With trillions of dollars committed to financial rescues, it seems that we now have decided that elected officials in Congress are superior arbiters of economic rehabilitation. Are we really to think that a polarized group of lawyers, doctors and who-knows-what-they-did-before will be prudent in their spending? The key word here is "spend." That is all the President, Congress, the cabinet or their designees can do: spend. Taxation and targeted spending are the only tools of the government's fiscal policy – and new taxes seem to be off the table, at least for the short term.
To date, the only approach to managing this crisis with some tangible results has been monetary policy (e.g., slashing interest rates). To be sure, much of this monetarist effort has been misdirected and not as efficient as it could or should have been. Still, given the choice of the lesser of two evils, I will take Bernanke’s resume against anyone's in Congress.
Unfortunately, we don't seem to have a choice. A Nobel Prize winning economist Paul Krugman asserts in his new book that the New Deal fell short in spending to reverse the affliction of depression. The new administration, under great political pressure to make a difference, seems to be taking this advice to heart. And that is the problem – the political pressure the President-elect is under.
It is unlikely that politically motivated spending will be as effective as a monetary approach the Fed's been pursuing. A simple view of history can tell that story. Infrastructure spending is the hallmark of Keynesian economic policy. But the New Deal did not add millions of new jobs, nor did it streamline government or remove obstacles to new business and investment. It saw well intentioned, but onerous government interference with wage-fixing schemes and the inefficient and costly layering of government bureaucracy simply for the sake of hiring. Once these hires are in place, they are there to stay – maintaining superfluous costs.
Keynesian economic policy was a proven failure in the depression era. Its haphazard application to address stagflation and "stabilize the money supply" in the 1970’s ultimately led to Paul Volcker's fight against inflation and a recession. But Alan Greenspan, another monetarist who followed Volcker, was willing to flood the world with dollars when the going got tough. The 1998 Asian financial crisis began us down a road of easy money and the “irrational exuberance” of asset prices; we are now at the end of that road.
To be clear, a more orthodox application of monetary economic theory won't solve our problems. However, Milton Friedman’s rejection of government intervention (read: Keynesian fiscal policy) was well researched in his conclusion that further government intervention is unable to correct the problems of an unbalanced money supply. The only outcome is higher debt and a prolonged economic malaise.
Our President-elect has a massive proposal for new infrastructure spending. Roads, schools, bridges and whatever else may soon appear on the wish list for Congress. Much of this investment really is needed, but the model of Japan shows that, once begun, this path is hard to turn away from. Projects can take years to complete (see Big Dig) and costs can soar and persist well beyond the period of economic difficulty.
We are already well into scary territory on the deficit scale, and history shows that the economic benefits of infrastructure spending are insufficient to recapture deficit spending. Hundreds of billions in infrastructure investing will likely lead to hundreds of billions more in cost overruns and inefficiencies; Japan still suffers one of the highest debt-to-GDP levels in the world. Why compound our current problems with more?
If we must choose between two evils – new government spending or monetary efforts – let’s give quantitative monetary policy another chance. The less national debt and current account deficit, the better off we all are. The next time Congress holds hearings, I hope it is a group of historians rather than economists that sits at the table.
Adapted from an essay originally published on December 18 in Bill Fox's Interest Rates Specialty Service. (See full menu for EWI's Specialty Services here.)
Bill Fox is EWI's Senior Bonds Analyst. He has been involved in the markets since graduating in 1988 from Vanderbilt University. He joined EWI in 1994; most of his subscribers are professional bond traders spread around the globe.