The dominance of monetary policy over other forms of policy is now an accepted aspect of Modern macroeconomic management. Discuss.

The dominance of monetary policy over other forms of policy is now an accepted aspect of Modern macroeconomic management. Discuss.

23rd August 2015 Ideas 0

Modern macroeconomic management is a complex affair. Ever since the first implementation of large scale economic policies by the governments and central banks of the world after the Great Depression, economists and politicians have been arguing back and forth for various approaches to managing the economy. Nowadays, the majority of economic authorities around the globe use a concoction of fiscal, monetary and supply-side programs in order to ensure not just stable, long term growth but also to quash inequality, improve living standards, create a more reliable financial structure and to pluck economies out of deep recessions. Each category of policy has its unique target and no sensible economist would rely wholly on just one type alone, yet in the last 30 years there seems to have been a widespread regard of monetary policy as the prevailing, supreme policy of choice for most of the advanced economies. For example, when financial crisis struck the global stage in 2007 and was followed with recession in 2008, the main response of the Bank of England was to cut base rates drastically; from 5.75% in December 2007 to 0.5% just 15 months later. Clearly great faith was placed in the capability of this strategy. The US Federal Reserve opted for similar action in response to the imminent recession – the Federal Funds rate was cut multiple times, lowering the target rate to between 0% and 0.25%, coupled with large purchases of mortgage-backed securities in order to support the crumbling housing market. So why has so much emphasis been placed on monetary policy in recent decades – why is it now considered superior to other forms of macroeconomic management? It certainly hasn’t always been that way.

The first pervasive use of macroeconomic management was in response to the Great Depression of the 1930s. The governing bodies of the world saw that contrary to the classical view, they could not simply sit back and wait for their economies to recover by their own means. With unemployment rates as high as 35% in the USA and the value of UK exports shrinking by almost 40%, the world had never seen a recession of such severity. From the turmoil that it produced, a new school of economic thinking emerged, led by the renowned John Maynard Keynes. By opposing the current position which claimed that markets tended to clear quickly and efficiently, Keynes composed his General Theory, which is now considered to be the foundations of modern macroeconomics. He suggested that the role of the state was to encourage spending in a recession to boost aggregate demand where business confidence and investment was low and even to spend itself if necessary. This was the first advocate for demand-side policy: the explicit use of government spending and taxation to influence the total expenditures in an economy. Keynes’ ideas quickly caught on and soon there was heavy argument for the use of fiscal stimuli in order to restart the economy. The idea was received similarly across most of the globe, and as such the use of expansionary and contractionary fiscal policy remained the dominant form of economic management for several decades. The popularity of fiscal policy continued throughout thebSecond World War, and several advanced economies adopted the strategy to smooth out business cycles well into the 1960s. However, as the 1970s unfolded, many Keynesian economists could not explain the phenomenon developing in front of them: stagflation. Current economic theory implied that the simultaneous occurrence of high inflation and unemployment rates was impossible, as defined by the Phillips curve. This shed doubt on the work of Keynes and led to a drastic rethinking of macroeconomic management; a new age of economic thought emerged: monetarism. This school followed the works of Milton Friedman, who suggested that the causes of the stagflation were to be primarily found in the rapid expansion of the money supply in the preceding years. Friedman proposed that in order to manage the macro-economy successfully, fiscal policy alone would be insufficient. He argued for a central control of the money supply in an economy, in order to tame inflation and keep unemployment low. This revolution in macroeconomic policy gathered supporters throughout the 1980s and saw large scale implementation under Margaret Thatcher in the UK and Ronald Reagan in the US. Ever since the belittlement of Keynesian fiscal policy in the 1970s and the consequent stable growth and steady, low inflation of the 1980s, monetary policy has taken centre stage in macroeconomic management.

So what advantages does monetary policy hold over fiscal policy? One major reason is due to the political neutrality of monetary authorities. Institutions such as the Bank of England, the Federal Reserve and the European Central Bank are, to all intents and purposes, separate from the state’s governance. This is generally regarded as a positive aspect of central banks, as political bias could influence any policies carried out. The main argument for independent monetary authorities is that targets such as high employment and price stability shouldn’t need political incentives – whichever political party is in power, the central bank should always strive to meet these basic yet vital targets. The autonomy possessed by centralised monetary authorities carries with it another advantage: the various people appointed to run the assortment of central banks worldwide are experts in their field, and – in contrast to fiscal policy, which is administered by political parties – have usually been performing their job for several years previously, which ordinarily gives them more experience and understanding of the policies they are implementing. There are – as always – exceptions to the rule. The Board of the Governors of the Federal Reserve is recommended by the US President and confirmed by the Senate and the Bank of England was only granted operational and managerial independence as recently as 1997. There is some argument for political guidance and cooperation with a central bank, mainly to prevent contradictory policies being enforced, but the independence of monetary committees guarantees pure, unbiased monetary policy and keeps corruption at bay.

