Summer Rerun: Why we shouldn’t use monetary policy to stimulate aggregate demand

Hi all. Here’s another summer re-run I wanted to post at NC, but this time from Marshall Auerback. As you know, there has been a heated debate amongst economists as to what policy makers should do if anything about the loss of jobs and the attendant fall in demand and output in the wake of a large credit crisis. As I see it, there are four schools of thought. If I could give crude labels to them and their advocacy, I would say: a) Keynesians – monetary and fiscal stimulus b) Monetarists – monetary stimulus c) Minskyians/Richard Koo – fiscal stimulus d) Austrians – no stimulus

Marshall Auerback falls into camp three and he presents the argument for fiscal over monetary stimulus below. This post originally ran at Credit Writedowns in September 2010 but I think the concepts are as relevant today as they were then, especially in light of the pullback in both monetary and fiscal stimulus now two years into this interregnum recovery.

Regardless, there seems to be an inevitability about policy decisions at this juncture because we seem to be marching straight down the path I laid out in October 2009 in my post “The recession is over but the depression has just begun”:

  1. The private sector (particularly the household sector) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect). That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.
  2. Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.
  3. Since state and local governments are constrained by falling tax revenue… and the inability to print money, only the Federal Government can run large deficits.
  4. Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
  5. Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with.  While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver.  However, when the prop of government spending is taken away, the global economy will relapse into recession.
  6. As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
  7. Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
  8. From an investing standpoint, consider this a secular bear market for stocks then.  Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.

The relevant points are #4-8 because they are recursive. We have already seen one round through in 2010. My sense is that the pullback in policy stimulus will be greater this go round, in Europe, the US, and in China in particular. This will lead to another round of economic weakness – inviting an even more aggressive policy response.

Here’s Marshall.

By Marshall Auerback, a portfolio strategist and hedge fund manager.

As is often the case, the genesis of this post is a conversation initiated by Edward (Harrison) on the question of why we aren’t using monetary policy to stimulate aggregate demand. That question was posed here by Tyler Cowen at Marginal Revolution.

The short answer that I gave Ed is that you can’t really use monetary policy to stimulate aggregate demand because the impact of monetary policy is much more diffuse and variable. As I’ve said before, for every winner who derives benefits from lower rates, there is a loser in the form of, say, a pensioner, who is deprived of income.  Tyler Cowen also points this out. Monetary policy is a very diffuse instrument – like using a meat cleaver instead of a scalpel for a surgery. I would also note that this dichotomy is of particular interest to people like Ed who worry that concentrating on aggregate demand obscures problems related to an economy’s resource allocation.

Fiscal policy is the only way to deal with both the problem of lack of aggregate demand and resource allocation. In particular, if we want to encourage private sector deleveraging, short of mass default or repudiation, this has to be supported by government spending, which means fiscal policy. This can take the form of direct government spending, but it can also take the form of tax cuts. That is a political/distributional question, as opposed to an economic one.

But for both, the underlying reality is the same: As the private sector withdraws spending (aggregate demand) and starts reducing its debt levels, the only way that GDP can continue growing is if there is an external trade boom (unlikely overall, especially since all countries by definition can’t become net exporters) and/or fiscal support.

Fiscal deficits have to provide the support to demand to keep national income growing to provide the capacity for the private sector to save. It is a basic macroeconomic reality. The paradox of thrift has to be subverted. As we’ve argued before, quantitative easing won’t cut it. Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts. It’s an asset shuffle, plain and simple. It does nothing to enhance aggregate demand, but does penalize savers at the expense of debtors.

The idea that monetary policy can be used to “unblock” credit and hence stimulate additional demand is wrong on so many levels. At the most basic level, most of us would probably agree that we don’t want a return to the status quo ante, whereby growth is overly reliant on private sector credit growth. We want income growth, which means we should be targeting policies needed to generate full employment. Again, this comes back to fiscal policy.

The notion that the evil banks who have received all of this government money but are holding back recovery because of a refusal to lend is ludicrous. Banks are fully capable of making loans at any time, but are unwilling to do so under present circumstances because (a) aggregate demand is so weak that they cannot find creditworthy customers and (b) economic activity is insufficiently robust to engender any confidence among borrowers that the things they might be better off by expanding production (with working capital borrowed from the banks).

Credit follows creditworthiness, not the other way around. Virtually all proponents of “monetary policy uber alles” fail to understand this elementary point.

In other words, today’s ongoing sluggishness reflects a policy misperception at the heart of policy today in both the US and the UK (the euro zone offers separate challenges, due to its institutional structures). Both governments, under the sanction of their respective central banks, have placed inordinate reliance on monetary policy and too little on fiscal policy as the preferred policy response, and, moreover, have encouraged the hysteria surrounding the increasing deficit through their own comments (talking about “exit strategies”, etc). Ed believes this will continue and has suggested a second dip may be coming as a result.

