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Monetary Policy Replaces Fiscal

The Federal Reserve’s Open Market Committee released this statement on August 10, 2010:

Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.

With this statement, the US Federal Reserve and its Open Market Committee entered the fiscal policy business. Not surprisingly, asset markets were both confused and cheered as the Fed did what they had been expecting it might do. The deflation risk in the economy – the prospect of a falling price level – has been deemed sufficient to keep the Fed from reducing its holdings of home mortgages, securities backed by home mortgages, and US Treasuries – the IOUs of Uncle Sam. As this great recession- or this not at all great near depression- plays out, the failure to get effective fiscal policy leadership is ballooning the role of the Federal Reserve and monetary policy. This is eerie at best. The great depression was triggered by a combination of inadequate fiscal policy, overly tight monetary policy and a context of state and local governments slashing spending under budget pressure. With the exception of the monetary policy, does this is all too familiar.  . . .

Since August of 2007, we have let monetary policy lead the way. The Fed has increased its balance sheet- the total of assets and liabilities that it directly holds- from a bit over $800billion to well over $2.3 trillion. The last Fed report on its own balance sheet (August 05, 2010) details Fed holdings of $1.17 trillion in mortgage backed securities. America is experimenting with the world’s first mortgage backed currency. This has occurred even as the Bush and Obama Administrations use larger than normal dosages of standard recession fighting fiscal policy. We have yet to see any structural help for the economy. Everything is partisan, one off, expensive and ill coordinated. Now Washington is full of Congress people and pundits who have found budget religion. This leaves a wheezing and damaged macro economy to fend for itself amid massive deficits. The medicine we have ordered for the patient is ever cheaper borrowing ability.

The August 10 statement does not mark a major policy decision and is unlikely to radically alter the course we are on as we stumble toward the Fall. However, it is one more move in the direction of a classic liquidity trap scenario. What does that mean? We are already awash in bank deposits and low, low interest rates. Today, 30 year fixed mortgage rates are under4. 5%. The 10 year US Treasury is yielding well under 4%. Corporations and banks are drowning in cash they won’t spend or lend. Households and governments are loaded up on debt. When making more credit available at lower cost stops working, we are in a liquidity trap dynamic. What else would you call an economy poised to near deflation with ultra low bond and mortgage interest rates and very low growth?

When the macro economy is adrift enough to make folks fear deflation, monetary policy offers little to fix imbalances. Our banks are not too interested in lending nor our corporations in spending when our households cannot risk spending. Will keeping rates low really do the trick? Might fiscal policy step to the plate here? Apparently we are going to rely on Fed and interest rates at this junction and that is a very risky strategy.

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Richard D. Wolff

Richard D. Wolff

Richard D. Wolff is Professor of Economics Emeritus, University of Massachusetts, Amherst where he taught economics from 1973 to 2008. He is currently a Visiting Professor in the Graduate Program in International Affairs of the New School University, New York City. He also teaches classes regularly at the Brecht Forum in Manhattan.

Earlier he taught economics at Yale University (1967-1969) and at the City College of the City University of New York (1969-1973). In 1994, he was a Visiting Professor of Economics at the University of Paris (France), I (Sorbonne).