Another justification for the preference of monetary policy is due to its incapacity to produce budget deficits or to accrue significant debts. This is one considerable pitfall of fiscal policy, which has a substantial tendency to overspend, particularly in recessions, where fiscal stimuli usually run into borrowed funds. Indeed, this trait of fiscal policy is so ubiquitous that in 1997 policy makers in the UK were forced to introduce certain fiscal rules to prevent large sovereign debts. The Golden Rule stated that the government budget should be balanced over any economic cycle – that is, that any borrowing the government has to make to spend in a recession must be repaid in the subsequent boom. In theory this plan made perfect sense; in order to revive the economy, certain deficits would have to be accrued, but to stop this habit growing into hazardous and mountainous national debt over years, the government would promise to pay off any debts after the depression had been averted. Another rule brought in by the government was the Public Debt Rule, which was perhaps the simpler of the two. It stated that total public debt should never exceed 40% of GDP. The success of these two rules can be seen in the statistics – since 1997 UK national debt has consistently remained below 40%, and as of 2003 the UK ran a much smaller national debt as a proportion of national income than most other European countries. Other countries have since implemented similar fiscal restrictions, such as France, Italy and Spain, and certain states in the US have self-imposed ‘fiscal straitjackets’, which act to restrict the time over which a state budget can run a deficit. Each of these countries has experienced the derogatory effects of large national debts and so has acted to preserve a balanced budget over time. However, time has proven how hard it is to maintain this fiscal balance, and since the 2008 recession government deficits and national debt has risen once again. Despite the austerity measures imposed in the UK, in 2012 the government had managed to boost sovereign debt to almost 90% of national income – a truly staggering amount. Other countries which had also tried to manage fiscal policy very carefully had similarly fallen from grace – Italy had by this time magnified its national debt to 127% of GDP. These national debts will be a considerable burden for future generations, requiring immense interest payments which in turn incur substantial opportunity costs, let alone the threat of another credit crunch. Clearly, one triumph of monetary policy over fiscal policy is its inherent inability to generate national debt and the obvious drawbacks that come with it.

Monetarists will also argue that fiscal policy has more detrimental effects than just budget imbalance – more classical economists state that any government spending, no matter how key to a recovery, will generally crowd out private investment, and that when dealing with taxpayers’ money, malinvestment and inefficiency are far more crucial to avoid. When a government borrows to finance spending in a recession, the demand for loanable funds effectively increases. This, as we know from basic microeconomic theory, will increase the price of credit: the interest rate. With an increase in the interest rate, private investment may well be discouraged, as investors will be guaranteed a greater return on savings and the cost of borrowing necessary for any investment will have increased. Theoretically then, the government spending designed to cause a growth in aggregate demand may simply replace lost private investment. This theory is still debated by economists today, and many would argue that in a recession, as resources are far from scarce, any increase in government spending will not create unwanted competition with the private sector. Whether the theory actually translates to reality or not, it is certainly one aspect that monetary policy does not have. Without the possibility of government interference, monetary policy carries less risk of negatively affecting the private sector.

Government spending can also be manipulated by political biases or pressure groups, with citizens’ taxes being poured into projects which do not bring the most utility to them. Misinformation can also be more significant concerning fiscal rather than monetary policy, as a malinvestment could also lower overall social welfare. These sensitive issues are not realistically applicable to monetary policy, yet they are still valid problems to consider when executing fiscal policy.

Despite the matters just discussed, the main advantage of monetary policy lies in its capacity to successfully curb inflationary pressures or to encourage spending. This can be achieved using a mixture of several monetary tools, but all serve to affect the rate of expansion of the money supply. By buying government bonds – for example – a central bank expands the supply of money in the economy, by replacing government debt with cash. Another tool is the bank base rate – this influences every other interest rate offered in the economy: for loans, mortgages, savings accounts etc. By raising the base rate the central bank can effectively force the cost of borrowing money and the reward for saving to rise, reducing aggregate demand in the economy. Thirdly, the central bank can dictate the reserve requirement for financial institutions in the economy. Under a fractional reserve banking system banks can lend out more funds then they have in deposits in order to create investment opportunities, but the central authority requires them to hold a certain percentage of their total deposits in reserves – that is, available to be withdrawn by customers. By decreasing the reserve requirement for financial establishments, they will be able to make more loans and therefore make borrowing more attractive. This expansion of credit may generate more spending and investment, causing a potential output gap to be closed, leading to stronger growth and higher employment rates. By controlling the rate of growth of the money supply, as suggested by Milton Friedman several decades ago, a central bank can help to stabilise prices and prevent rampant inflation, which allows government, businesses, investors and consumers to make more informed decisions in an economy.