The reason credit is tight in the US at present is because the banks are being very cautious and they do not perceive a strong demand coming from credit worthy customers. Once they assess that there are worthy borrowers they will lend regardless of the central bank expansion of reserves. Additionally, borrowers have minimal capacity or ability to borrow, due to declining incomes which precludes the ability to service existing loans. Credit, as James Galbraith reminds us, is a two-way contract between borrower and lender, not a one-way “credit flow” from banks to borrowers, which can be solved by “unblocking credit” via bank bailouts.

One other point which is seldom made on the virtues of fiscal policy: it actually enhances financial stability. A fiscal policy deployed properly toward generating full employment (say, via a Job Guarantee scheme) means you have growing incomes and, hence, a great ability on the part of the borrower to service his/her existing debts. Debt which is successfully serviced means reduced write-offs for banks and, hence, less impaired balance sheets. In other words, fiscal policy starts the process of financial reform from the bottom-up, rather than top-down. The sooner President Obama and others figure this out, the better will be the outlook for the US economy. But don’t hold your breath. We still seem far away from that.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. bold'un

    This post does not mention the mortgage market; there are surely creditworthy home purchasers out there, but banks need to be be confident they will be able to securitize the resultant mortgages in order to avoid balance sheet constraints on new mortgage finance.
    The most important thing that the Obama administration can do to get recovery is to kick start house building (without which there is no good recovery). I would summon leading bankers and tell them to come up with a proposal to restart private-label mortgage finance in a way that does not overburden the Treasury with guarantees or cheat investors.
    Many posts on this site refer to alleged fraud in the securitization and servicing of mortgages. IMHO the greatest ‘sin’ was to allow the banking community to shut down the pipeline of new securitizations when the going got rough in 2008. This has greatly accentuated the severity of losses on foreclosure.
    This is not to exclude infrasructure spending as they did in the 1930s, but to argue that private mortgage lending needs to grow too.

    1. okie farmer

      bold’un, you don’t know what you’re talking about. You need to spend some time on Calculated Risk blog to get a better idea of the housing oversupply we are already suffering from and the reduced numbers of qualified buyers due to unemployment/ruined credit/unsellable houses. There is already plenty of “private label mortgage fincance” available, it doesn’t need to be “restarted”; and if by some miracle it could be restarted it would only expand the housing bubble we’re trying to unwind. You need a better understanding of the fundamentals of this bust.

      1. bold'un

        “trying to unwind a housing bubble”??
        Hmm, I actually never believed there was a housing bubble in the USA. There was a relaxation in credit standards, to be sure, but the ballooning current account deficit is a sign that it was not just marginal house buyers who profited from excess credit…
        If we look today at the price of houses in the USA versus the rest of the world, they are relative bargains, and I am sure that if the tax systems allowed it there would be plenty of foreign qualified buyers of US real estate figuring that it was a better bet in the long term than say US Treasury bonds or stock-index ETFs. Rental income is the best and most time-honored inflation-proof pension!
        The old model of housebuying was to go for an unaffordable property and wait for rising salaries to make it come right. Sadly US real personal income growth stalled and this was reflected in the trade deficits. That’s not a boom, it’s an income deflation which is turning into a debt deflation. The sudden closure of private mortgage securitization made matters a lot worse, particularly for developers of upmarket properties.
        But the article above was suggesting fiscal policy (which I imagine as infrastucture projects such as communication backbones, transport, energy) was superior to trying to encourage private enterprise with cheap loans.
        I’m saying that if the past is a guide, there is no growth without the housebuilding sector, because of its sheer size. If the government wants to free up budgets for infrastructure – not a bad thing in itself – they would do well to balance their risks by reducing exposure to mortgage finance.

        1. Jason

          No housing bubble, but a relaxation in credit standards? My friend, there was no relaxation: there was an eradication of every standard known to organized society.

          I too am sure that if tax systems allowed it there would be billions poured into the US housing market, but it wouldn’t be because of the good house prices: it would be capital flight to avoid taxes at home. The US would become a massive version of London where every warlord and oligarch could stash their ill-gotten goods while simultaneously draining their home nation of the taxes used to pay for education, roads, and health-care.

          You mention rental income but house prices and the accompanying debt burden exceeds rental income. That’s what one would call a bubble. If you can’t rent it out for what you paid, then it’s overpriced.

