If our choice is fiscal vs. monetary stimulus, choose monetary

The social distancing resulting from the COVID-19 pandemic has led to a severe decline in economic output and employment. U.S. government policymakers have responded with a blizzard of activity involving fiscal stimulus, credit market support and monetary stimulus. The fiscal stimulus is costly and much of it is likely to be ineffective. The costs of monetary stimulus are far smaller, and thus it is a superior method of economic stimulus.

Many observers lump together fiscal and monetary policy when thinking about “stimulus,” but they are actually quite different. With fiscal stimulus, the federal government redirects existing money from one sector of the economy to another. Money already in circulation is acquired through taxes, or more likely borrowing, and then redirected to various beneficiaries.

In contrast, monetary policy involves the creation of new money, which is then injected into the economy through the purchase of various assets, usually Treasury bonds. Fiscal stimulus leads to a larger national debt, while monetary policy usually reduces the net government debt, as money creation is a source of tax revenue for the government. It is both more effective and much less costly than fiscal stimulus.

Some recent fiscal actions seem justified by the severity of the economic crisis, most notably the extension of the unemployment insurance program to include a wider range of individuals, especially independent contractors. There’s also a good argument for spending more on initiatives to directly address the medical crisis. 

It is much less clear why the government decided to send checks for $1,200 to most Americans, even those with stable jobs. This is especially true given that the COVID-19 pandemic has reduced the typical American’s “cost of living” in two different ways. First, it has reduced the price of a given basket of goods, due to sharp declines in the prices of gasoline and other commodities. Second, it has reduced living expenses by closing down some types of consumption, including tourism and restaurants.

Of course, this second factor is more properly viewed as a reduction in living standards. If we choose to produce less as a way of slowing the pandemic, there is no magic formula for preventing a fall in real incomes and living standards (a basic economic principle is that total aggregate income equals total aggregate production). Regardless, the temporary result of the shutdown of certain industries is extra spending money in the pockets of those who remained employed, so the solution is certainly not sending everyone a $1,200 check. 

One argument for the fiscal stimulus is that it will speed re-employment once the mandatory lockdowns end. Even if this were the case, however, monetary stimulus can achieve the same goal at a much smaller cost. A massive fiscal stimulus will impose a tax burden on future generations.

Right now that future tax burden looks manageable, as interest rates are extremely low. But looking back on economic history, we’ve seen many cases of a “new normal” that lasted for just a few decades and then unexpectedly gave way to an entirely different economic environment. Who can say that interest rates won’t move back to higher levels at some point in the future, in which case a large national debt would become a far more substantial burden?

If there were no alternative, then fiscal stimulus would certainly be worth the risk. But there is a much less costly alternative: Aggressive monetary stimulus. The Fed should follow Ben Bernanke’s advice and consider switching to a “level targeting” approach, which would speed economic recovery by promising to bring the economy back to the previous trend line for the price level (or nominal GDP) once the crisis is over. This should be combined with a “whatever it takes” approach to asset purchases — a willingness to buy as many assets as necessary to hit the Fed’s inflation target.

In my view, the Fed should buy only safe assets such as Treasury bonds when there are enough safe assets to hit its target. But the cost of economic depression is so great that it is better to buy some riskier assets as well rather than fall short of the policy target. 

Fortunately, Congress recently provided funds to cover potential Fed losses on risky asset purchases, if they occur. It would have been better if Congress also indicated that risky assets should only be purchased when absolutely necessary — but any move that insures adequate monetary policy tools is helpful during this economic crisis.

Scott Sumner is an emeritus professor of economics at Bentley University and director of the Program on Monetary Policy at the Mercatus Center at George Mason University.