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Stiglitz: We need more stimulus, not quantitative easing

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I'll have a column this weekend on what Fed Chairman Ben Bernanke needs to do to make a second round of quantitative easing work. As part of my reporting for the column, I called Nobel Prize-winning economist Joseph Stiglitz, who's been very skeptical of further action from the Fed. The column, in part for reasons relating to my assessment of the politics of the issue, ends up taking a different position than Stiglitz, but I thought it worth publishing his interview in full, and he graciously agreed. An edited transcript follows.

Ezra Klein: You’re skeptical of further action from the Federal Reserve. Why?

Joseph Stiglitz: The Fed, and the Fed’s advocates, are falling into the same trap that led us into the crisis in the first place. Their view is that the major lever for economic policy is the interest rate, and if we just get it right, we can steer this. That didn’t work. It forgot about financial fragility and how the banking system operates. They’re thinking the interest rate is a dial you can set, and by setting that dial, you can regulate the economy. In fact, it operates primarily through the banking system, and the banking system is not functioning well. All the literature about how monetary policy operates in normal times is pretty irrelevant to this situation.

EK: But didn’t quantitative easing work in 2009?

JS: But think of the various channels through which monetary policy will operate now. The one that traditionally is the focal point is investment. Remember that quantitative easing’s effect on interest rates, after all, is only .2 or .3 percent. So broadly, there are two categories of firms right now: the large enterprises flush with cash -- they’ve got about $2 trillion, and a slight change in the investment rate won’t change their investment policy. Then there are the small and medium-sized enterprises that are cash-starved, and here, the funds need to be channeled through the banking system, and that part of the banking system is still sick. So if normally it might have a small effect, now it’ll have a smaller effect. So that channel is blocked.

Then there’s a second channel, which is the mortgage market. Those interest rates will go a little lower. But again, it won’t directly affect very much. We have too much capacity already. Those lower interest rates will move some money around, taking it from the elderly who hold long-term government debt and put it into the hands of people with mortgages. That’s just redistribution.

Third, it will have a very small effect on equity prices. But that won’t have much effect on either consumption or investment. People recognize that this is a temporary intervention and the government won’t maintain it for long, so they won’t run to spend that money. There might be some help on collateral prices, but that won’t be much.

Then there’s competitive devaluation, which is that lower interest rates could lead to a lower exchange rate. But for that to work, other countries need to allow it to work. And they’re saying that they won’t, that they’ll get into currency wars with us, and that may be worse.

EK: What about people who say that the right thing to do now is to put monetary and fiscal policy together, so the government spends and the Fed buys bonds to make sure the spending doesn’t raise interest rates?

JS: People who say that are living in a peculiar world. In normal times, people would worry about fiscal expansion driving up interest rates and government spending crowding out private spending. In those times, monetary policy could undo this crowding-out effect and increase the effectiveness of fiscal expansion. But all the evidence is that as government spending went up during the last two years, interest rates didn’t go up, and are not likely to go up now. We are not in a crowding-out situation. You can’t talk about crowding out with interest rates at 2 percent.

EK: And presumably, if you did a fiscal expansion now, you could always bring in monetary policy later if interest rates did rise.

JS: My view is that if it turns out that that’s wrong and fiscal expansion brought interest rates up, monetary policy would have to be brought to bear. But the way I’d think about using monetary policy first is in a cost-benefit analysis. The likely benefit of monetary easing is very low for all the reasons I’ve said. Now, if it were costless, you might say, sure, the Fed messed up, it feels guilty, it wants to show it’s worried about unemployment, so why not let it do what it can do? But this is not costless.

The first cost is the potential of currency wars, which we talked about. The second cost, which people haven’t talked about, is that the reason the private market for mortgages has dried up is that everybody knows the moment the government withdraws from the mortgage market, the effect will be that there will be a capital loss on the mortgages -- and the same thing goes for our long-term bonds. Now we don’t use mark-to-market accounting, so we’ll pretend they don’t occur, but they will have occurred. We’ll have experienced a loss. The third point is that to avoid recognizing the loss, the Fed is likely to do silly things, like rather than buying and selling government bonds, they’ll pay interest on deposits banks make to the Federal Reserve in order to absorb the liquidity.