      2. Hal Roberts

        I can remember a few articles about empty homes that weren’t even counted on the book because it made the housing numbers look bad. I have also read about whole communities in Detroit and Chicago that were leveled because of liabilities owners just walked away no interested buyers the local government was left holding the bag the cost was to much so they just leveled everything. I guess that helped housing numbers a little bit.:)

  2. chris

    This is complete BS!. The banks have been gifted bargain life by the bailout. There are countless income producing properties that are on the market at bargain prices. There are countless Americans that are qualified for loan modificiations and I am sure there are countless businesses that are still able to service a mortgage. In all 3 of these circumstances deals are not getting done. Why? It is not because of the credit worthiness of the borrower. It this crap that people keep thinking the banks are on the side of the people that shows just how brainwashed people have become as the banks hold the country hostage.
    This drivel by those who think they are so much smarter than the rest of the world makes me wonder how we even made it through the 1990s without a major meltown.
    the banks make the best las vegas hypnotist look like amatuers.
    this article shows how much people are under the spell.

    1. Cahal

      I’m not sure his main point was that the banks are actually lovely. It was that they are not lending because there is not enough AD, which seems pretty self evident to me. Nobody is saying they are ‘on the side of the people’ – the only way they can make money is to lend, so they would if they thought it was a good idea.

  3. Beavis Jones

    ” Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government. ”

    Nothing wrong with benevolent populist sentiment, ‘specially the kind that reforms the ‘Lil’ Eichmanns’ and brings peace, harmony etc.

  4. Hal Roberts

    Funny thing about our Federal Stimulus to the economy via the stock market and big business,big business and corporate America they are making it well know that they have no intention of heiring back the people that are laid off and out of a job.? OK The fed mandate is to stimulate employment so it’s giving stimulus money to these business is totally counter to what the Feds intentions are. Someone needs to wake up and find another way to get people back to work.

    Infrastructure construction, but Harry Reed knew that and said the heck with construction workers when this whole thing fell apart, in 2007.? I don’t think the Fed gives a dam about the unemployed it’s just a excuses to bail out and line the pockets of their friends.

  5. Ransome

    These workers may have been surplus back in 1998. Many persisted through the bubble economy and the credit craze. Companies know the core they need to meet obligations, when orders dropped off, workers were shed like fleas. Real workers were laid off all along due to outsourcing, but they found a job at Home Depot or became part of the bubble workforce in housing.

  6. Charlotte Winslow

    Put me in the ultra-Austrian category. I don’t see how doing nothing could possibly be worse than all the disastrous tinkering done so far.

    People are extremely good at optimizing their own situation if you just quit changing things every two minutes. Nobody is going to risk capital in a constantly changing environment. Tell people what the rules of the game will be going forward so they can make business plans.

    Why would anyone assume that the government can fix this better than Main Street? We are a nation and economy of individuals – not some theoretical aggregate construct.

    1. Rycoka

      I think a fifth category needs to be added to the “camps”. This is Western Government Intervention. Democratically elected governments acting in the interests of their lands and people.
      The reasonable belief in the wisdom of “markets” needs to be balanced by the realisation that the global financial system no longer resembles any model of a market. From China through to Goldman Sachs the players have thrown out the rule book and moved to cheating, deceit and bullying to extract maximum benefit from system.
      Western democracies are foolishly throwing the full faith and credit of their public institutions behind a system that represents organised theft. The result of continuing in this manner is now being played out in Greece. Governments (the peoples democratically elected representatives) stripped of power while the transnationals and the sovereign wealth funds of thinly disguised dictatorships do battle to snap up their assets. “Austerity” is the cry. Let’s get these undeserving western layabouts with their ridiculous concepts of “freedom” back to work. Let’s extend the working week, push back the retirement age, bring down wages and entitlements. Let’s make the Chinese peasant the target state for those who are not part of the new global elite.
      Einstein said we can’t solve problems by using the same kind of thinking we used when we created them. Ficsal and monetary policies are now the slaves of the global financial system and are the wrong responses. The “Austrian” do nothing” response is actually better as it does not waste the faith and credit of the public institutions, however it ignores the fact that at some stage the mess will have to be cleaned up. The people need to elect governments that can find new solutions. The Global Financial system as a mechanism for the efficient allocation of resources is dead. Let’s declare it, turn off the life support, do our greiving and move on with the confidence that it is our culture that gives us our freedom, not “the market”.

      1. Sundog

        Rycoka that is indeed an awesome comment.

        Here’s a suggestion that I think could move the US polity in the direction you suggest.

        “GDP” should be largely abandoned as a metric (remember M1, M2, M3?) in favor of a measure of household income weighted by local cost of living after taxes and healthcare. The SEZs of metro NYC and DC should be omitted, as should the top 0.1% and the bottom 20%.

        Attention to the latter should focus on mobility, in other words differentiating the underclass from young folks just getting on their feet, and the untapped potential of the underclass.

        Attention to the former should focus on just why confiscatory levels of taxation could not return us to a reasonable ratio of worker vs executive compensation and focus attention on our dysfunctional methods of corporate governance.

