In late 2011, the economist David Beckworth and the writer Ramesh Ponnuru wrote an editorial in the New Republic on how “both liberals and conservatives are wrong about how to fix the economy.” How were they wrong? Conservatives were wrong because, contrary to common belief on the right, the Federal Reserve wasn’t in fact doing enough to boost the economy.
Liberals, however, were wrong in opposing austerity and calling for more fiscal stimulus in the form of stimulus spending or temporary tax cuts. In Beckworth and Ponnuru’s view, the Federal Reserve still had plenty of room to boost the economy. Not only would fiscal tightening be good over the long haul, but it would force the Fed to act. And they argued that as long as the Fed is working to offset austerity, the country “won’t suffer from spending cuts.”
We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments -- specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It’s still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.
Of course, policy wasn’t made because of a random New Republic piece. (One hopes.) The fiscal cliff and sequestration were the end result of a long series of policy decisions, including President Obama’s desire to lock in $4 trillion in deficit reduction. Those policies have led to deficit reduction and fiscal contraction at rates that haven’t been seen outside periods of military demobilization. Ben Bernanke was certainly trying to counter the upcoming austerity in his December move, as well as address a chorus of academic criticism that he wasn’t doing enough, while also building a consensus on the Fed’s committee about further action.
Now, before I hear, “How could monetary expansion fail? It’s never even been tried,” it’s worth reflecting on how dramatic the Federal Reserve’s actions were in December. It was an effort to address at once all the criticisms that the Fed should be doing more.
Some had criticized the Fed for committing to keeping rates low until a certain date rather than using the power of forward guidance to peg rates to how well the economy was doing. So the Fed committed to keeping rates low until unemployment hit 6.5 percent. Others thought that it wasn’t clear the Fed would ever let inflation go above 2 percent, and that this would choke off a recovery before it started. So Bernanke said inflation could go as high as 2.5 percent without the Fed tightening. This balancing between unemployment and inflation is in line with the view of people who would like to use nominal GDP as a target.
There were, finally, those who thought the “expectations” channel of when the Fed would start raising rates mattered less than actually going out and buying things. So the Fed committed to making $85 billion dollars in assets purchases every month until the economy recovered. Something for everyone!
So, has monetary policy offset this contraction? Economists will debate how much expansionary monetary policy is offsetting fiscal policy for decades, but we can look at a couple of items already. The first is inflation expectations, as calculated by the Federal Reserve Bank of Cleveland. One-year inflation expectations initially bumped up for December 2012, which many commentators viewed as a positive sign for the new Fed policy. However, in 2013, it has fallen back down, to an average rate lower than that of 2012:
You can also look at long-term interest rates as a sign of how well the economy is doing. An increase in interest rates would signal inflation, higher expected growth and less demand for safe assets. Here, too, there was an initial boost after the December announcement, but as 2013 has continued, interest rates have dropped back down. Growth in GDP, as noted from yesterday, has also come in below expectations, with government spending a main culprit.
So where does this leave us? First of all, just because the Fed’s December actions weren’t capable of offsetting fiscal austerity doesn’t mean that it’s the wrong policy. The biggest threats to a full recovery are both early fiscal and monetary contraction. The Evans Rule is the right rule to communicate to the markets the Federal Reserve’s stance, which is properly a balance between price stability and full employment. The Federal Reserve was, in fact, sitting on its hands, and it is no longer doing that. (Like Beckworth and Ponnuru, I was also in the New Republic in late 2011 calling for the Fed to actually try and do its job.)
Second, there is still more the Federal Reserve could do to try and balance out austerity in 2013, but those moves would require a big change from current policy. Minor tweaking is unlikely to help. Joseph Gagnon of the Peterson Institute for International Economics suggests that, instead of committing to mortgage purchases, the Fed could target the mortgage rate for a time. Other economists, such as Brad DeLong, suggest that an explicit higher inflation target would be important. Still others, ranging from Christina Romer to market monetarists, think the Fed should explicitly target a nominal GDP.
Given that the Fed appears to be having trouble getting these new policies to move inflation expectations or interest rates, a dramatic change may be harder than originally thought. And if even subtle statements by the FOMC can break expectations of policy, as many are worried about, monetary policy at the zero lower bound will be far too fragile to carry us to recovery. However, the status quo of a low inflation target teamed with “break out unconventional policy in case of emergency” doesn’t appear robust enough to handle future recessions.
But the most important lesson to draw is that fiscal policy is incredibly important at this moment. In normal times, the broader effect of government spending, or the fiscal multiplier, is low because the central bank can offset it. But these are not normal times. It’s not clear why the Federal Reserve’s actions haven’t balanced out fiscal austerity. But since they haven’t, we should be even more confident that, as the IMF put it, “fiscal multipliers are currently high in many advanced economies.”
These multipliers work in both directions. As spending benefits the whole economy more in these times, austerity is also much more vicious than it would normally be. Using fiscal policy also avoids the expectations problems that plague monetary policy. When President Obama signs a law promising spending, the public believes the government will spend. That's not so with the Federal Reserve, where a random statement from a Federal Reserve governor can cause markets to doubt the Fed's long-term commitment.
Meanwhile, the idea that there exists a debt “danger zone” that should cause us to embrace austerity has recently collapsed due to questionable data and methodology. The question is, will we now move to stimulus to complement the Fed’s efforts to get to full employment, or will we continue to sabotage the recovery?
Mike Konczal is a fellow at the Roosevelt Institute, where he focuses on financial regulation, inequality and unemployment. He writes a weekly column for Wonkblog. Follow him on twitter here.