Monetary Policy

The following is a comment I posted on the recently established blog of Scott Sumner, a very intelligent economist who provides an interesting outlook on the role of monetary policy in the
current economy, and more broadly:

Certainly, further use of monetary policy should play a role in the current stimulus efforts as the policies outlined thus far are likely to be ineffective in terms of closing the output gap and generating substantial economic activity. Its evident that the latest iteration of the stimulus package is relying on the traditional Keynesian framework, based on substantial spending multipliers. Given the current economic condition, the effects of the proposed fiscal spending policies will likely fall short of expectations (too small, likely to be allocated extremely inefficiently, Ricardian equivalence as a real factor in consumer and business behavior, etc). Furthermore, the tax cuts that have passed are also unlikely to generate the desired effects. We would have been better served with payroll tax cuts as suggested by Mankiw.

As a result of the aforementioned shortfalls of the current stimulus policy it seems necessary that an effective use of non-traditional monetary policy will have to be employed alongside the current stimulus in order to generate economic growth. While the fiscal spending and tax cuts are likely to have some stimulus effect, albeit
multipliers are likely to fall short of expectations, it seems likely that monetary policy can indeed be effective in the current environment despite the fact we are facing a zero bound.

Take as an example, the very entity that most economists are relying on to lead us out of this economic slump, the consumer. Over the past decade a significant increase in household debt has fueled the type of PCE that has sustained economic growth. As a matter of fact, household debt as a percentage of PCE reached an all time high of 140% in 2008 and as you would expect there is a significant correlation between the increase in household debt outstanding and the percentage change in PCE, in real terms and on and annual basis (p value <.001). It is reasonable to suspect that the absence of a proper stimulus will lead to a significant de-leveraging in household debt outstanding and in turn further decreases in consumer demand (why should the financial institutions have all the fun).

As previously mentioned, it seems unlikely that the proposed fiscal policy will be effective in containing the de-leveraging in the consumer sector, and a significant
increase in the money supply coupled with aggressive inflation rate targeting rhetoric from the Fed could better serve to stabilize current household debt levels, increase consumer demand, and in turn support PCE.

Sumner appears to be one of the only economists consistently pointing to the fall in aggregate demand (recently Martin Wolf has noted the same) resulting from a contractionary monetary policy and a failure by the Fed to prevent a crisis from spreading following the sector-specific sub-prime collapse, as the basis of the current crisis. While other economists have reverted back to traditional Keynesian models, Sumner has shown consistency in his belief that it is monetary policy primarily (if not solely) that should be used to stimulate the economy. As a student of the Great Depression, much like Bernanke, his views certainly warrant consideration.

All 20+ of Sumner's posts so far are worth a read by anyone truly interested in getting a fresh take on the current economic situation and potential solutions.