OCTOBER 25, 2010.
Our Fiscal Policy Paradox
Government's kitbag is overflowing with ways to spur demand. Yet fiscal policy sits idle, paralyzed by extreme partisanship.
By ALAN S. BLINDER
The practice of monetary and fiscal policy is fraught with difficulties, but the central concept is straightforward, compelling and, by the way, 75 years old: The government should push the economy forward when unemployment is high and slow it down when inflation threatens.
To do so, governments normally have two principal sets of weapons. Fiscal policy means moving some taxes or elements of public spending up or down to either propel or restrain total spending. In the United States, such decisions are made politically, by Congress and the president. Monetary policy normally (but not now) means lowering or raising short-term interest rates to either speed up growth or slow it down. That power, of course, resides in the technocratic Federal Reserve.
In 2008 and 2009, the U.S. government rolled out the heavy fiscal and monetary artillery to stave off Great Depression 2.0. Taxes were cut, spending was increased, and the Fed pushed the federal-funds rate all the way down to virtually zero. It worked.
But that was then and this is now. Today, the economy still needs a boost. But we seem to be trapped in what I call the paradox of macroeconomic policy: The policies that might work won't be tried, and the policies that will be tried might not work. If that sounds irrational, well, you've got the message.
There are plenty of powerful weapons left in the fiscal-policy arsenal. But Congress is tied up in partisan knots that will probably get worse after the election. On the other hand, the Fed stands ready—indeed, seems eager—to act. But it has already deployed its most powerful weapons, leaving only weak ones. That's the paradox.
How might fiscal policy speed up growth? As Elizabeth Barrett Browning once said, let me count the ways. Actually, let me not, because there are too many. Here are just three of my personal favorites:
• New jobs tax credit. The government could offer tax breaks to firms that increase their employment above some base level. In fact, Congress did just that with the HIRE (Hiring Incentives to Restore Employment) Act in March. But it was legislated on a pitifully small scale and will expire at year's end. We need a larger version that stays around for a while.
• Government hiring. The government could hire people directly onto public payrolls, as Roosevelt did with the Civilian Conservation Corps and the Works Progress Administration. These days, many of the new hires would wind up on state and local, rather than federal, payrolls. But the federal government can still foot the bill.
• Cut sales taxes. Slightly more exotically, the federal government could create tax incentives for consumers to spend more now by offering to replace the lost sales tax revenue of any state that will cut its sales tax for, say, the next year.
But those are only my favorites; you may have your own. The point is that the fiscal-policy kitbag is overflowing with ways to spur demand. Yet fiscal policy sits idle, paralyzed by extreme partisanship, tarred by a successful public relations campaign against the 2009 stimulus bill, and consumed by fears of large budget deficits.
But aren't those fears warranted? Not if deficit-increasing measures are temporary. Our real deficit problem—and it's a whopper—lies in the future, not the present. Right now, with so much slack, there is little or no danger that public spending will crowd out private spending. And with Treasury interest rates at or near historic lows, there is little doubt about the Treasury's ability to finance a larger deficit—at least for a while. If you're worried that larger budget deficits will either depreciate the dollar or cause inflation, stop worrying. A lower dollar would be just fine right now, and the present danger is not inflation but deflation.
But what about using monetary policy? Chairman Ben Bernanke and his Federal Reserve colleagues are not paralyzed by politics. They have not fallen victim to misleading advertising claiming that past policies have not helped. And expansionary monetary policy does not raise the budget deficit. So why the hesitation?
Actually, there no longer is any. The Federal Open Market Committee will almost certainly announce another round of quantitative easing at the close of its next meeting on Nov. 3. Specifically, unless the Fed has wrong-footed everyone, it will announce its intention to purchase medium- and long-term Treasury debt. Why? To lower the yields on those securities and, via arbitrage-like linkages, to lower the yields on a wide variety of private-sector securities as well—though probably by smaller amounts.
That's good news. But many of us worry that this second round of quantitative easing will not be powerful enough to move our $15 trillion economy much—for two main reasons.
First, the markets for U.S. Treasury securities are the deepest and most liquid in the world, with enormous trading volumes every day. If the Fed decides to buy, say, $100 billion per month, or about $5 billion per trading day, that relatively small increment to overall buying may move market prices only modestly.
Second, there will be further slippage between changes in (risk-free) Treasury interest rates and changes in (risky) business and individual borrowing rates. To attach some illustrative numbers to this concept, suppose the Fed succeeds in trimming government-bond rates by 30 basis points, and that brings down corporate bond rates by 15 basis points. Will that make a big difference to corporate spending?
Don't get me wrong. The two main thoughts that are probably going through Mr. Bernanke's head today are, first, "I sure wish I could get some help from fiscal policy," and second, "I probably can't, so I'd better do whatever I can." He's right on both counts.
In a more rational world, it wouldn't be this way. Fiscal policy, which packs the power, would be doing the heavy lifting—by combining tax cuts and spending today with credible deficit reduction for the future. Monetary policy would take the back seat by keeping interest rates low. But we don't live in a rational world. And as Donald Rumsfeld might have said, you go to war against recession with the army you have. Right now, that's the Federal Reserve. The fiscal army is AWOL.
Mr. Blinder, a professor of economics and public affairs at Princeton University and vice chairman of the Promontory Interfinancial Network, is a former vice chairman of the Federal Reserve Board.
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