Monetary and fiscal stimulus are not the same thing
I’m still working my way through the IMF’s thoughts on the UK economy. But so far I’m inclined to agree with Larry Elliot’s take at the Guardian:
The IMF says plan B should involve the Bank of England cutting interest rates from their already record-low level of 0.5% and chucking some more newly minted money at the economy through the process known as quantitative easing. Only if that fails to do the trick does the Fund think the chancellor should resort to fiscal policy – decisions affecting tax and spending – to boost demand. As far as the Fund is concerned, deliberately increasing borrowing in an attempt to stimulate demand is plan C not plan B.
The IMF is advocating a monetary stimulus first, followed by (if that doesn’t do the trick) a fiscal stimulus. And their preferred form of fiscal stimulus would be an increase in investment funded by cuts/tax rises elsewhere. In other words, the balanced budget multiplier championed in the States by Robert Shiller and in the UK by the SMF’s Ian Mulheirn.
All very interesting, but I was somewhat surprised that the IMF argued for monetary stimulus first over a fiscal stimulus.
I’d argue that a monetary stimulus can certainly be helpful but at a time when the banks aren’t lending and the monetary transmission mechanism is broken there is always the worry that it fails to address the challenges in the real economy whilst boosting activity and profits in the financial sector (Aditya Chakrabortty’s column in today’s G2 is very good on this phenomenon).
But at least the IMF has implicitly, by recommending one over the other, recognised that monetary and fiscal stimulus are not the same thing (even if I disagree with them on which is more useful in the short term). This recognition is sadly lacking from much of the current government’s rhetoric.
while we may be fiscal conservatives, we are monetary radicals injecting cash into the banking system and introducing credit easing measures to make it easier for small businesses to access finance.
George Osborne is equally fond of arguing that his tight fiscal policy allows the Bank of England room for monetary stimulus. The government seem, again implicitly, to argue that monetary and fiscal stimulus are close substitutes for each other. It doesn’t matter if the government is cutting back as the Bank can extend support.
I’m afraid I don’t really agree with this. Leaving aside my doubts on the effectiveness of a conventional (and QE is the ‘new’ conventional) monetary stimulus at a time when the financial system’s operations are impaired, fiscal and monetary stimulus impact upon the economy in different ways.
As Philippe Aghion (a Harvard professor and advisor to President Hollande) has recently argued the two are not really substitutes, drawing on work he has carried out for both the OECD and the Bank of International Settlements . He notes that:
Countercyclical fiscal policy enhances growth more in sectors that are more dependent on external finance or in sectors with lower asset tangibility
Countercyclical monetary policy enhances growth more in industries that are more dependent on finance and in industries that are more dependent on liquidity
In other words, even in ‘normal’ times fiscal and monetary policy will impact upon different sectors in a different way.
Yes, any active policy to increase demand is to be welcomed at the moment – but we shouldn’t pretend that monetary easing will automatically offset fiscal tightening.
(And this is before we start talking about different types of fiscal stimulus such as investment, VAT cuts, etc, etc)