Paul Krugman, having failed at getting Congress to spend more, has now shifted his more stimulus rhetoric to Ben Bernanke and the Fed:

But here we are, visibly sliding toward deflation — and the Fed is standing pat.

What should it be doing? Conventional monetary policy, in which the Fed drives down short-term interest rates by buying short-term U.S. government debt, has reached its limit: those short-term rates are already near zero, and can’t go significantly lower. (Investors won’t buy bonds that yield negative interest, since they can always hoard cash instead.) But the message of Mr. Bernanke’s 2002 speech was that there are other things the Fed can do. It can buy longer-term government debt. It can buy private-sector debt. It can try to move expectations by announcing that it will keep short-term rates low for a long time. It can raise its long-run inflation target, to help convince the private sector that borrowing is a good idea and hoarding cash a mistake.

Nobody knows how well any one of these actions would work. The point, however, is that there are things the Fed could and should be doing, but isn’t. Why not?

What Krugman recommends in this article and what Bernanke recommended in his 2002 speech (and in others over the years) is not novel. Scott Sumner and other monetary economists have been advocating a more expansive monetary policy from the beginning of the crisis. Sumner even goes so far as to blame the crisis - if not the recession- on too tight monetary policy in the fall of 2008 and I must say he makes a very persuasive case. In fact, Krugman is no doubt right that if the Fed were to pursue some of these policies they could raise inflation expectations and Nominal GDP. And Bernanke knows that he can raise NGDP anytime he wants; he has written previously about how to end Japan’s deflation (I would argue that Japan has not wanted to end their deflation, but that is a conversation for another day) by implementing price level targeting and asset purchases. He surely knows that what would work in Japan would work here. So why doesn’t he push for these policies right now?

Actually, part of the problem is that Congress has already taken Krugman’s previous advice to spend like drunken sailors. The huge deficit spending constrains the Fed because if they expand their asset purchases at this point and buy more Treasuries the market may take that as confirmation that the Fed is merely facilitating the spending. Central banks who monetize the debt of profligate politicians are not the most credible and the Fed has to avoid even the appearance of being beholden to the political class. Monetary policy is constrained in this case by fiscal policy.

In my opinion, there is another problem with the monetary approach. This monetary approach sees the economy as homogeneous when nothing could be further from the truth. Will raising aggregate demand do anything to retrain construction workers who are unemployed because we have an excessive inventory of houses? The reality is that many of the unemployed worked previously in industries that are not about to start hiring anytime soon regardless of what happens to NGDP. The deflation Krugman speaks of only applies to certain sectors of the economy and attempting to stop the deflation in those sectors with monetary policy will merely add demand to sectors that don’t have excess capacity. Once the excess capacity in the deflationary sectors is eliminated - eventually we will get rid of the excess houses - the result will be rising prices. Krugman, Sumner and others who advocate this approach exhibit a confidence in the Fed’s ability to recognize and head off this future inflation that I don’t share and history demonstrates conclusively is unwarranted. That isn’t to say a more expansive monetary policy at this point would not work; I think it probably would. My concern is the longer term implications of such a policy. Fed policy has already created an industry that expects the Fed to bail them out any time they get in trouble; would Treasury purchases now create an expectation in Congress that the Fed will always be there to bail them out too?

Fiscal policy and its interaction with monetary policy also cannot be ignored here.  We’ve tried tying the private sector in knots through excessive regulation, high taxes and government directed investment while the Fed pursues an overly loose monetary policy to raise NGDP. It was called the 70s. Companies did not invest to expand capacity because policy gave them little incentive to do so and when monetary policy was used to raise NGDP the result was demand that outstripped the capacity of the economy to produce. That’s why the Reagan approach became known as the supply side revolution. Private industry was given incentive to invest and it responded dramatically. The demand for capital for investment rose and the demand for gold and safe investments fell. Paul Volcker didn’t slay inflation; Ronald Reagan did by giving private industry a reason to invest and expand the supply side of the economy which allowed Volcker to run a contractionary monetary policy.

You might have heard recently about the large amount of cash sitting on the balance sheets of the S&P 500 companies. These companies have over $1.5 trillion in cash but they aren’t hiring and they aren’t investing in new capacity. The Keynesians say that these companies aren’t investing because there is insufficient demand to justify new investment and that therefore the government should spend or the Fed should stimulate demand through expansive monetary policy. Others say that companies are not investing because of uncertainty surrounding future government economic policy from taxes to regulations. In this narrative the way to get these companies to invest is to remove the uncertainty. The truth? Probably some of both but the answer is critical to determining whether monetary policy will be effective.

(By the way, I’m aware that this cash is invested somewhere and just because the S&P 500 isn’t investing it doesn’t mean it isn’t being invested at all. However, if they are buying Treasury bills the capital is at best being invested inefficiently or being used for present consumption and if they are buying other forms of short term investments such as commercial paper they are funding operations of other large companies. And banks are parking excess reserves at the Fed where they get paid a risk free rate. The bottom line is that long term productive investments are not being made at a sufficiently high rate to create real growth near potential.)

If companies are not investing because of insufficient demand then more expansive monetary policy would probably be effective. Increased demand would convince companies to hire and invest which could transform the recovery into a lasting expansion. On the other hand if companies are not investing because of government policy uncertainty, the increased final demand created by more expansive monetary policy will not induce companies to invest and any recovery will only last as long as the stimulus. Furthermore, if the Fed continues to follow that path and companies continue to refuse to invest, the ultimate result will be what we got in the 70s  - rapidly rising prices as the artificial demand outstrips the diminished capacity created by a lack of investment.

The Krugman’s of the world concentrate exclusively on the demand side of the economy. Many on the other side of the debate concentrate almost exclusively on the supply and incentive side of the equation. Call me crazy but I think we might ought to be looking at both sides of the equation. Yes, we could use more monetary stimulus but we are unlikely to get it from this Fed unless Congress acknowledges and starts to address our long term fiscal problems. And yes, uncertainty about future economic policy from taxes to regulations to labor policy is a problem and needs to be relieved. There is no magic bullet for ending this recession and achieving a growth rate closer to our potential. It will require that all parties try things that are outside their comfort zone. Let’s stop arguing about it and get on with it.