Tricky Policy

     What follows is a response to the the Economist's article "Economics focus: War footing” of Sept 4, 2010.

     This article discusses the challenges of simultaneous fiscal and monetary policy implementation. Having reached interest floors, central bankers are concerned with the sole option of applying fiscal policy. Although neither fiscal nor monetary policy is ineffective in theory; Eric Leeper’s presentation addresses the practical difference, whereas monetary policy undergoes vast economic analysis, “fiscal policy is highly politicised.” Politicization decreases the timeliness and effectiveness of policy, leading Leeper to say “Fiscal alchemy can undermine monetary science.”

     Leeper warns, if the public loses confidence in the Government’s ability to cover the cost of its fiscal stimulus and the central bank will “inflate away the debt,” hyper-inflation may ensue. To prevent this problem central bankers are calling for austerity measures or limits to fiscal stimulus. Along with the historically low interest rate environment, inflation expectations have been driven away, similar to Japan’s “lost decade.” To avoid deflation, Mr. Leeper suggests, “simultaneous fiscal and monetary expansion.”

     A key caveat to quantitative easing is that central bankers cannot “force banks to lend or companies and households to borrow.” Therefore, although QE is intended to increase the money supply and lower interest rates, the potential benefits may never reach the economy. This would lead to sustained high unemployment and the threat of deflation.

     The depression of interest rates and long-term threat of inflation caused by QE must be carefully dealt with. This is evident from the United States’ implementation of fiscal and monetary stimulus during WWII, which led to inflation thereafter. To avoid such a problem stimulus must be injected into the economy today and fiscal austerity imposed in the future.