Kicking Over My Traces

If it can, will it? Should it?

Tyler Cowan at Marginal Revolution analyzes the monetary proposals of Scott Sumner.

Sumner thinks that the Federal Reserve should force banks to spend their reserves by intentionally causing a two or three percent increase in inflation.

Here is Cowan talking about Sumner:

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The Fed has already taken some unconventional monetary measures to stimulate the economy, but they haven’t been entirely effective. Professor Sumner says the central bank needs to take a different approach: it should make a credible commitment to spurring and maintaining a higher level of inflation, promising to use newly created money to buy many kinds of financial assets if necessary. And it should even pay negative interest on bank reserves, as the Swedish central bank has started to do. In essence, negative interest rates are a penalty placed on banks that sit on their money instead of lending it.

Much to the chagrin of Professor Sumner, the Fed has been practicing the opposite policy recently, by paying positive interest on bank reserves — essentially, inducing banks to hoard money.

Eek, I say.

Sumner’s target may be banks newly cautious in their lending practices, but he’s liable to take out a swatch of ordinary folks with shakey personal cash flow who don’t have the extra money to spend.

Long term, mild inflation may buck up the economy and create jobs. Maybe.

Short term? It will lower the purchasing power of the little money passing through the hands of hard-pressed consumers.

UPDATE: Arnold Kling at EconLong jumps into the conversation:

In Sumner’s model of the economy, monetary policy takes effect more quickly because monetary growth targets affect expectations. I do not buy that model, for reasons I have occasionally suggested, although I probably owe people a fuller explanation. Not today.

What I find most troubling right now is that fiscal policy is subject to long and variable lags. I am willing to bet that the majority of the fiscal stimulus enacted earlier this year will actually hit the economy after positive economic growth has been restored. Furthermore, the multiplier effects of fiscal policy tend to hit with a lag, so we will be getting even more stimulus late in the game.

It is true that employment growth will be sluggish (if my guess is right), so it might not seem as though stimulus in 2011 is so bad, but the sluggish employment growth will reflect structural problems (mismatch between growing sectors and the employee skill base), not cyclical problems. The bottom line is that I think that in 2011 and 2012 we may be experiencing increased inflation while unemployment is high. This would be true whether we tried using monetary policy to stimulate the economy or using the unfortunate delayed-action fiscal policy to stimulate the economy.

Tags: Economic, Federal Reserve System, Inflation, Marginal Revolution

This entry was posted on Sunday, August 2nd, 2009 at 9:19 am +0000 GMT and is filed under Business, Politics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.