The Paradox of Thrift and Monetary Policy
Kash Mansori of The Street Light and Mark Thoma of Economist’s View argue that now may be a bad time to cut the US budget deficit, given the relatively slow economy and the risk of a recession. pgl of Angry Bear argues (in a post whose title I stole) that now is as good a time as any, provided that the Fed does its job. pgl's argument seems pretty solid, but there are a few possible reasons one might consider deficit-cutting dangerous:
- From the time of implementation, fiscal policy operates with a shorter lag than monetary policy. Usually, there are long political lags before fiscal policy gets implemented, but during that period there is also uncertainty. The Fed would not be able to respond to a deficit cut until it could be confident about its taking place. That might be too late to prevent a recession.
- Interest rate cuts would weaken the dollar, and dollar weakness could exert an inflationary effect independently of its stimulus effect, causing the Fed to be excessively cautious using this type of stimulus. Deficit borrowing, by contrast, would tend to keep interest rates high, thus keeping the dollar from collapsing. (On the other hand, deficit cuts might increase confidence in the dollar, in which case investors might continue to demand dollars even at a lower interest rate.)
- Does the Fed have enough ammunition to fight, reliably, the depressing effects of a substantial increase in national saving? You might remember that, back in 2000, interest rates were higher than they are today, perhaps giving the impression that the Fed had plenty of room to cut them; yet three years later, the Fed was starting to debate the types of unconventional policies that might be necessary if short-term interest rates approached zero. With the international savings glut still on and plenty of room for retrenchment by US consumers, I wouldn’t want to be overconfident about the impossibility of a liquidity trap.
- Although the world economy is growing rapidly, its potential seems to be growing even faster. The stimulus from the US budget deficit and consumer spending is helping the world make up this gap. US monetary policy would not provide such a stimulus for the world economy.