We Are Moving From Monetary to Fiscal Policy Dominated Economics (Part One)

TW: Economic policy for the past 30 years has been dominated by monetary policy management. The inflation of the 1970's was addressed in a bi-partisan fashion by the Volcker led Fed. Subsequently, Greesnspan for better or worse dominated economic policy through the 80's and 90's with aggressive interest rate changes. This current financial crisis does not appear solvable strictly through the use of monetary policy. Fiscal policies will re-emerge after decades of hibernation to take a prime spot on our economic planning. Obama signaled as much on Friday with his clear statement that a fiscal stimulus will be forthcoming either immediately or as soon as feasible after he enters office.

There was one stimulus package enacted over the summer of roughly $150 billion. The next stimulus will be a multiple of that figure. I would not be surprised to see $500 billion plus perhaps something closer to a trillion.

Why fiscal policy? Without getting into serious detail, monetary policy will not be sufficient to reverse the slide in the economy. Reducing interest rates is now roughly akin to pushing on a string. Many financial institutions are merely trying to restore their own solvency and are not lending regardless of their own now lower cost of capital due to the interest rate cuts. When no one is lending economic growth slows rapidly. Deflation becomes the risk in place of inflation. Deflation is a potentially far more dangerous phenomenon than inflation. If everyone assumes assets will be cheaper next month (e.g. housing, cars, plane tickets, businesses) then everyone waits leading to further deflation or in other words a circle of doom. More later.

The pump must be primed. The one remaining pump primer the federal government. As the quote below illustrates, state and local governments are ill-suited to prime the pump due to the fiscal restraints built into many of their constitutions. Fiscal stimulus brings risks, it must done wisely otherwise the pump will not be primed properly (e.g. in this case someone getting a stimulus check and saving would not achieve the goal of stimulating consumption). Correspondinly government spending once started is devishly difficult to reverse (much like any decrease in a tax is difficult to reverse). Some projects such as infrastructure building are one-off projects which have a natural end but those projects have long lead-times.

From Paul Krugman at NYT:
"Economists may remember that the president of the European Commission once the eurozone’s “stability pact,” which was supposed to set a rigid limit on budget deficits, the “stupidity pact” — because it would have forced tax hikes and spending cuts in the middle of a recession.

Well, we’ve got our own stupidity pact: state and local governments operate under fiscal rules that lead to booming spending and tax cuts when the economy is strong and the reverse when the economy is weak. This is bad governance: services are cut precisely when people need them most. It’s also bad macroeconomics: it exacerbates the business cycle.

Right now, we’re seeing a sharp drop in state revenues, which is going to lead to big cutbacks in spending and tax increases at exactly the wrong time.

Obama mentioned aid to state and local governments in his press conference yesterday. Indeed. This is a very quick form of fiscal stimulus, because it’s not about starting new spending, it’s about sustaining current spending. It should be done immediately.
But what if Bush says no? Congress should pass the aid plan anyway, and Obama should promise to sign it as soon as the current tenant vacates the White House. That way states will know that the money is coming, and be able to budget accordingly."