Congress and the Fed Need to Think Inside the Same Box

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

Though there are sadly many choices, one of the most troubling economic missteps in recent years has been fiscal and monetary policies working at cross-purposes.  Far too often, the economic weather report has been one of monetary tailwinds met by fiscal headwinds.

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One simple way to show this, as in the figure below (pay no attention to the annotation for now), is just to compare the movements in the federal funds rate — the interest rate that the Federal Reserve lowers when it wants to stimulate growth and raises when it wants to slow growth — and the deficit as a share of gross domestic product, a measure of fiscal stimulus.  During the worst of the Great Recession, fiscal and monetary stimulus pushed in the same direction. But starting in 2010, the administration and Congress pivoted to deficit reduction while the Fed kept stimulating the economy through announcing that they were holding rates at zero and adding quantitative easing.

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In other words, for numerous years, monetary stimulus has been offset by budget austerity.

It is not a coincidence that those years have been a slow slog out of the downturn, with low growth and sluggish job creation.  When the private sector economy is weak, fiscal and monetary stimulus are highly complementary. Monetary policy sets the table but fiscal stimulus brings customers in to eat.  The Fed lowers the cost of borrowing, but absent consumer and investor demand, not enough people will take advantage of the Fed-induced rate reductions.  Policy ends up “pushing on a string,” as John Maynard Keynes put it.

Back when these cross-currents got underway, I made the box below to represent the simple matrix of policy makers’ choices.  In Boxes 1 and 4, Congress and the Fed are pushing in the same direction, toward growth or contraction, but in Boxes 2 and 3, they are working at cross-purposes.  As the first figure points out, from 2007 through ’09, we were well ensconced in Box 1, with monetary and fiscal stimulus both in growth mode. Since then we’ve been in Box 3.  That’s better than Box 4, which is where many critics of stimulus of any sort would have us be.  But Box 3 is a demonstrably bad box to be stuck in, as the tepid recovery has revealed.

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What’s the point of reviewing all of this?  Because there is another recession out there, and we should learn from our mistakes. With that in mind, allow me to suggest a number of policies that can help keep us in Box 1 when that is where we need to be.  I’m going to focus on fiscal policy because a) the Fed is and should remain independent of the policies I’m about to suggest, and b) they have been and will continue to be more reliable in this regard.

Also, I’m going to need you to suspend political disbelief for a moment.

As the Fed’s monetary policies are guided by inflation and unemployment targets, so should fiscal policy.  Automatic stabilizers (like unemployment insurance and food stamp extensions), state fiscal relief, infrastructure spending, subsidized employment: fiscal support for these should all be keyed off of indicators such as the unemployment rate or the gap between actual and potential G.D.P.  With such rules in place, we could avoid the uncertainty-generating and economically destructive partisan fights that have broken out every time a program has expired in recent years.  And as these measures return to normal, these stimuli would automatically shut down, avoiding inefficient spending and unnecessary budget pressures.

If that one is pretty straightforward, this next one is a bit outside the box. (Actually, it’s very much inside Box 1.)

Dedicate the money the Fed earns to stimulus, until remittances return to normal levels.  When the Fed expands its balance sheet, as is often the case in downturns (though not nearly to the extent that it has in this last one), the interest it earns on its holdings are turned over to the Treasury and used for deficit reduction. Instead, when the indicators noted above are flashing red, those remittances should be automatically dedicated not to deficit reduction but to fiscal stimulus.

This has at least two aspects to recommend it. First, it seals policy in Box 1, automatically tying monetary stimulus to fiscal stimulus.  Second, as the Fed winds down its monetary policy, fiscal stimulus follows suit.  From 2009 through 2013, the Fed remitted $350 billion to the Treasury. With a multiplier of 1.5, conventional estimates suggest that is another, much-needed five million jobs.  To be clear, however, as I noted, this quantitative easing-driven amount is far above past remittances.

O.K., you can switch your political disbelief back on. I’m well aware that there is not a lot of traction for these types of ideas, despite the fact that the general principle — the Fed and the Congress should be in Box 1 in recessions (and weak recoveries from them) — is textbook macro.

All that tells you is that we have between now and the next downturn to relearn these lessons.