“No postwar recovery has died in bed of old age—the Federal Reserve has murdered every one of them.”- Rudy Dornbusch
It becomes ever more important to discuss the limits of the United State’s Federal Reserve power to control interest rates that influence the economy. To begin we must examine how monetary policy has affected the economy during recent recessions through the Federal Reserve. In general the media does a good job of explaining the impact of monetary policy and its limitations. However, as a whole we fail to go into more in depth to talk about the limitations of Monetary Policy in the current environment in relation to Fiscal Policy, which may be undermining it.
Federal Fund Rates, or interest rates is the proportion of a loan that is charged as interest to the borrower. If interest rates are low, people buy houses and cars, and businesses invest because they are virtually paying a lower rate over time. This type of incentive creates demand for goods and services, which stimulates the economy to everyone’s benefit. So, to stimulate a sluggish economy the Fed pumps money into the system by lowering the federal funds rate (the rate the Fed charges banks), which works its way into the interest rates businesses and consumers eventually pay. At some point in the “business cycle” the economy may begin to become too large causing inflation (increase in the general price level of goods and services in an economy over a period of time). If the economy goes through a period of inflation, the US dollar begins losing its value, and can oftentimes wipe out everyday people’s savings. To compensate, the Fed does the opposite by raising the Fed funds rate in order to slow the economy down through higher interest rates, which discourage consumers and businesses from borrowing money. This can be thought of as a classic monetary policy.
The Fed used monetary policies to combat the recent recession. When there is a crisis, like the Housing Market crash in 2007, investors and banks pull back and don’t invest causing the risk of a further slowdown, maybe even deflation (the general level of prices in an economy reduce). In response, the Fed employed monetary policy to cut interest rates to near zero. As many economic reporters explain the Fed also took the unprecedented step of “Quantitative Easing”. Quantitative Easing is basically the government buying vast amounts of mortgage bonds for the purpose of keeping interest rates as low as possible. Doing this provides incentives for people to take out more mortgages and keep the housing market and the economy healthy. Most media outlets discuss that this approach may have been successful in avoiding a deeper recession, but that it will be difficult for the Fed to now change direction and raise interest rates, because that may cause the economy to react badly.
While these explanations can be helpful, they generally do not discuss the impacts of the government’s fiscal policy (how the government taxes and spends its money to influence the economy) which could be undermining the goals of the Fed to stabilize the economy. In addition to monetary policy (how the central bank or other regulatory committee decides to control interest rates), the government can also practice “countercyclical fiscal policies’ ‘ to help address problems in the economy. Counter-cyclical fiscal policy is defined as “fiscal policy designed to moderate the severity of the business cycle” (Principles of Macroeconomics). This would include changing tax rates and government spending to influence the direction of the economy. This approach can be considered Keynesian Economics, “An economic theory of total spending in the economy and its effects on output and inflation” (Investopedia). This theory would involve stimulating business and consumer demand during economic slowdowns by increased government spending and lowering of taxes. Lower taxes encourage people to spend more because they have more to spend, thus stimulating demand and the economy. Government spending employs people who produce goods and services it purchases, which also stimulates the economy and gives people and business more money to spend. Keynesian economics would encourage the government to incur a deficit during this time because it is necessary to fix the economic conditions.
Generally the media fails to address the impact of recent fiscal policies on the Fed’s monetary policies. While the government did make some efforts to employ Keyn’s fiscal approaches, the government’s reaction was really dominated by the Fed’s monetary efforts to keep interest rates low. While the government did increase some spending, it didn’t cut taxes. In short, the general media is sort of accurate by focusing on the impact of monetary policy. By keeping interest rates low, the Fed made stocks and equities more attractive versus bonds. Because interest rates on bonds were so low, in order to get a good return, investors bought equities and stocks to raise their prices. This should have made people feel richer, so they would buy more, in turn helping the economy grow. Investors and homeowners should have borrowed more money because interest rates were staggeringly low, stimulating the economy. Eventually, all this consumption should have pulled the economy out of recession.
While the economy stabilized, the government’s actions did not stimulate the economy nearly as strongly or quickly as monetary policy would have predicted. We fail to explore why this was or what role the government played in this result as a result of its weak fiscal policy. One theory popular among liberals is that the government did not expand spending nearly enough. The conservatives would argue that taxes should have been cut. This is often referred to as Supply Side Economics, or Reaganomics. The concept behind Ronald Reagan’s economic theory was cutting taxes and investing into American businesses. By doing this, the hope is that business would pump money into forms of production. This too would lead to a “trickle down effect”, where business would then be employing more everyday people, producing more and lower government spending.
Perhaps what the media should be portraying the argument that while the government was stimulating the economy through monetary policy and not so much on fiscal policy, it was at the same time, increasing regulation and hurting business. Business and consumers then had less reason to feel confident in making big investments and purchases, which all held back the recovery of the economy as planned. We must also discuss how Quantitative Easing bond purchases itself undermines business confidence, because of all of the debt the Fed was building up and how that was arguably less effective than direct government spending on things like roads and works programs.
Most modern day media outlets main points are that no one knows if the Fed can reverse its monetary policies by raising interest rates and returning things to a more normal state of affairs. This suggests that there is something unique about this recession and the Fed and the government’s response. However in general this doesn’t exactly say what this is, it just says things are different this time. Some argue the difference is the weak fiscal policy employed by the government, or Quantitative Easing. The fact that the government continued to raise our debt, without having quicker success is concerning the future of our economy. Society in general implies a lot of these problems but does not directly address them. It only says that this time might be different and we should be very concerned that we don’t know how it will all play out. This should be of concern to everyone, and question whether our leaders have the knowledge to manage these types of situations. We need to make sure our government assesses these situations more thoroughly before making economic decisions, such as raising interest rates to stabilize the economy. While America media in general is correct in its analyses of the theory behind using monetary policy to correct economic problems, and portrayed some unique problems we now face as a result of the actions of the Fed. I argue that we should work on discussing the importance and impact of fiscal policy instead of ignoring it. The way these two work with one another is important to understanding what makes the most recent situation different from other recessions.