There are two problems with this. First, it’s costly, as we’re now paying interest when we didn’t before. Second, we don’t know how well this will work. And because it’s uncertain, you might say that the financial markets, recognizing we’re going into uncharted territory, will request a risk premium. That’ll hurt the U.S. Treasury and would be bad for the economy. So this is not costless. If it were the only instrument, you might say we have no choice. But it’s not. Fiscal policy is a choice, or it should be a choice. By putting fiscal policy off the table, we’re moving down the cost-benefit curve to something much riskier and much less cost effective.

EK: Why are you so confident that more fiscal policy will work?

JS: The point is the stimulus did work. They made a very big mistake in underestimating the severity of the downturn and asked for too small of a stimulus, and they didn’t do enough in the design. About 40 percent was tax cuts, and we all knew that wasn’t going to be very effective. But it worked; without it, unemployment would’ve peaked between 12 and 13 percent. With it, it peaked at 10 percent, and that was an achievement. A better, bigger stimulus would’ve gotten it still lower. The severity of the recession was too big to be dealt with by a stimulus of that size. I’d also note that one-third of government spending is at the state and local level, and you’re seeing cutbacks there, which is why we’re losing jobs. If you look at the net stimulus -- federal and state and local -- the full stimulus was extremely small, particularly when you see how much was tax cuts.

EK: And part of the argument here is that the channels by which fiscal policy operates are more straightforward than the channels by which quantitative easing operates, right? If the Fed buys long-term Treasury bonds, other things need to happen before anyone gets a job. If the government decides to build a bridge, people who build bridges, and people associated with the building of bridges, get jobs.

JS: Right. We know from the historical experience that unemployment benefits get spent almost dollar-for-dollar, and infrastructure spending actually gets spent, and you get new assets to boot.

EK: So if I understand your argument as a whole, it’s that we should be doing fiscal policy, and the Federal Reserve should basically announce that they won’t let interest rates rise, but shouldn’t step in before they’re specifically needed.

JS: Exactly. And one more thing: It would be good if more of the spending shifted to investment. Borrowing increases debt and investing increases assets. If markets were rational, they would look at this and say our fiscal position was actually getting stronger. I joke that one of our advantages is that we’ve underinvested in the public sector for a decade, and so we have many high-return investments to choose from.

Photo credit: Andrew Harrer/Bloomberg News.

By Ezra Klein  | October 21, 2010; 3:05 PM ET
Categories:  Economic Policy, Interviews  
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Comments

This makes a very good case for a National Infrastructure Bank (NIB). It would give the Fed another, more direct conduit for quantitative easing to stimulate the economy without picking winners and losers. Instead of buying Treasuries, or bonds from Fannie or Freddie, the Fed would buy bonds from the NIB. That money would go to fund infrastructure projects in much the same way that Fannie and Freddie bond purchases go to fund mortgages. I never hear anybody mentioning this, though. Either this is a good idea that nobody has thought of, or a bad idea that is so colossally bad nobody is even talking about it.

Absent a NIB, could the Fed buy bonds from states or localities directly? You get some picking of winners and losers, but you know that the money actually gets spent rather than sitting in a vault somewhere.

Posted by: wayward_va | October 21, 2010 3:32 PM | Report abuse

I would be lying if I claimed to be looking forward to seeing how your "assessment of the politics" leads you to "taking a different position than Stiglitz". Frankly, there is nothing novel or interesting about politics getting in the way of sensible economics.

Posted by: Adam_Smith | October 21, 2010 3:36 PM | Report abuse

"EK: And part of the argument here is that the channels by which fiscal policy operates are more straightforward than the channels by which quantitative easing operates, right? If the Fed buys long-term Treasury bonds, other things need to happen before anyone gets a job. If the government decides to build a bridge, people who build bridges, and people associated with the building of bridges, get jobs.