        1. Rycoka

          Sundog, I agree new metrics are needed. I would also suggest that with democracy and the internet the US has the tools to create a new and workable order. Here’s a thought for a start. Why not start a campaign for an properly motivated Congress. Establish a web site where people who want office can register for support if they are willing to do two things. Reject all campaign donations, and convert all their assets to US dollars (the stuff their constituents are paid in) held on deposit in a local bank. Such people, if talented, would surely find volunteers ready to work on the ground as well as in the blogosphere. A companion “Hall of Shame” site could list the known assets and campaign contributors for rivals so people could see who they were fighting against.

  7. KFritz

    Economic cognescetti please correct me if I’m off the mark.

    “Creditworthiness,” is not an intrinsic, personal or institutional quality. It is an extrinic economic/business condition that exists only as part of an economy/market. Personal or institutional intrinsic qualities can be a part of creditworthiness, but they are not creditworthy in and of themselves. A manufacturer can produce a wonderful product with a skilled workforce directed by top management, but if the products can’t be sold in curent market conditions, it’s not creditworthy. The best built home can’t be sold to a buyer of the highest character, if the market value (extrinsic again) isn’t matched by the net worth and expected income of the buyer. Conversely, no financially sound buyer is likely pay a price much over current market value, no matter the quality of the property or investment made by the builder.*

    Some of the above posters don’t seem to grasp all of this.

    *The ueber-rich often show off by violating this rational rule.

    1. Charlotte Winslow

      I agree that creditworthiness (sounds uncomfortably close to “truthiness” :) ) is an assessment by the market made about an individual or entity’s ability to pay.

      In that sense fiat money is a little fishy because the borrower is declaring its own creditworthiness as a matter of law. That’s well and good until the creditors say “I’m sorry but I beg to differ”, eg currency revulsion. In the extreme case currency becomes a hot potato that you dump as soon as you get it.

  8. wh10

    Thanks for posting, but please give credit where credit is due if you are going to label the schools of thought: Auerback hails from Modern Monetary Theory (MMT). Minsky and Koo provide valuable perspectives that are compatible with MMT (though Koo departs from MMT in several ways), but MMT is much more.

    From what I know, today’s MMT is a confluence of ideas from Warren Mosler and Post-Keynesians such as L. Randall Wray, who was a PhD student of Minsky. MMT happens to also harken back to Abba Lerner’s Functional Finance, and the work of Wynne Godley has also made important contributions.

  9. joebhed

    Being unrealistic, as I am, perhaps a nugget of “cause-and-effect”ness might be appropo.

    Marshall says that economic reality in a balance sheet recession(general de-leveraing across economic sectors) can only be offset back to restoring aggregate demand through either direct government spending, or tax breaks, either of which would put more money in the hands of the general public, and require more public debt.

    This truth stands in contrast, on its face, to the failure of “monetary policy” under today’s money system, the result of which has long been to blow up the “excess reserve” balances at the homes of the Wall Street elite.

    The problem is that all of this stands in opposition to another, unspoken reality. This reality is that both the crisis itself, and the lack of politically viable solutions have been caused by a simple, overlooked reality – the cause is the debt-based money system itself.

    Only if we are willing to get down and dirty with the money system that we’re working under, where, somewhat paradoxically, we cannot have the money(exchange media) we need without having more debt, can we begin to chart our way back to relative economic prosperity.

    Please Google up Dr. Bernd Senf’s work on The Deeper Roots of the World Financial Crisis and find his English-language lecture on this question.

    The deeper roots lie in the debt-money system.

    Without an alternative to the debt-money system, where exponentially growing, compounding interest demands greater and greater “costs” to our economy, the result of which becomes the greater and greater accumulation of “wealth” in the hands of the fewer and fewer, the only result coming is the one that most NC readers know as “the second dip”, a national economic wipe-out resulting in ever greater accumulation of monetary assets back to the one-percent.
    This is the result of the debt-money system.

    While Dr. Senf does not address the form of the needed alternative to our debt-based money system, fortunately we in the US have one laid out in the form of Congressman Dennis Kucinich’s National Emergency Employment Defense(NEED) Act, available here:

    It’s time to start discussing alternative monetary systems.

    1. Rycoka

      I just read the preamble to the Bill – a great example of the kind of thinking that is actually required. The National Reserve Banking System is at the heart of the Global Financial System and the takeover of that system by democratically elected governments would be a critical step in a Western Government Intervention approach. Did the Bill ever get voted on?

      1. Rycoka

        Another issue is floating currencies. This system can only work if all systemically significant national entities are fully participating. If China doesn’t fully float, then the whole system is impaired. The bigger China gets, the more the whole system is impaired by its non-participation. Forget being diplomatic – this is a systemic issue. If China believes that its national interests are best served by not fully participating, then it is a betrayal of Eurpean and US national interests to keep pretending the system works.

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