Sunday, November 2, 2014

Why Fiscal Policy Has Replaced Monetary Policy As Weapon Of Choice

Monetary policy was the preferred method of dealing with recessions in the high inflation era in early 1970s.  That is because a 1% cut in interest rates, with inflation at 5%, led to a real interest rate of -4%.  That encouraged households and businesses to reduce savings and increase spending.  Now that inflation is close to zero, and is likely to remain close to zero for the rest of the decade,  monetary policy is less effective.  With households and businesses saving more than they spend there are only two ways to increase employment.  Governments can run deficits to absorb private savings or countries can export more than they import.  Germany has used exports surpluses to maintain employment, but that advantage is disappearing as exports of machinery is slowing down.  The weapon of choice, despite all of the attention that has been given to the extraordinary use of quantitative easing by central banks,  is fiscal policy.  Nations that have employed relatively moderate levels of fiscal policy stimulus have done better than nations that relied solely on monetary policy.  Moreover, nations that attempted to run budget surpluses have done poorly.  We have returned to the 1950's when fiscal policy was the weapon of choice in recessions.

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