Uncertainty Mutes Impact of Monetary, Fiscal Policy

Time and an agreement on taxes may restore businesses’ ‘animal spirits.’

Milton Ezrati of Lord AbbettIt is popular these days to compare current hard times to the Great Depression. The temptation is easy to understand. Because the events of the 1930s convey high drama and not a little romance, they make a good lead for almost any article. Of course, there’s enough difference between these two events to render such links misleading from time to time, but one very fundamental and important parallel does exist. As in the Great Depression, the crisis of 2008-2009 muddled perceptions about how the economy works, how effective policy moves will be and how the economy will perform in the future. The attendant insecurity has fostered general reluctance in the business community and that has muted all economic responses, even to the best-conceived policies.

The extent of this muddling was evident in the recent election campaign. Still, through the fog, two basic narratives emerged: On the left of the political spectrum are the neo-Keynesians, led by columnist Paul Krugman. This group would ratchet up government spending and borrowing still more, to “jump-start,” in the popular phrase, the economy. On the right, apart from the bias against big government, the analytical focus seems to lean toward monetary policy. This group would have the Federal Reserve, the Bank of England, the European Central Bank and other central banks keep markets well supplied with liquidity, effectively greasing the wheels of commerce until more fundamental healing can occur. There is dispute within this camp as to the appropriate extent and duration of such monetary ease, but this general approach seems to be where the bulk of their analytical effort has gone.

Curiously, this combination of tax threats and limited confidence may also explain why the monetary solution has failed thus far to get the economy back on track. Fed Chairman Ben Bernanke has poured huge amounts of liquidity into the system and, confronted with a muted economic response, has simply argued for more. Even the stock market has failed to respond fully. Though it’s up dramatically from its lows, its pricing still remains depressed compared with less risky assets, such as Treasury notes and high-grade corporate bonds. No doubt the confusion and concern about what might happen has also made business and the public reluctant to take full advantage of the ocean of liquidity offered by the Fed.

This problem is evident not only in the still disappointing state of the economy but in the benchmarks used by the Fed itself. Currency in circulation and bank reserves, two things the central bank controls directly, have surged under the influence of easy monetary policy. In the past two years, bank reserves have jumped 15.5% a year, and the so-called monetary base, which adds currency in circulation to measures of bank reserves, has increased at a 21.1% annual rate. But because the lack of confidence makes banks reluctant to lend and the public reluctant to borrow for either business or personal use, only a portion of these reserves has flowed into circulation. The broad M2 measure of money circulating in the economy, for instance, has grown only 7.9% a year during this time, faster than the economy, to be sure, but clearly slower than the Fed intends.

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