Dems Need to Pay Attention to Monetary Policy!

I’m not nearly the first to this party, but want to bring it up for my readers who may not be clued in to it.

For the second year in a row, some of the best economics bloggers on the Web (this year: Matt Yglesias, Mike Konczal, Karl Smith, Lisa Donner), did a session at Netroots Nation on monetary policy, and how the progressive left (including Democratic lawmakers) needs to saddle up and counter the destructive right-wing influence in this area.

Why the Fed is the Most Important Economic Issue You Know Nothing About

This is a big deal. Monetary policy often, even usually, has a far more potent effect on national well-being and the distribution of wealth and income than the fiscal policy that progressives consider to be so important. (At least in the short- to medium term.) Those fiscal issues are important. But ignoring monetary policy is like ignoring coal plants in discussions of global warming.

Lefty idol Paul Krugman has given this example a zillion times: when Volcker opened the monetary taps in ’83 (after clamping down to tame inflation), the economy — and the employment situation — turned around hugely, within months. That was something of a special case, but it imparts the potential power and immediacy of monetary policy compared to many/most fiscal initiatives, which usually take quite a while to play out, and are rarely large enough to be big short-term game-changers.

But in the political realm, Democrats have largely ceded their voices to the ‘Pubs (HT Ryan Cooper) and their inflation hysteria (which survives like a zombie that won’t die, year after year, even while being wrong, year after year):

“I wish you would take QE3 off the table,” said Texas Rep. Kevin Brady, the ranking Republican on the committee. “I wish you would look the markets in the eye and say that the Fed has done too much.” Similarly, Sen. Jim DeMint (R-SC) complained to Bernanke that many of the stimulative measures the Federal Reserve has taken “are giving us a false sense of security.”

By contrast:

The ranking Democrat on the committee, Sen. Bob Casey, merely inquired, in a neutral tone, whether the Federal Reserve was planning to take further action. Bernanke simply replied that the Fed was still contemplating the matter, and a lot depended on whether “there will be enough growth going forward to make material progress on the unemployment rate.” (Fed officials meet on June 19 to discuss their next steps.)

The Fed is supposed to:

1. Provide for both stable prices and full employment.


2. Be politically independent.


1. It has criminally abdicated its responsibility for employment in recent years, while fetishizing its inflation mandate.

2. It is subject to political pressure, as the quotations above make clear.

More proof of #2, from Binyamin Applebaum (HT Matt Yglesias), quoting Eric S. Rosengren, president of the Federal Reserve Bank of Boston:

“We’ve done things that are quite unusual. We’re using tools that we have less experience with,” Mr. Rosengren said. “Most of the criticism has been that we’re being too accommodative. That is a concern that we have to put some weight on.”

It’s time for progressives and congressional Democrats to start exerting some of that pressure. Pay attention, people!

Cross-posted at Angry Bear.







13 responses to “Dems Need to Pay Attention to Monetary Policy!”

  1. Detroit Dan Avatar
    Detroit Dan

    Steve– This is crazy! Monetary policy is worthless, in my opinion. Yglesias, Krugman, Smith, and all are wrong. The Fed is powerless. They can backstop the banks, but can’t get money circulating in the economy. This is the single stupidest position taken by liberals, in my opinion.

    Tell me why I’m wrong…

  2. vimothy Avatar

    @Detroit Dan


    Imagine a typical firm engaging in some sort of production process. Importantly, there is an amount of time between the start of this process and the point at which it sells the output so produced. Because of this gap, the firm borrows to cover its costs against its future expected revenue–it has to pay its workers before it is able to reap any reward from the efforts of their labour, etc, etc.

    Therefore, the rate at which the firm borrows contributes to its cost of working capital. If the central bank can raise this rate to a high level, and keep it there for a long time, it can discourage firms from investing–think of a firm making a net present value calculation when deciding to undertake a project. Similarly, it can also do the reverse. This is known as the “cost channel” of monetary policy.

  3. Tom Hickey Avatar
    Tom Hickey


    Right, firms tend to borrow to cover payroll. As rates rise, that compresses the profit margin, effectively raising the cost of labor without raising the wage and increasing worker income allowing consumer prices to be bid up. But at first, count on firms raising prices instead compressing margins to the degree they can. When that is not possible any longer, then they may compress margins somewhat to stay in the game while the economy is still hot. But at some point in margin compression, firms in aggregate will recognize that this is not a viable strategy for them in that their ROI is slipping below an acceptable level. Then they start laying people off, which reduces worker incomes in aggregate and creates a drag on AD that slows the economy and reduces wage pressure as the buffer stock of unemployed expands.

