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Are Fiscal and Monetary Policy Too Tight?

The common belief is that money is “easy” right now because interest rates are at 0% and QE^n has been in effect for 7 years. But there are many of us who have been arguing for years now that fiscal policy and/or monetary policy is too tight.  That is, we actually haven’t done enough to get us back to full employment and the private sector has remained unusually fragile as a result.

I know, I know.  That sounds ludicrous.  But it’s more logical than you might think.  For instance, we know that the economy is probably operating way below capacity. With a U6 unemployment rate at 10.3% and an output gap at almost 3% there’s clearly still something very wrong with the economy.  Despite being a fairly long recovery this has been a rather subpar one thanks to the credit crisis.  And while I’ve stated that we’re doing better than some doom and gloomers would have you think I still think this economy should be doing much better than it is.

And here’s the thing – by many measures fiscal and monetary policy actually look fairly tight right now.  What I mean by “tight” is that policy is constrictive or excessively procyclical when it should be more countercyclical. Here’s some evidence:

  1.  As Scott Sumner has argued for years, the Fed is failing to hit all of its monetary targets.  But I’ve been pretty vocal that I don’t think the Fed has the tools to loosen policy that much.  Inflation is way below target.
  2. When the US government can sell bonds for 0% you have to wonder why we aren’t refinancing the entire curve and more at low rates.  The markets are clearly screaming that they can’t get enough safe government assets right now.
  3. Using the IMF’s Cyclically Adjusted Budget Deficit figures it’s clear that US fiscal policy has been tightening for the last 4 years.

Now, I don’t know how much the Fed can actually do here.  Negative interest rates and more QE are about all it has left in the arsenal and those aren’t very effective policies in my mind.  So, if the economy still has a good bit of slack that can be pulled tighter and the private sector is having trouble tugging it tight then maybe a bit of tax cutting will help?¹

Using a simple model like Okun’s Law would get us to about a 4% unemployment rate if we boosted the deficit by about $500B (assuming tax cuts have a multiplier effect of 1).²   That’s a pretty rough figure, but the debt markets are basically screaming for the US government to borrow more so we’d actually kill a bunch of birds with one stone here.  We’d solve the “safe asset shortage” problem, help liquify the bond markets that many are worried about and we’d add a bit of stimulus to the economy at a time when things are clearly pretty weak.  And since we can all agree that tax cuts are great this shouldn’t be a big hurdle in Congress.

But no, instead of a tax cut that everyone would love the Federal Reserve seems intent on raising rates and further tightening policy at a time when the global economy looks increasingly fragile.

¹ – Before you yell at me about the USA being Greece, being unable to afford the deficit or having a high interest burden please read this post on the Biggest Myths in Economics.  Also, when in doubt about one of these topics ask yourself if it would scare Peter Schiff and immediately conclude that the opposite must be correct.  

² – I used a 4% unrate target because that’s what the Humphrey Hawkins Act says.  I don’t know much about Humphrey or Hawkins, but I am an expert on the movie Hudson Hawk and I highly recommend it for those of you looking to remind yourself how bad movies were in the 80s and 90s.