The legislature is clearly impotent to do much to improve the economy right now. It looks like the best it can hope for is piecemeal bills to keep things from getting much worse. Given that it seems the Fed really needs to step in, stop worrying about its image, and do what it can to help the economy. Here’s a few ideas that seem worth trying to me.
If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year.
In a self-fulfilling prophecy, the Fed could stimulate spending and the economy, and at no cost to the Treasury.
Mark Thoma seconds Cowen’s own questions about that policy:
As for Tyler’s (and others’) call for monetary policy instead of fiscal policy, here’s the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it’s unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you’ll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it’s hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.
Thus many economists believe that the Fed has unwittingly encouraged banks to sit on their cash and not lend it by paying interest on reserves. Eliminating interest on reserves would therefore encourage lending. A rumor that the Fed might do so caused the stock market to rise earlier this week, according to press reports. But the policy remains in place.
Discouraging Excess Reserves
Some economists go further and suggest that the Fed impose a penalty rate on excess reserves. This is what Sweden’s central bank does. There, banks currently pay 0.25 percent on reserves — called the deposit rate — rather than receiving 0.25 percent as they do here. This may be a key reason why Sweden has bounced back much more rapidly from the worldwide economic crisis than the United States has.
Scott Sumner enlists Milton Friedman to support monetary stimulus:
I forget to mention the interest on reserves policy, which is very similar to the 1936-37 policy of doubling reserve requirements. Both programs only raised short term rates by about a 1/4 point, but Friedman (and Schwartz) understood that the 1937 policy was highly contractionary despite the tiny interest rate increase, because it sharply reduced the money multiplier. He would have been a severe critic of the current IOR policy.
[update 09/20]: Here’s a David Leonhardt column from about a month ago that should help squelch some readers fears about inflation.
(Bureau of Labor Statistics, via Haver Analytics) (Six-month change in the Consumer Price Index.)
Over the last two years, inflation has been zero. Over the last year, it has been just 1.3 percent. Over the last six months, it has been below zero — negative 0.7 percent.
The Fed — especially the regional Fed banks — is filled with economists and bankers who have strong memories of the 1970s and 1980s inflation. They’re always on guard against it.
There is no question that inflation can be terrible. Right now, though, it sure looks like the last war.
By the way, can we at least fully staff the Federal Reserve!?