Without Further Stimulus, Can the Federal Reserve Jumpstart Growth?

Without Further Stimulus, Can the Federal Reserve Jumpstart Growth?

Although economists still debate whether further fiscal stimulus is necessary or desirable, as a political matter the debate is essentially over. There is simply too little support in Congress for much beyond extending the Bush tax cuts to prevent a significant tax rise beginning next year. Consequently, increasing attention is being focused on the Federal Reserve in hopes that there is still scope for monetary stimulus.

From the start of the economic crisis some economists have argued that the Fed and only the Fed was the key to restoring growth. They believe all that was necessary to restore growth was for it to expand the money supply sufficiently. Fiscal stimulus was not just unnecessary but counterproductive, they argued, because the increase in debt was destabilizing and portended higher taxes in the future. This is usually called the monetarist perspective.

The alternative view, endorsed by most mainstream economists and those in the Obama administration, is that monetary policy is ineffective unless complimented by an expansive fiscal policy. Without fiscal policy there is no practical way of getting money out into the economy where it will be spent or invested and hence raise growth. This is usually called the Keynesian view.

I think the weight of evidence supports the Keynesian view because the money supply has in fact expanded enormously, but without counteracting the deflationary forces that are at the root of the economy's problem. As I explained in my column last week, the reason is that velocity—the rate at which people spend money—has fallen by 11 percent, which has the same macroeconomic effect as if the money supply shrank by 11 percent. It puts downward pressure on wages, prices and output, creating unemployment and stagnant growth.

Perhaps the best evidence that simply increasing the money supply is insufficient to offset the decline in velocity absent expansionary fiscal policy to raise spending in the economy is the vast increase in bank reserves. These data are shown in the table below. As one can see, they have risen by a factor of 25 since before the crisis.

Bank Reserves and the Money Supply (millions of dollars)
Date Required ReservesExcess ReservesTotal ReservesMoney Supply*
Dec. 200543,1881,90045,0886,671,600
Dec. 200641,3571,85243,2197,071,700
Dec. 200741,4291,78443,2147,501,400
Dec. 200852,972767,332820,3048,239,700
Dec. 200963,1871,075,4101,138,5978,543,900
May 201064,5831,044,9081,109,4918,580,200
*M2 Source: Federal Reserve

The Fed creates bank reserves by buying assets, usually Treasury securities, and paying for them by crediting the account of the seller—in essence creating money. Banks have accounts at the Fed just like individuals and businesses have accounts at banks. The Fed requires the banks to keep a certain percentage of their deposits with the Fed to provide liquidity in the event that large numbers of depositors demand cash all at once. These are called required reserves.

Excess reserves are funds that banks could lend. Like money we keep in our checking accounts or in our wallets; reserves Earns little if any interest, so people as well as banks normally try to keep such funds to an absolute minimum. It’s better for excess funds to be invested in stocks, bonds or other income-earning assets; for banks, this means lending money at interest. And just as it would be unwise for individuals to keep all their savings in a non-interest-bearing checking account, it also makes little sense for banks to have large amounts of excess reserves.

There is no consensus among economists as to why banks are not lending— which would get money circulating in the economy—and why they’re sitting on vast reserves in excess of what the Fed requires. Some believe that banks are being too strict with their lending standards, making it too difficult for businesses to get loans. Other economists think the problem is on the demand side; businesses aren’t asking for loans and in fact are sitting on vast amounts of liquid assets themselves. As I noted last week, nonfinancial businesses have about $1.8 trillion in liquid assets that could be used for investment.

While there is no doubt that lending standards have been tightened, the preponderance of the evidence says that the weakness in bank lending is largely due to a lack of demand. Businesses normally borrow to finance expansion to increase production as sales increase. But sales remain weak. In June, total retail sales were down 0.5 percent on top of a 1.1 percent decline in May. The latest from the National Federation of Independent Business lists poor sales as the number one small business problem. It also shows that business credit needs are largely being satisfied.

If people really believe that the Fed can and will create inflation,
then it might change psychology and get people to start spending.

Moreover, the NFIB survey shows that weak sales continue to force prices down—deflation. As the survey notes, "Widespread price cutting contributes to the high percentage [of businesses] reporting declining sales revenues. Plans to raise prices fell three points [in June] to a net seasonally adjusted 11 percent of owners." In other words, 11 percent more businesses plan additional price cuts than plan price increases. Small business owners have reported net price cuts every month since November 2008.

Other evidence that deflation is the central economic problem includes the high unemployment rate, the low industrial capacity utilization rate, declining Producer Price Index and low level of interest rates. Although the Consumer Price Index continues to rise modestly, many economists think this is more a function of measurement error than actual inflation. There is a considerable amount of research showing that the CPI overstates inflation by about one percent per year. If that's the case then it means we have essentially had zero inflation for the past year.

Most economists believe that inflation and deflation are largely, if not exclusively, monetary phenomena. When the Fed creates too much money it encourages people to bid up prices. Inflation also increases spending and the velocity of money because people try to buy things before prices rise further. Thus at some point inflation becomes self-reinforcing and can only be broken at great economic cost.

Deflation creates the opposite phenomenon. People put off buying because they expect that prices will be lower in the future. Thus deflation can also become self-reinforcing—encouraging households, banks and businesses to hold excessive cash balances and reducing spending, which reduces velocity and makes the deflation worse.

Some economists suggest that the Fed should publicly announce that it plans to increase the money supply by whatever amount is necessary to get prices rising again; that is, to have an explicit inflation target. But as noted earlier, there is a problem in that all the Fed can really do is create bank reserves; it can't make banks lend or make money circulate. But the hope is that if people really believe that the Fed can and will create inflation then it might change psychology and get people to start spending on cars, houses and other goods before their prices rise. This would raise velocity, reverse the deflation and hopefully create self-sustaining growth.

However, the Fed views its primary mandate as price stability and the idea of intentionally creating inflation runs deeply against its grain. Although some Fed officials such as Eric Rosengren of the Federal Reserve Bank of Boston have expressed concern about deflation, others such as Thomas Hoenig of the Federal Reserve Bank of Kansas City think inflation is right around the corner because of the increase in the money supply over the last two years.

Nevertheless, the Fed may not be able to resist political pressure to at least try and use monetary policy more aggressively and creatively to jumpstart growth since it is really now the only game in town.

Bruce Bartlett is an American historian and columnist who focuses on the intersection between politics and economics. He blogs daily and writes a weekly column at The Fiscal Times.  Bartlett has written for Forbes Magazine and Creators Syndicate, and his work is informed by many years in government, including as a senior policy analyst in the Reagan White House. He is the author of seven books including the New York Times best-seller, Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy (Doubleday, 2006).