Why the Federal Reserve Can't End the Recession

Increasingly we're seeing calls from the Left for the Federal Reserve to unleash the floodgates and pump more money into the economy. After all, the argument goes, with unemployment high and inflation kissing zero, what exactly is the risk of getting creative?

The Economist hosts a good online debate about monetary policy, with some experts saying the Fed needs to sit still to maintain its integrity (a position I'm not sure I understand) and others accusing the Fed of reckless abandonment of the economy (a case I'm not sure I buy).

Then there's Richard Koo, chief economist of the Nomura Research Institute, arguing that the whole debate is moot. If banks and companies and individuals are set on deleveraging and paying down debt even with zero-bound interest rates, more Fed action won't make much of a difference. Here's his argument in full:

THE next move for the Fed, a long overdue one in my view, should be to announce that the US is afflicted with a balance sheet recession, a rare disease that strikes only after the bursting of a nationwide debt-financed asset price bubble. With its asset prices collapsing while its liabilities remain, the private sector is forced to deleverage or minimise debt even with zero interest rates in order to repair its battered balance sheets. The Fed should explain that in this type of recession, monetary policy is largely ineffective because those with negative equity are not interested in increasing borrowings at any interest rate. The Fed's continued failure to explain the exact nature of the disease only increases the public's expectations for monetary policy which could lead to a big disappointment later with an equally serious loss of credibility for the central bank.

Moreover, during balance sheet recessions the effectiveness of monetary policy actually depends on the government's fiscal policy. This is because when the private sector is deleveraging, money supply shrinks as bank deposits are withdrawn to pay down debt. The only way to keep money supply from shrinking is for the public sector to borrow money. Indeed the US money supply grew after 1933, following the worst balance sheet recession in history, precisely because of government's New Deal borrowings. Japan's money supply never contracted after 1990 in spite of massive private sector deleveraging, also because of government borrowings.

And be sure to check out the full debate at the Economist.