These policies can also be fine-tuned very regularly. With most central bank committees meeting very frequently, monetary variables can be tweaked at a moment’s notice in order to maximise the effect of enforced policies. This flexibility is one key edge that monetary policy holds over fiscal – plans for increasing government spending on infrastructure or for reducing income tax can take several quarters to meet with approval and be implemented, let alone have an effect. In stark contrast, the bank base rate is usually altered or updated every month, with other tools being monitored with similar consistency.

For these reasons, monetary policy is the preferred, dominant form of macroeconomic management today. However, that is not to say it doesn’t have its own flaws. Many New Keynesian economists argue that although monetary policy is extremely competent at keeping inflation at bay during a boom, it is far less successful in its endeavours to increase spending in a recession. The argument falls behind the title “pushing on a string”, and states that no matter how low interest rates fall, or by how much the money supply increases, the main determinant of expenditure and investment is to be found in Keynes’ original concept of ‘animal spirits’. Using an appropriate analogy of pushing on a string to show how ineffective the policy may be, economists still contend that unless business and consumer confidence is strong, low interest rates or cheaper mortgages will have little or no effect on overall demand. Another issue regarding monetary policy is its tendency to create a liquidity trap. This occurs when any attempt by a monetary authority to lower interest rates fails, due to the liquidity preference that, again, Keynes described several decades ago. This states that if members of an economy are fearful of the future, they will accumulate cash, or other highly liquid assets – that is, those which are easily sold or converted into cash. If government bonds are paying very little return, then economic actors would rather possess cash in savings, where at least liquidity is guaranteed. Monetarists have acknowledged that monetary policy can become ineffective when interest rates reach close to 0%, and have responded to this by developing new monetary tools, such as quantitative easing. Instead of buying short-term, low yield government bonds, central banks have experimented with purchasing financial assets from commercial banks. This, in theory at least, should expand the money supply and raise the price of the assets, as a final effort to encourage spending and prevent deflation. The Bank of Japan was the first major central bank to implement such a monetary venture back in 2001 in order to combat deflationary fears. In total, it injected ¥35 trillion into the Japanese economy, but the inflation rate did not rise above 0% until 4 years later. This slow response was discouraging for upholders of quantitative easing, yet several other economies still tested it in the following years. The US, UK and Eurozone all went through with a QE program in the wake of the 2007 financial crisis, where interest rates were bordering on 0%. Did these programs work? The IMF stated that the credit easing that occurred in the late 2000s in advanced economies was critical to the recovery, by reducing risk in the financial sector and underpinning business confidence. However, recent experience in the Eurozone has cast doubts on these claims – despite prolonged expansionary monetary policy, the European Central Bank seems unable to shift consumer spending and investment. With a negative bank deposit rate just announced, the situation is looking desperate for several Euro member states, where inflation has fallen dangerously close to 0% and growth has seen pitiful shifts in the desired direction. Whether or not quantitative easing and other unconventional monetary policies are viable or effective remains to be confirmed, but it does show that the manipulation of monetary variables is an ever evolving category of macroeconomic management, adapting to provide potential solutions to current affairs.

Looking at the global economy around us, it is clear to see that monetary policy is indeed the dominant form of macroeconomic administration. Nevertheless, as stated at the beginning of this discussion, no policy could successfully support or maintain a stable economy on its own. Just so, despite the preference of monetary policy, fiscal policy is still in widespread use. One only needs to look at the colossal state bailouts of financial institutions after the crisis in 2008 or the sizeable fiscal stimuli still used by governments around the world today to realise that fiscal policy has certainly not been consigned to the scrapheap. In fact, if anything, the failure of monetary policy to completely rescue the global economy from the wreckage of the recent recession has arguably prompted the re-emergence of fiscal policy in a new light: that of sensible, cautious spending, minimal taxation and reduced debt. Newly elected governments in the UK, US and most of the Eurozone have collectively endorsed the new fiscal concept of austerity; to cut expenditure drastically and eradicate extensive national debts. These governing bodies have also embraced long-forgotten supply-side policies, by endeavouring to raise productivity and boost capital investment. Monetary policy certainly has definite benefits compared to fiscal policy, and when considering most modern, advanced economies, it is accepted as the dominant form of macroeconomic management. But putting the clear advantages of monetary policy aside, through a sensible combination of monetary, fiscal and supply-side policies, the economic authorities of today have the potential to create a far more secure and balanced economy for the future.

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Andrew Tan: Head of Technology and Website Development. 2nd year Economist at St. John's College. Please e-mail me with any inquiries/issues regarding the website at!


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