Monetary and fiscal stimulus make a potent, if uneasy, combination

The monetary system needs to be purged. These low real interest rates reward debtors and penalise the savers.

Over the decades monetary authorities have allowed excessive credit to create various asset bubbles to the detriment of all.

Talk about generals fighting the last war. Why should central banks be so inflation-phobic right now when deflation is the enemy? If deleveraging is the headwind, a little inflation that would lower the real value of household debt could be just what the doctor ordered. And talk about a Weimar- or Zimbabwe-style hyperinflation is way over-blown.

No matter what Ben Bernanke tries, it'll be an exercise in abject futility. The US economy has tanked & is NOT going to recover, no matter what he attempts.

It has long crossed the point of no return, thanks to the diabolic acts of financial treason commited by the Bush-Chenay Junta, over eight long years of insane bungling, profligacy & rank ineptitude.

Now live with the consequences & repurcussions, for a L-O-N-G time to come, folks & you have the Republican/Rightwing Administration to thank for it.

Enjoy..

@straight, no chaser

No, deflation is the clear and present danger. "Attempts to distort markets" is way too abstract. Markets exist in the complicated, real world, not a vacuum, and will always be affected by distortions. If you have a problem with particular distortions, please cite.

And inflation, like deflation, has winners and losers on both sides of the income scale. At this time, excess debt is the greatest problem for moderate-income households. so some inflation for that class would probably be a net gain.

I have no idea what your CDO analogy is meant to convey. That some things have unforeseen consequences? Well, duh. But that shouldn't paralyze attempts to revitalize the economy.

"Supplying trillions of dollars of reserves and driving interest rates to zero cannot force banks to lend or companies and households to borrow."

Gee - no kidding ?

I can imagine Congress agreeing to rational control of fiscal policy . . . sure I can.

The Republicans have declared a phoney fiscal crisis that will end as soon as they are the ones who get to borrow and spend. There is obvious investment needed to counter decades of neglect of roads and bridges. But the GOP wants the economy to stay down until the next Presidential election.

I cannot remember a party doing so much intentional damage to the country for political advantage. Yet, it may backfire if they gain control of either House or Senate. Then, they will too obvious to escape blame if this unpleasantness persists.

@ der perfesser --

What crowding out? Companies are sitting on huge piles of cash, interest rates are about as low as they can go. The whole point of Keynesian stimulus is for govt to tap idle savings and recycle it back into the economy.

But I agree with your other points. If the problem is deflation and lagging demand, and govt debt is already high, why not print some money? Seems to me that kind of flexibility is one of the attractions of a fiat currency.

"Mr Leeper says the answer may be to create fiscal institutions that mimic the rigour and autonomy of central banks, as Sweden, Chile, Hungary and New Zealand have done to varying degrees"

Perhaps you (or Mr Leeper) might explain how you create autonomy for fiscal institutions in an electoral democracy? Are you saying the power to make decisions on how to spend public money should be taken away from politicians?

The economist seems to spend half its time trying to export democracy abroad, and the other half trying to take power away from pols and put it in the hands of unelected technocrats.

ps: "And talk about a Weimar- or Zimbabwe-style hyperinflation is way over-blown."

If in 2006 or early 2007 someone presented to you a list with the names of banks and companies that would no longer exist in 2009 or would be rescued by uncle sam, you would probably find it way over-blown as well.

@g. powell

I beg to differ. Deflation is not the enemy. The enemies are attempts to distort the markets, which are desperately searching for equilibriums, and incentives.

You wrote: "If deleveraging is the headwind, a little inflation that would lower the real value of household debt could be just what the doctor ordered."

Yes, I partly agree, a little inflation would lower household and government debt. But let's not forget the other side of this coin: it would also decrease the value of savings of those who live within their means and do not rely on debt for support. Moreover, "a little inflation" will raise prices, which many less affluent will not be able to afford. Higher prices will also require everyone whose wages will not keep up with inflation to spend a larger portion of their income on rents, food, energy and anything else they might desire; or worse, they might be forced to borrow just to make ends meet. So no, it just NOT what the doctor ordered.

ps: Many believed a triple A rated CDO to be a great, almost riskless, investment and many preached citing historical evidence that housing prices always rise. Time proved them wrong. Inflationary myths will shortly join the club and time will tell. Unfortunately, it'll probably be one of the most painful and costly lessons our modern civilization will learn.

