Contractionary Fiscal and Monetary Policy, at the Same Time?

David Beckworth:

…Most hard money advocates are in the GOP which also happens to be calling for fiscal policy restraint. The belief is that hard money and sound government finances are necessary for a robust recovery to take hold. The problem is that the hard money approach–which means tightening monetary policy–makes it next to impossible to stabilize government spending. It also makes it likely the economy will further weaken.

How do we know this?  First, in almost all cases where fiscal tightening was associated with a solid  recovery  monetary policy was offsetting fiscal policy.  Last year there was a lot of attention given to a study by Alberto F. Alesina and Silvia Ardagna that showed large deficit reductions were often followed by rapid economic expansion.  Further digging by the IMF and by Mike Konczal and Arjun Jayadev found, however, that this was only true when monetary policy was lowering interest rates.  Fiscal tightening coincided with a recovery only because monetary policy was easing.

Second, a key lesson of recent years is that monetary policy overwhelms fiscal policy.  Thus, from 2008-2009 when monetary policy was effectively tight the easing of fiscal policy didn’t quite pack much of a punch.  Similarly, in late 2010, early 2011 when there was not much fiscal stimulus, but some monetary policy easing under QE2 there was some improvement in the pace of recovery.

Beckworth is directly addressing the views of the Right, specifically hard money supporters, but a weaker version of this view has become common wisdom among the leadership class. This argument states that in order to speed up the recovery we need to show leadership and instill “confidence” by cutting the short-term budget, even though interest rates are at an all-time low. Meanwhile, runaway inflation is just around the corner and the Fed needs to tighten based on events that could happen.

I’m glad Beckworth linked them together.  I’ve been looking at each for a while but haven’t taken the step back and realized that the one-two punch of these measures taken together will devastate the economy.

Krugman makes the link to the 1937-1938 double-dip part of the Great Depression explicit:

We usually focus on the great fiscal error of 1937, as FDR decided that it was time to slash spending and reduce the deficit. But there was also a turn toward contractionary monetary policy: the Fed got nervous over the alleged inflation risks from the existence of large excess bank reserves, even though those reserves weren’t being lent out, and decided to sharply raise reserve requirements. F&S say that this caused the 1937-8 downturn, although the Romers pointed out long ago (pdf) that their evidence was far less conclusive than advertised.

I’ve got a really bad feeling about this.

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