Some Late-Night Thoughts on Monetary and Fiscal Policy

While there is an entire economic literature devoted to the effects of monetary and fiscal policy, there are practical reasons to prefer monetary manipulations over fiscal ones.  In particular, monetary policy is determined by a relatively small group of experts who can determine the optimal policy with the least political pressure practically possible.  On the other hand, using fiscal stimulus requires pushing a bill through Congress, potentially producing suboptimal contamination by special interest groups with noneconomic motivations.  Given the convoluted and incoherent legislation that results from Congress in response to complicated, high-profile exogenous shocks, this is particularly problematic.  Already, we see that Obama's stimulus plan was prepackaged to contain large amounts of tax-cuts to win over Republicans, even though tax cuts are far less likely to generate immediate economic activity than alternatives like infrastructure construction.

Monetary policy does have some limits. Interest rates can only go to zero.  In liquidity traps, the government can obviously just increase liquidity by simply printing more money.  This is a perfectly viable option as long as inflation is low.  Indeed, this has the effect of raising inflationary expectations, thereby lowering the expected real interest rates charged by banks.  

So far, the US has not attempted this kind of "helicopter money", but the monetary policies thus attempted appear to be insufficient to stabilize the economy.  Barack Obama's $800 billion stimulus package would add fiscal stimulus to the mix.  This is all well and good, except that the US is already running an estimated $1.2 trillion deficit for the current fiscal year.  It is not altogether clear what the upper limit of US spending power is.  It is clear that there is a theoretical limit, however, and there is some evidence that we could be approaching it.

Financing government deficits requires that someone buys government bonds.  The reason why small countries cannot afford to be as fiscally irresponsible as the US is because they have lower credit ratings, investors are more hesitant to lend to them, and borrowing is consequently much more costly.  But the US could end up in an analogous situation.  China is currently the largest holder of US treasuries, and that country has dramatically reduced its purchases of new US bonds.  This suggests that US bonds are looking less appealing to foreign investors.  This could partially be due to the low yields present today.  But these low yields are due to strong domestic demand for treasuries.  The moment economic recovery begins, demand for treasuries will further dry up, causing borrowing to become far more expensive for the government.  Worse yet, such a decrease in the price of treasuries would mean that the many investors who bought treasuries when yields were at record lows would face a loss if they sold their bonds, inducing many to simply hold their bonds to maturity to get a profit.  This would have the consequence of keeping private investment mired in government bonds, and necessitating (or perhaps just prompting) more fiscal stimulus.  This additional stimulus would necessarily be funded borrowing at ever higher rates of interest.