Monetary policy through the looking glass
Many have noted that central bank lowering of short-term interest rates is running up against its limits, andÂ we are hearing calls for major fiscal stimulus, i.e. large deficits. In a normal world, this raises the spectre of the government having to sell bonds to the private sector to get the funds, which could actually increase long-term interest rates and partially undo the stimulus. But in our potentially deflationary situation there is an important monetary connection that recommends going out on a ledge and not issuing public debt but still running the deficits.
I have been influenced here by some Post-Keynesians, notably Randall Wray of University of Kansas City Missouri, taking the position that government can just write cheques, it does not need the tax revenues to come back to it to balance a budget; the deficit is just an addition to the money in circulation. Alternatively, it can be constructed as the central bank buying up the government bonds that finance the deficit. The effect is essentially the same.
Two recent posts go into the mechanics of how this might work. William Buiter at the London School of Economics walks through this in an extended blog post for the Financial Times. Carleton’s Nick Rowe at Worthwhile Canadian Initiative puts additional central bank options beyond interest rate cuts into the Canadian context. These are last resort options, to be sure, but worth thinking through now that the spectre of deflation has raised its ugly head.
Minimally, we need to think about really large government deficits over the next couple years, and I’ve been pressing for shoring up income support programs to get money into the hands of those who will spend it, plus a green retrofit of our infrastructure that would create new jobs. We should be biased towards excess, and if we go to far then the central bank can raise rates, so that we are shifting to fiscal policy as the first mover but they will ultimately have to be coordinated. Paul Krugman’s latest oped makes this argument.