A Fed engineered Ice-Age

In The Economy May Be Stuck in a Near-Zero World, Justin Wolfers posits:

If the Fed can’t cut rates as much as required to fight a slowing economy, then recessions will become more common and more painful. It suggests an urgent need to reconsider how we will counter the next bout of bad economic news, preferably before it arrives. If monetary policy won’t be enough, perhaps fiscal policy will be. Certainly, this is no time for complacency.

In a nutshell, the American economy appears to have changed in a way that undermines the effectiveness of monetary policy but not fiscal policy, which may need to be wielded more actively.

Nothing new there. Two years ago the WSJ wrote: U.S. Lacks Ammo for Next Economic Crisis, where they question the capacity of even fiscal policy to come to the rescue:

Many economists believe relief from the next downturn will have to come from fiscal policy makers not the Fed, a daunting prospect given the philosophical divide between the two parties.

Republicans doubt federal spending expands the economy, and they seek to shrink rather than grow government. Democrats, meanwhile, say government austerity hobbles the economy, especially in a downturn.

At the time, Kevin Drum posted:

I don’t really have any good hook for posting this chart, but it’s one of the most important ones you’ll ever seeIt’s from the Wall Street Journal and it shows total government spending (state + local + federal) during the recession and its aftermath:

For about a year following the Obama stimulus, total spending was a bit higher than average for recession spending. But after that, spending fell steadily rather than rising, as it has after every previous recession. The result: a sluggish recovery, persistent long-term unemployment, and anemic wage growth.

However, let´s not be too quick to “idolize” fiscal policy. The chart below compares Aggregate Nominal Spending (NGDP) on the same basis.

While spending went negative for the first two years of this recession, it never faltered on the other occasions.

One might argue that in many other instances inflation went up a lot. Therefore, the next chart compares NGDP for the noninflationary occasions, considering only the previous 3 recessions/recoveries. The pattern is the same.

The least one could say is that you also have to consider monetary policy. This time around, both fiscal and monetary policy have been tight!

How can we distinguish their relative “guilt”? The next chart compares fiscal policy (government spending) in the 1990 and 2007 episodes.

Initially, fiscal policy was significantly more expansionary in the present episode, although this expansion has been weaker throughout.

Now, contrast nominal spending in the two episodes.

Maybe monetary policy really trumps fiscal policy!


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