Paradoxically, the US financial crisis is bringing back old discussions about monetarism versus fiscalism as well as about monetary policy instruments. For many reasons, but it is only necessary to mention: a) the zero interest rate bound; and b) the major increases in Government spending.
The fact that interest rates will be reaching zero very soon is decoupling monetary aggregate targets from interest rate targets. In other words, when interest rates reach zero, the Fed can increase the monetary base (basically purchasing Federal Government bonds) without limits, because the basic interest rate cannot be negative in nominal terms. As a matter of fact, if there is deflation, real interest rates can be highly positive. The question of Government spending raises the old textbook discussions about financing of the deficit: printing money versus bond financing. The difference here will not be necessarily in terms of interest rates, but mainly in terms of the credit market, to the extent that a bond financing of new Government spending tends to produce a crowding-out effect on the credit markets, by leaving less space or no space at all for private borrowing through loans or bonds. On the other hand, the question of “printing money” always brings back fears of inflation or even hyperinflation. This may sound paradoxical, but the Great Depression specialists such as Friedman and Schwartz always emphasized that those fears certainly affected the decision of monetary policymakers at that time, even though there was deflation (perhaps because of the European hyperinflations of the twenties). The fact is that monetary aggregates in the US in 2008 (practically nobody seemed to pay attention to them in the past 15 years, but we believe this will change from now on) are behaving as follows: a) the monetary base was flat for one year (around US$ 850 billion) and jumped dramatically to US$ 1.5 trillion between September and November 2008 (almost 80%);
b) On the other hand, M1 and M2 continued to be basically flat in the past 14 months, with only a slight increase of less than 10% in both cases. Going back to textbooks of money, credit and banking, what is happening is an amazing fall in the so-called “money multiplier”, which is basically influenced by two ratios: currency/deposits and reserve/deposits. The public is bringing the C/D ratio up intensely (hiding cash under the mattress) and the banks are also bringing the R/D ratio up very quickly (showing their preference for cash, as opposed to loans and investments). Given the uncertainties about the behavior of the money multiplier (basically dependent on confidence) as well as the uncertainties about the effectiveness of fiscal policy without monetary expansion (due to the crowding-out effect), the only solution for Bernanke’s Fed is to do much more of the same – print much more money (monetary base) –and forget about those fears of inflation or hyperinflation. With zero interest rates and a major confidence crisis, both monetary and fiscal policy must be used intensely. Printing money and increasing the Government deficit. At this point in time, the monetarist debates of the 60s and the 70s about the impact of an increase in nominal GDP produced by a mix of aggressive and expansive fiscal and monetary policy – producing at the end of the day only inflation and not necessarily real economic growth – become entirely meaningless. Forget about the Phillips curve, particularly the accelerationist Friedman-Phelps-Lucas curve. In other words, we must be all monetarists now, but with a twist. Just like Friedman and Schwartz did when they studied the Great Depression. In normal times, Friedman emphasized that one cannot get away from a recession by printing money and by more government spending/deficit. But in crisis times, we can. And who cares about inflation or hyperinflation in 2008? As a matter of fact, Bernanke is worried about deflation, that is, zero nominal interest rates and positive real interest rates. This is why the monetary base need to grow much more than 80% and economic analysts must become “monetarists” again, not “Keynesians”.