July 15, 2011 10:21 AM EDT
The US economy is at an inflection point after the end of the second round of Quantitative Easing (QE2). Two rounds of monetary and fiscal stimulus since 2008 have had only limited impact on growth or unemployment. The question is,'What next?' will there be another round of monetary and fiscal policy easing? Analysts at American Enterprise Institute for Public Policy Research (AEI) are of the opinion that fiscal and monetary policies have reached their limits.
A third round of either monetary or fiscal stimulus in 2011 is impractical as it would lead primarily to higher inflation and a higher ratio of government debt to gross domestic product (GDP) in 2012, according to AEI resident scholar John H. Makin.
"The significant risk of deflation that prompted last year's second round of quantitative easing has passed, and with inflation rising, monetary stimulus is no longer an option," says Makin.
He also says two rounds of fiscal stimulus have produced neither a sustained rise in growth nor a sustained drop in the unemployment rate. Another round would merely increase deficits and debt levels.
"Rather than enacting further stimulus, the Federal Reserve should aim for lower, steadier inflation, and Congress and the president should cut spending and reduce tax expenditures to finance lower tax rates and reduce the debt-to-GDP ratio."
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The Following is the full text of Makin's outlook report:
US growth slowed during the first half of 2011 while the sovereign-debt crisis ebbed and flowed and unsettled financial markets, just as occurred in the second quarter of 2010. It is no surprise under these circumstances that the Fed has been under pressure to initiate another round of quantitative easing or that the White House, former Treasury secretary Lawrence Summers, former chair of the President's Council of Economic Advisers Laura Tyson, and former vice chairman of the Federal Reserve Alan Blinder have suggested the need for another fiscal stimulus package. While rising core inflation has appropriately engendered hesitancy on a third round of quantitative easing, rising federal debt has--also appropriately--done the same for fiscal stimulus. If stock markets fall again or unemployment rises further or even stays the same, expect calls for more stimulus to grow louder.
Nevertheless, after two rounds of monetary and fiscal stimulus since 2008, the time has come to ask whether we have reached the stage of diminishing marginal benefits from returning to either approach. The recent rise in core inflation suggests that we are approaching the stage of negative returns for further monetary stimulus, while the alarming rise in government debt signals that the same may be true of further fiscal stimulus.
This is not to say that an abrupt reversal of the Fed's second round of quantitative easing and a boost in interest rates, along with a trillion-dollar cut in government spending over the next year, would make the economy better off. Such measures would risk a global depression. But it is time to recognize that monetary policy cannot do much more than avoid deflation while keeping inflation low and stable. For its part, fiscal policy can stabilize growth and employment while providing a temporary boost when private demand slows, and conversely tightening--and thereby reducing debt--when private demand overheats. Because monetary and fiscal policy are countercyclical, their impacts on growth and employment are temporary and tend to be reversed once they are withdrawn. In 2011, after repeated rounds of fiscal and monetary stimulus, would efforts to boost the economy or support asset prices with additional stimulus of either kind be endeavors where the long-run present discounted value of the costs outweighs the short-run benefits?
Consider some relevant history. After the volatility of the 1970s and early 1980s, US policymakers broadly employed monetary and fiscal policy as countercyclical, stabilizing measures to lower the volatility of growth and inflation. A less volatile economy promotes better decision making by households and corporations and thereby enhances productivity growth while allowing unemployment to drift downward.[1] The period of less volatility in macroeconomic behavior came to be called the "Great Moderation" in the United States. It lasted from about 1985 to 2007, when the housing bubble burst and led to a global financial crisis. The figure shows that over the full period, the mean GDP change per year is 3.27 percent with a relatively large standard deviation of about 2.7 percent. During the Great Moderation, the standard deviation is less than half that at only 1.3 percent.
In retrospect, the Great Moderation and the benign outcome for the economy of well-managed countercyclical monetary and fiscal policy had its downside. The business cycle was declared largely dead. Many became convinced based on less volatile growth and inflation that a serious downturn--including a steep drop in home prices--was virtually impossible. But such a conviction, as it turned out, created a bubble in home prices that ultimately burst and led to a serious global financial crisis, the aftermath of which is still with us.[2]
The period following a financial crisis can prove and has proved very difficult for policymakers attempting to affect the level of growth and employment over an extended period with the usual countercyclical policy tools designed essentially to stabilize the paths of these variables rather than affect their levels. This is true even if those tools are employed on an extraordinary scale, as has been done with both monetary and fiscal policy since 2008.
Now in mid-2011, the evidence that expansionary monetary and fiscal policy measures can no longer support the economy or financial markets is accumulating. After substantial second rounds of additional quantitative easing (QE2) and additional fiscal measures late in 2010, growth in 2011, at or below 2 percent so far, is lagging well below expectations of the markets and the Fed at the beginning of the year. Moreover, we are already being warned about the negative impact on growth later this year and in 2012 when existing fiscal stimulus is withdrawn.
The Limits of Monetary Policy
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