Great Recession stemmed from excessive borrowing facilitated by cheap credit, insatiable bankers and indolent regulators, the core problem afflicting world’s richest countries -- not just the US -- went largely unnoticed: sustaining a nation’s prosperity by foolishly ramping up consumer or business credit without considering how economic growth will outpace debt accumulation, is a sure formula for financial disruption. A truism of sorts.
 
No, credit does not guarantee wealth, but it might help generating it. Wealth is created by pairing investment with human ingenuity in the employment of productive labor, but with one important caveat: real and durable economic value must eventually outgrow indebtedness. In other words, credit must be used for economically productive goals. Speculation is definitely not one of them.
 
Since the late 1990’s abundant credit nourished speculation masquerading as valuable economic activity. Both the Tech Crash of 2001 and the real-estate swoon of 2008 are direct results of massive indebtedness fueling excessive speculation, both facilitated by abnormally low interest rates. Yet, by the time overleveraging was officially declared “the problem” in 2009, the Great Recession had already wrecked the balance sheets of many global banks, quickly saddling the imprudent governments behind them with the most invasive fiscal deficits in recent memory.


Unfortunately, consequences is all that matters: seeking refuge in their unintended nature does not reduce the national burden. 
 
Last but not least, the notion of financial stability: an indispensable requirement for a prosperous society. Hoping to attain it, without appropriately and inescapably  coordinating monetary and fiscal policies, is perhaps one of the most unrealistic expectations  of the Western world.