Together at Last!
Stellar Capital Management
By Stephen J. Taddie
January 22, 2011
Many people get lost when economists start talking about monetary and fiscal policy. By definition, fiscal policy is the use of government expenditure and revenue collection to influence the economy through borrowing, spending and taxation. Monetary policy is the process by which the monetary authority of a country (the Federal Reserve, or “Fed”, in the U.S.) controls the money supply in that economy through targeting interest rates or buying and selling securities from its portfolio. In the end, the two policies are just two different tools used to manage an economy.
We’ve read about the various “austerity” programs being implemented around the globe, as politicians have used the current crisis to implement fiscal policies that would never have seen the light of day in more normal economic times. For political cover, many have relied on expansionary (loose) monetary policy to offset the negative economic impact of those austerity programs. It makes political sense, but for the leadership economies not much economic sense, as the two policies should be coordinated. Overreliance on monetary policy to overcome contractionary (tight) fiscal policy to foster required economic growth eventually leads to concerns about currency devaluation and inflation.
In the mid-1930s, monetary policy was very expansionary and fiscal policy inadvertently became stimulatory in 1936 due in part to a large bonus given to World War I veterans. The economy was on the road to recovery, but was still in a precarious place and not yet at a point where private demand was ready to carry the full load of generating growth. In this fragile environment, fiscal policy turned sharply contractionary in 1937, as the one-time veterans’ bonus ended and Social Security taxes, which substantially reduced disposable income, were initiated. At the same time the Fed became concerned about the effects of its extended loose monetary policy and the buildup of bank reserves on future inflation and also turned contractionary. In an effort to create the flexibility to tighten if it needed to, the Federal Reserve doubled the reserve requirements in three steps in 1936 and 1937. Shaken from the bank runs of a few years earlier, banks reacted by building even more reserves which resulted in the already-weak
lending plummeting. As you know from history books and previous Commentaries, these combined policy mistakes added a few more years to the Great Depression.
As we have previously discussed, recently the U.S. was potentially on the cusp of experiencing a 1937 style déjà vu, with a precarious economy on the road to recovery, while not yet at a point where private demand could carry the full load of generating growth. Fed Chairman Ben Bernanke has long said that the economy needs continued fiscal support from Congress, as long as it is paired with a “longer-range” plan to rein in deficits and stabilize public debt levels. Throughout 2010 the tide ebbed and flowed on extending the Bush era tax cuts, mostly ebbing in mostly partisan driven debates. Over the summer, Lyle Gramley, a former Fed governor, stated, “The chances of getting some stimulus from fiscal policy are close to zero.” Robert J. Gordon, an economist at Northwestern University, believed that without additional fiscal stimulus to match the loose monetary policy, economic frailty was bound to persist, stating “This greatly increases the probability of a Japanese-style lost decade that would span the decade 2007-17.” Against this backdrop, and amid the apparent lack of interest in adjusting fiscal policy, the latest round of quantitative easing (QE2) was expected to help offset upcoming fiscal tightening in 2011.
Whether the politicians noticed on their own what was happening to currency and inflation expectations by relying too heavily on monetary policy, or whether the voters brought it to their attention in November can be debated, but with less than two weeks left in the year, fiscal policy for 2011 went from tight to loose with the passage of H.R.4853, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.
We may currently be in a minority, but we believe this change in fiscal policy (going from being tight to being loose almost overnight) is significant. This legislation will start to have an immediate effect as it will increase take-home pay for many individuals, despite the expiration of the Making Work Pay tax credit. It also extends unemployment benefits and keeps other federal investment and income tax rates at previous levels. In one fell swoop, disposable income got a shot in the arm and the uncertainty regarding tax policy was resolved. This should help offset any required fiscal tightening at the state and local government levels due to balanced budget requirements, which force spending cuts and tax hikes when economic activity declines and state tax revenues fall. If investor and consumer confidence improve as expected, this should lead to upward revisions in economic growth forecasts and, combined with what may end up being a too much monetary stimulus (in light of the fiscal policy reversal), upward revisions to inflation expectations as well. It wouldn’t surprise us to see QE2 run its course and result in having the Fed bump interest rates higher, sooner than popularly expected to better balance the impact on the economy, but following, rather than leading the interest rate market.
In the end, a well-run worldwide expansionary policy spreads both the burdens and the benefits of the recovery, rather than just shifting expansion from one country to another. Memories of this present downturn will linger for years, and the deleveraging trend sparked as a result will impact economic growth rates for years. We are starting from a position far stronger than our parents and grandparents were in 1933 and, if we continue to heed the lessons of the Great Depression, we can emerge from this economic setback stronger than before. However, the bill for these recovery policies is large, will come due, and must be paid, eventually. The payment structure will need to be negotiated between the political parties just prior to the next election cycle. The jig is up, and we all need to be a little bit smarter this time around.
(c) Stellar Capital Management
