Sunday, December 15, 2013

Limitations of Monetary Policy - Comment on Miles Kimball's Blog

I just commented on Miles Kimball's article on Expansionary Monetary Policy.  I totally agree with his concern that we need to explore alternative approaches to monetary policy.  I've re-blogged my comment here:
I enjoyed this article tremendously. I've been putting a lot of thought in the limitations of monetary policy myself. The zero-lower bond is one obvious limitation, but also asset booms and bust which are a permanent side effect of an active Fed. Both of these limitations have the same source. The Federal Reserve can only control the supply of money, but not what people do with that money (aka the demand for money). In the 1960's and 70's active fiscal policy drove inflation expectations - accordingly people plowed any changes in money supply into the real economy driving inflation. After Paul Volker defeated inflation in the 1980's and active monetary policy took center stage, people responded by treating money as an asset. As a result, changes in the demand for money drove asset booms and bust ( I point to some historical evidence here)

The idea of charging negative interest rates on electronic money needs to be flushed a little bit more. I am afraid there will be many unintended side-effects. Specifically, people will withdraw from the banking system resulting in even more hoarding of cash. Also, alternative currencies will begin to proliferate (and I don't mean the bitcoin, but true currencies issued by credit-worthy non-government parties). Finally, the political framework to make this work simply does not exist - such an act would be characterized as grand theft by government.
I believe the solution lies in tackling the fundamental problem - monetary authorities do not control the demand for money. I believe this problem can be solved by giving the Federal Reserve full control over fiscal deficits and surpluses. This will enable the Federal Reserve to expand and contract the supply of money via monetary flows in the real economy, rather than simply printing money that people can put in their mattresses, which is exactly what's happening today. I am working on a future post to lay out these ideas in more detail. It will be titled: The Liberal Argument for a Balanced Budget Constitutional Amendment. Requiring the Treasury to run balanced budgets and giving the power to run deficits or surpluses to the Fed can provide the political framework for a feasible compromise.

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