On March 25, 2015, Narayana Kocherlakota sat in my office at the University of Michigan; we talked especially about negative interest rate policy. (See my preface to “Yichuan Wang on Narayana Kocherlakota and coauthors’ “Market-Based Probabilities: A Tool for Policymakers.”) He has since emerged as a major presence on Twitter; you can get a sense of this from my storified Twitter discussion with him: “Narayana Kocherlakota and Miles Kimball Debate the Size of the US Output Gap in January, 2016.” But don’t miss the chance to go to Narayana’s Twitter homepage as well.
Yesterday, February 9, 2016, Narayana posted: “Negative Rates: A Gigantic Fiscal Policy Failure,” arguing quite explicitly for negative interest rates. Narayana writes about moving to negative interest rates. In his words:
- It would facilitate a more rapid return of inflation to target.
- It would help reduce labor market slack more rapidly.
- It would slow and hopefully reverse the ongoing and dangerous slide in inflation expectations.
So, going negative is daring but appropriate monetary policy.
Narayana then goes on to criticize low levels of government investment given very low interest rates. This is an issue I have written about more than once, in a way generally sympathetic to Narayana’s point:
- What to Do When the World Desperately Wants to Lend Us Money
- One of the Biggest Threats to America’s Future Has the Easiest Fix (coauthored with Noah Smith)
- Capital Budgeting: The Powerpoint File
- Discounting Government Projects
I don’t come down in exactly the same place as Narayana, though. As I noted to John Conlin, who pointed me to Narayana’s post, I tend to think that monetary policy should be used to stabilize the economy, not fiscal policy. Once monetary policy does its job, if the medium-run natural rate of interest is still low, then we should undertake more government investment. (See “The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate.”) And we should undertake crucial government investments even if interest rates are high after the economy recovers. But it is just too hard to time government investment effectively in order to stabilize the economy.
Monetary policy has a lag of 6 to 12 months in its effects. Even so, it is much nimbler than government investment. Private investment and imports and exports can’t turn on a dime; hence the 6 to 12 month delay in the effect of monetary policy. But government investment typical takes even longer than that to turn around.
Using monetary policy as it should be used, aggregate demand is no longer scarce. Monetary policy can provide all the firepower needed. But fiscal policy can still play a role. Fiscal policy is most helpful in economic stabilization under two circumstances:
1. When (as is not the case for government investment) it can move faster and act faster in its effects than monetary policy, or
2. When monetary policy is somehow constrained.
Other than automatic stabilizers, which are extremely helpful, but not enough by themselves, the one type of fiscal policy that acts fast is fiscal policy that affects household consumption which can realistically change within a matter of days. Some might think of tax rebates in this regard, but I have argued at some length that tax rebates are a strictly dominated policy in “Getting the Biggest Bang for the Buck in Fiscal Policy.” In brief, I argue that the ratio of stimulus to ultimate addition to the national debt is much more favorable for lines of credit from the government than tax rebates. For example, it is not unreasonable to think that, since much of it would be repaid, a $2000 line of credit from the government would ultimately cost the government about as much as a $200 tax rebate. But a $2000 line of credit is likely to provide a much stronger impetus to consumption than a $200 tax rebate.
As for constraints on monetary policy, the zero lower bound is crumbling all around us. After that the most important constraint on monetary policy is the fact that so many European countries share their monetary policy in the euro zone. For these countries, fiscal policy–or if you want to call it that, credit policy of the sort I talk about in “Getting the Biggest Bang for the Buck in Fiscal Policy”–can be very helpful in adjusting the overall level of macroeconomic stimulus to different needs from one country to another in the euro zone. There may also be a place for government investment as a countercyclical tool in the euro zone. But given vigorous monetary policy, it might well be that government investment, even in the euro zone, might best be directed at medium to long-run considerations rather than short-run considerations. My posts bulleted above address some aspects of those medium- to long-run considerations.
Note: Also, don’t miss my contribution to long-run fiscal policy as laid out in “How and Why to Expand the Nonprofit Sector as a Partial Alternative to Government: A Reader’s Guide.”