JS: Right. We know from the historical experience that unemployment benefits get spent almost dollar-for-dollar, and infrastructure spending actually gets spent, and you get new assets to boot."

To add to this exchange I have this quote:

"FB: Nothing is more natural than that a nation, after making sure that a great enterprise will profit the community, should have such an enterprise carried out with funds collected from the citizenry. But I lose patience completely, I confess, when I hear alleged in support of such a resolution this economic fallacy: "Besides, it is a way of creating jobs for the workers."

The state opens a road, builds a palace, repairs a street, digs a canal; with these projects it gives jobs to certain workers. That is what is seen. But it deprives certain other laborers of employment. That is what is not seen."


Posted by: justin84 | October 21, 2010 4:44 PM | Report abuse

This right wing conservative agrees almost completely with Stiglitz. I completely agree that people focused only on monetary policy are completely avoiding any thought of downside risk... which Stiglitz is good enough to vocalize.

I also agree that when we spend money to build bridges, we at least have a bridge.

Now, to where I disagree. Social Services spending (unemployement insurance) would be ok if we did not have a $13T debt. But right now, we have to focus only on construction stimulus that get's people to work on non-recurring projects. Social Services spending does not give the nation anything to have in the long-run like roads and bridges.

Posted by: lancediverson | October 21, 2010 4:46 PM | Report abuse

"But it deprives certain other laborers of employment. That is what is not seen."

Nice argument from authority. Got any evidence? Got any suggestion of who the workers might be who are "deprived of employment" when the government builds much-needed infrastructure in a time of high unemployment?

Economics has developed quite a bit since 1848, and just because your "expert" from 160 years ago declares it doesn't make it true.

Posted by: jimeh | October 21, 2010 4:58 PM | Report abuse

"everybody knows the moment the government withdraws from the mortgage market, the effect will be that there will be a capital loss on the mortgages -- and the same thing goes for our long-term bonds. Now we don’t use mark-to-market accounting, so we’ll pretend they don’t occur, but they will have occurred. We’ll have experienced a loss."


We've already experienced a loss. Just because accounting fraud has been used pretend it doesn't exist doesn't make it not so. Our pension plans, our insurance companies, our banks, the Fed's balance sheet, Freddie and Fannie are stuffed with toxic assets.

That's what TARP was supposed to fix, but despite the much ballyhooed "success" of TARP and the fictitious money it has made us, it didn't fix it. Instead, some of the losses have been placed on the taxpayer instead of on the bank shareholders and bondholders where the losses belong. The losses incurred by such as PIMCO, BlackRock, and TurboTax Timmy's New York Fed are now being tossed like a hot potato back to Bank of America, which will no doubt try to prevail upon TTT to engineer TARP II in order to stick the taxpayer with still more of the losses.

Posted by: bgmma50 | October 21, 2010 5:09 PM | Report abuse

Stiglitz is absolutely correct. The only possible reason to do QE is to let it crash and burn and prove to Congress that fiscal policy is the only remaining option.

There is more than enough work that needs to be done.

Posted by: bakho | October 21, 2010 5:12 PM | Report abuse

The idea behind TARP was to place the losses on the books of the government and the Fed, which could presumably hold the paper to maturity or until such time as the collateral recovered in value and the assets could be resold into the market. Not only has that not happened, the value of the underlying collateral has continued to erode. And Fraudclosure is dangerously close to making it crystal clear to everybody that the value of the mortgages will never be recovered. The end of extend and pretend.

Posted by: bgmma50 | October 21, 2010 5:14 PM | Report abuse

"Nice argument from authority. Got any evidence?"

Um, this is basically all the stimulus has going for it. Argument from authority. Some expert puts a bunch of numbers into a model that churns out a result which agrees with his priors. We receive periodic update that, yes, the model spits out the same result if you run it again.

