Wednesday, May 02, 2007

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:
  1. 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.

  2. 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.)

  3. 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.

  4. 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.
OK, have you got any better reasons? I’d be curious to know how Kash and Mark look at this.

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Blogger mark said...

I'm trying to find time to get back to this - I will later if at all possible.



Thu May 03, 01:12:00 PM EDT  
Blogger Biomed Tim said...


It seems like the reasons you listed would apply almost ANY time. (with the exception of the strength of the dollar)

Do you specifically oppose reducing the deficit NOW?

Thu May 03, 06:50:00 PM EDT  
Blogger knzn said...

I think these reasons are somewhat specific to the present. #1 applies because the risk of a recession is higher than usual. #3 applies because the savings rate is negative and the core inflation rate is low; the risk of a liquidity trap is high because the savings rate could shift positive again – producing a dramatic drop in demand – and the temporary inflationary factors could shift to being deflationary. #4 applies because the potential of the world economy is growing unusually rapidly, while the world faces a savings glut. All but #1 would also have applied a couple of years ago, but not so much in previous decades.

Thu May 03, 07:10:00 PM EDT  
Blogger Biomed Tim said...

"...the risk of a liquidity trap is high because the savings rate could shift positive again – producing a dramatic drop in demand – and the temporary inflationary factors could shift to being deflationary..."

Professor, isn't the core inflation rate low due in part to the housing-slump? If so, wouldn't a positive savings rate trigger a growth in the housing sector? Is that significant enough to relieve deflationary pressure?

Thanks for the timely responses btw. I always learn a lot from your awesome blog.

Thu May 03, 10:22:00 PM EDT  
Blogger knzn said...

(Actually I’m not a professor; I’m a private sector economist.) Right now housing is increasing the core inflation rate, because rents go into price indexes but purchase prices don’t. Because now people want to rent rather than buy (or else can’t buy because credit standards have tightened), they are bidding up rents. In the longer run, all the new housing constructed during the boom should tend to put downward pressure on rents, but this is taking a while to work out. A positive savings rate would tend to reduce interest rates, which would make buying attractive again and put additional downward pressure on rents.

Fri May 04, 09:32:00 AM EDT  
Anonymous Anonymous said...

Fascinating, as Spock would say. Thanks knzn - always enjoy your discussions, although I have some reservations on macroeconomics.
Macroeconomics, with its focus on GDP, regardless of its composition and its contribution to welfare needs a little more scrutiny.
For instance, how much has the IRAQ war contributed to American welfare? It certainly has contributed substantially to GDP, along with reconstruction costs. If it were to be terminated immediately, surely we'd have some sort of recession, but would we be worse off? Clearly, distribution and resource allocation would be issues, but if we could manage a reallocation, would we not be better off (the soldiers could be enlisted in the fight against obesity, or climate change, for instance; or moved to Darfur)? Of course getting from A to B when politics are involved and human capital need to be retooled is excrutiatingly difficult.
In any case, the only other sensible short term way to reduce the deficit at this point is to increase taxes, as there is no more room left for cuts. How likely is that to happen?

Fri May 04, 12:27:00 PM EDT  
Blogger mark said...

Okay, let's see. On 1,I agree. I've always taught that the overall lags are about the same - monetary policy can be implemented quickly but has long lags, fiscal policy has shorter lags but takes longer to work throough the political process.

One qualification though. The "$400 rebate" they id awhile back was put into place very quickly, faster than I would have expected, so there are tmes when fiscal policy can be pushed though relatively quickly. It may not be there for small downturns, but may stills erve as insurance against big shocks when everyone would quickly come together and agree quick action is needed.

I also wrote this quite awhile ago - back when interests rates were lower:

All of these questions would be much easier if both monetary and fiscal policy hadn’t already been used to such an extent. With deficits as high as they are, using fiscal policy to stimulate the economy is politically and economically infeasible. With interest rates this low it’s hard to get much stimulation from driving them even lower. They can't go much lower in any case, though interest rates could be raised if the Fed decides to tighten in response to a stagflationary episode. Thus, because the usual tools for stimulating the economy are largely unavailable, the result of recent monetary and fiscal policy is increased vulnerability to negative output shocks and a stagflationary episode.

but with interest rates higher, monetary policy is "reloaded" to some degree.

On 2, I'll just add that I don't think the Fed worries much about exchange rates except o the extent that they feedback into the domestic economy.

For 3, kind of covered that already above, but I think there is some room to lwer rates. But I don't know how powerful a stimulus that will provide since there is already fairly cheap long-term money available.

4 - I don't think U.S. monetary policy has powerful global effects.

Again, my point was a simple one - if there are signs of weakness, then now is no the time to be cutting spending or increasing taxes.

Sat May 05, 06:16:00 PM EDT  
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