@g. powell,

My apologies for the ambiguity: I assumed it was clear I referred to the FED - the greatest market manipulator. Government programs such as cash for clunkers, cash for appliances and the housing tax credit, to name a few, are also market distortions.

I agree with you: "markets exist in the complicated, real world, not a vacuum, and will always be affected by distortions," unfortunately. For example, a government market distortion, which unfairly incentivizes buying a place to live, is a tax deductible interest paid on a mortgage. Government policy unjustly grants owners income tax deductions while renters receive no benefits. Although I disagree with the policy its impact on the housing market and the economy is miniscule compared to that of the FED.

Yes, inflation, like deflation, does have winners and losers. I strongly believe and advocate that free markets should determine who wins and who loses, not the FED, the government or anyone else. Further, "at this time, excess debt is the greatest problem for moderate-income households so some inflation for that class would probably be a net gain." What about the other classes, why should the "moderate-income households" be rewarded at the expense of the others, particularly those who make sound financial choices and do not rely on excessive debt? Lastly, tackling excessive debt problems with more debt will not work. Throwing logs onto a fire only briefly tames the flames. Once the added logs begin to burn the fire rages stronger. It is also unsustainable; eventually there are no more logs to burn.

My last paragraph, which you misunderstood, was not an analogy (I wasn't clear). Triple A rated CDO, comprised of many 'junkiest' sub-prime loans, is still the same crappy bundle of the same crappy loans. The fact that these loans were pooled together and split into traunches managed to convince many that CDO was now a solid investment unlikely to default; hence the triple A rating. Therefore, it's spectacular demise is not an unforeseen consequence, far from it. Among many other things, the demise of a CDO evidently demonstrates how misleading and damaging once bullet-proof conventional wisdom might turn out to be. The Keynesian approach favored by the FED will follow the fate of the CDO. If you wish to know why, may I suggest you read jcfoot's post on another forum? I'm a big fan and he's much more articulate:

http://www.economist.com/blogs/multimedia/2010/08/tea_economist#comments

Very briefly, and this is a very basic summary of what is need as current economic policy related to the current economic situation of a country like the USA or Germany:

the country has to be put back on the "growth cycle" - "positive feedback".

To do this it is generally recognized that the government has to actively stimulate the economy by investing in high multiplier market activities, and also at the same time preventing a contraction in the money supply, preferably gradually increasing it.

OK How does it do this? Spend money.

To spend money it has to do one or more of the following:

1. Raise taxes ( a no-no in a recession).
2. Borrow. Not good. Money borrowed by the government "crowds-out" what will be spent or invested in the private sector.
3. Print money. Create new money which it spends.

Is 3. inflationary? It depends... But not at the depths of a recession. Many non-monetary economists do not realize that in a recession the quantity of money CONTRACTS. It is not a fixed quantity. It varies with velocity and activity in the economy.

So, in a depression/recession money creation is a good thing. It prevents a contraction of the money supply (which is very, very bad) and also provides money for the government to go about its stimulation activities.

Printing money in a recession is probably the best policy.

And I hate the euphemism "quantitative easing". There was no need for it. I can imagine the farts in the Boards of the reserve banks coming up with such a silly name.

Deflation/low inflation is the present problem. If in any case we get unusually high inflation the Fed has tremendous ability to drain reserves from the system. Our economy at this point resembles a lot at that of Japan in the 90s. The central bank has to take unusual measures to prevent a similar situation to materialize. In my view a good dose of QE or any other method which would increase the monetary aggregates may just be what we need.

Monetary stimulus is a very good idea BUT we must stop the banks creating money at the same time. See www.legalforgery.com and Ben Dysons site.www.BankofEnglandAct.co.uk
BillDavies

@straight, no chaser:
maybe time proved also rating agencies wrong.

I think the subject of the article is quite interesting.
While the study by Leeper is very long, it does not mention the role of the exchange rate at all, which is quite strange if you consider Mundell-Fleming model: the regime of exchange rates implies the level of efficiency of fiscal policy, because it is generally less efficient when we have flexible exchange rates. For the same reason, the Economist itself should be wary of forgetting that fiscal expansion increases consumption, but can hinder private investments (through crowding out caused by the increase of interest rates) and exports (through appreciation of the currency).
At the same time, the Economist could easily tell Leeper that the "alchemy" in fiscal policy was very much reduced by the liberal approach introduced by Reagan and Thatcher in the Eighties, through the Laffer curve and its positive effects. Having said that, the difference between monetary and fiscal policy (in terms of time horizon) keeps on being quite clear, considering how Trichet (unlike Bernanke) is remembering the importance of fiscal credibiliy in the medium term. And fiscal expansion can not be taken to the extremes: the IMF is showing us, through its current publications, how the level of public debt is becoming unsustainable and how useless any default would be in advanced economies.