Unfortunately, the real world is too complex to put into a computer model if you expect accurate results. For example:

"At the unpleasant session yesterday, I did learn something interesting from Doyne Farmer of the Santa Fe Institute, while he was ranting against the state of the art in macroeconomic models. He said that in 2006, the Fed simulated a 20 percent decline in home prices in its model, and the effect was minor."

Of course, home prices had fallen 20.1% per the Case Shiller index from peak to August 2008, and as measured by the FHFA index they have yet to fall 20%.

http://econlog.econlib.org/archives/2010/10/finance_tarp_an.html

"Got any suggestion of who the workers might be who are "deprived of employment" when the government builds much-needed infrastructure in a time of high unemployment?"

That's the whole point of the essay, had you bothered dwelling on it for a moment. It's easy to point to jobs spending creates - it's what's seen.

But of course, the money is being borrowed from investors, who would have done something else with it had the Treasury not issued bonds - that's the unseen.

Consider another bit from Bastiat on demobilization:

""Discharge a hundred thousand men! What are you thinking of? What will become of them? What will they live on? On their earnings? But do you not know that there is unemployment everywhere? ... Consider further that the army consumes wine, clothes, and weapons, that it thus spreads business to the factories and the garrison towns, and that it is nothing less than a godsend to its innumerable suppliers."

Private sector activity surged after World War II, despite a 70% decline in government purchases. Where were the multipliers? Why were silly Keynesians running around worrying about a relapse into depression?

Also consider the recession of 1920. It was about the same or a bit more severe than 2007-2009, and prices were falling rapidly. Rather than stimulate, the Harding Administration slashed spending and ran a budget surplus, and we hit full employment by 1923. What odds would you place on hitting full employment in 2011 (or even 2013)?

"Economics has developed quite a bit since 1848, and just because your "expert" from 160 years ago declares it doesn't make it true."

That must be why we've had such a powerful recovery and now enjoy broad prosperity today.

Not that there have been no advacements, but I'd argue most of the important details were figured out by the classical economists. In many respects, Keynesianism was just a regression to old fallacies.

Posted by: justin84 | October 21, 2010 6:14 PM | Report abuse

I think Richard Koo is more persuasive on this - http://www.scribd.com/doc/13970982/Richard-Koo-Presentation

Koo actually argues for sustained fiscal stimulus, but inflation seems to be just as likely a mechanism for speeding up deleveraging - both for banks and households. And it's just a bonus that it incentivizes companies getting that $2 trillion out of the bank and back into the economy.

The downside is it's effectively a tax on salaries, but after so long without raises, I think a lot of workers would get a psychological boost from a raise, even if it only matches inflation.

Posted by: AlanW27 | October 21, 2010 6:42 PM | Report abuse

Stiglitz is a pretty interesting guy. I've only seen him on the internet, never live.

I think he may be not addressing that thing we talked about last week. Unemployment is the Fed mandate they take least seriously, but use as an excuse for other things. I think Bernanke has made the decision to monetize the debt by debasing the currency. If you look at it that way, all his decisions make perfect sense, including QE. Remember in his latest remarks he was even pretty transparent saying that he wanted 2%, but I'm guessing the real goal is more. Fiscal policy won't address this.

If you ask me, and no one did, they are AWFULLY worried about the quality of the assets they took in return for TARP. I haven't seen a lot of commentary about it, but the Maiden Lane action to go after BOA is just extraordinary. No way they would have jumped in like that if their goal was to boost the economy.

Posted by: 54465446 | October 21, 2010 10:27 PM | Report abuse

By the way, a good take on Stiglitz's viewpoint from monetary economist Scott Sumner:

http://www.themoneyillusion.com/?p=7547

The concluding gem:

"I have no objection to people criticizing the Fed; I do it all the time. But then suggest an alternative policy. What is your nominal target? How do you think the Fed should try to improve the macro economy? My problem with Stiglitz is not that I disagree with his answer; it is that I suspect he doesn’t understand there is a question that needs to be answered."

Posted by: justin84 | October 21, 2010 11:57 PM | Report abuse

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