I would suggest a three pronged strategy to economic recovery:

Firstly, a housing stabilization program (where the government would receive first rights home equity in return for making part of the monthly mortgage payment for those facing foreclosure, with the government disposing of its share in 10-15 years). The current foreclosure rescue plans are too indirect, they involve some write offs on the part of the lender and also give away government money. Under my plan, there would be no government giveaways, the burden would be on the homeowner (by not building equity) and the banks possibly having to writeoff some mortgage balance in 10-15 years time. In return the homeowner gets to stay in his home for 10-15 years (as long as he or she does not default) and the bank to receive monthly mortgage payments for the same period of time. By reducing the number of homes being foreclosed, new housing construction employment will increase.

Secondly, a temporary investment bank to lend to those borrowers who otherwise would be able to borrow during normal economic times, but can not now due to risk averse banks. By the bank hiring employees with commercial banking experience and deferring part of their compensation to be based on loan repayment, it would help ensure sound lending decisions. Also it would only accept loan applications that have been rejected by commercial banks to avoid competing with them. After economic recovery, the bank's loan portfolio would be sold off to commercial banks and the temporary bank shut down.

Thirdly, to a limited extent and depending on how the first two programs work out - a stimulus program. By the way, the first stimulus program is still expected to have an effect, there was a delay because stimulus work needs to be planned first to avoid waste. Check out the article "Stimulus Money Unspent as Economy Struggles" dated August 16, 2010 on the CBS News website for more information on unspent stimulus.

The first two programs would be revenue/expenditure neutral (debt to be paid back by eventual revenues). The goal should be 5% unemployment and 3% inflation rate before the above programs are closed.

We seem to be close to a deflationary period hence the need for the above strategy.

By the way, incurring debt is not bad in the short run if there is low inflation and the purpose is to reduce unemployment to more normal levels. There has been huge debt incurred since the Great Depression and the Second World War, and the American economy has still thrived.

For those advocating tax cuts, keep in mind that people may just hold on to their additional money thereby not stimulating the economy and not reducing unemployment. Therefore, I believe my strategy is much better for economic recovery.

Create the money but make sure it's effectively spent by employing the un/deremployed at minimum wage, this money will get spent with minimal price effect given the large labour/capital/output gap. Businesses will have confidence to start investing their cash piles, resources will be effectively used meeting ALL of the nation's real basic needs and will lead to less debt default problems for banks and free them to lend.

In Norway every young person up to age 24 and anyone long term unemployed over 26 weeks are guaranteed work/training so youth unemployment has been abolished in recent times, it can be done.

http://bilbo.economicoutlook.net/blog/?p=1352

@ straight, no chaser:
I can see your point. Indeed, rating agencies were right in a subjective perspective, but wrong as for many of their valuations, which should help investors' choices. The conflict of interest you correctly underline should lead to regulatory reforms, in my opinion. And in the case of sovereign bonds, the influence of rating agencies on investors is even greater, as we saw here in Europe last spring.

@Marco 1975,

Not really, rating agencies were simply exposed as rubber stampers to the public. 'Long before' investors understood that their credit analysis and rating can't be relied upon.

"By 2006 MBIA had plunged into the much riskier business... Yet the rating agencies didn’t so much as blink. On Wall Street the problem was hardly a secret: many people understood that MBIA didn’t deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: “Is MBIA Triple A?” (The answer was obviously no.)

At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA’s guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA’s failure became such an open secret that nobody any longer cared about its formal credit rating.)" ~ MICHAEL LEWIS and DAVID EINHORN

der perffessor;

I don't mind a bit of growth, but 'positive feedback' is something else.
Positive feedback is impossible to control & leads to bubbles, poor allocation of rescources, & loss of equilibrium.
Let's plan some growth, but stay away from the positive feedback.

Up to 20 illegal Mexicans have taken American jobs; and unknown millions of jobs have been taken by Chinese. There is no enforcement of their immigration laws and there are no taxes that nullify the advantages of cheap foreign labour.