  4. vimothy Avatar


    There are many stories that we could tell about monetary policy. The story that I was trying to tell is a story in which there is an amount of time between investment in a particular project and sale of resultant output. During this period, there is nothing to sell and no revenue: hence the need to borrow from banks or capital markets to meet payroll, etc.

    Since the CB can make the effective cost of labour arbitrarily high, it can move these projects into sharply negative net present value.

    Why tell this story? To decompose monetary policy into constituent effects. The only effect of monetary policy is not on aggregate demand (via: cost of capital, wealth effects, income effects, and intertemporal substitution effects), but also on aggregate supply, via the cost of production for firms who require credit to finance their working capital needs.

    Either way, it seems wrong to say that monetary policy can have no effect. It can have lots of effects, some of which you note in your comment, and some of which I’ve noted here.

  5. Tom Hickey Avatar
    Tom Hickey


    Yes, I was agreeing that monetary policy works through the investment channel to force supply adjustment, which reduces worker income in aggregate, which gets passed to aggregate demand. I was just trying to show from a firm perspective how monetary policy affects supply by increasing costs that lead to reducing inventory accumulation, which eventually leads to lower aggregate worker income due to layoffs, which then reduces AD.

    I think that many people believe that raising rates increases cost of capital thereby reducing investment in capital goods, or else raises consumer borrowing rates, which is in effect a price increase that slows consumption. I don’t disagree that there is some of this happening, and that the real punch of monetary policy in raising rates act through the housing channel longer terms.

    However, the immediate effect is through increased borrowing cost to meet payroll. This is in effect a wage increase, and firms are very sensitive to wage increases, since labor is the major expense in most firms. Add that to rising PPI due to inflation, and there is either a profit squeeze or layoffs and eventually layoffs win when cost of goods sold rises faster than consumer price inflation can offset, as consumers begin to resist. So price-increase resistance on the part of consumers is one jaw of the vise, and rising labor costs due to increased borrowing cost is the other.

    Everyone in business for a while knows this drill and the cb knows it, too. That’s how they increase the buffer stock of unemployed to reduce labor bargaining power, hence wage pressure, to reduce inflationary pressure under NAIRU.

  6. Asymptosis Avatar

    Sorry to be slow getting back to this.

    I think Dan may be talking about our current ZLB/IOR situation, not the general efficacy of monetary policy. (Personally, I can’t ignore the ’83 employment turnaround within months when Volcker eased.)

    It’s much harder to tell a convincing monetary stimulus story right now. Pushing on a string and all that. So my call to arms is a longer-term call.

    But the objection that I find implicitly in Dan’s post has real merit: we need fiscal, and Dems ranting about monetary — suggesting it can do what the fiscal authorities won’t — is something of a rhetorical surrender.

  7. Tom Hickey Avatar
    Tom Hickey

    SR: “But the objection that I find implicitly in Dan’s post has real merit:we need fiscal, and Dems ranting about monetary — suggesting it can do what the fiscal authorities won’t — is something of a rhetorical surrender.”

    The point is that monetary policy works quickly by increasing and decreasing labor costs by the borrowing cost of working capital as I pointed out above. Otherwise it affects asset prices, often quickly due to expectation, but certainly longer term via housing through mortgage rates.

    So monetary policy can contract supply to increase labor cost and the buffer stock of unemployed to reduce wage pressure, and it can reduce rates to lower the cost of labor but this doesn’t create a demand for labor absent rising demand. Increasing asset prices may increase consumption in the top tiers but not in the middle and bottom. Similarly, reducing the cost of borrowing may increase consumption somewhat, but consumer credit is not very responsive to monetary policy, but rather to income changes and credit capacity. Monetary policy does not affect either income or credit capacity.

    When monetary policy contracts a burgeoning business cycle when inflation flares, usually at the point at which wage pressure increases, by increasing labor cost to affect supply and through that incomes, credit capacity often remains, so that when rates drop even without an immediate increase in income, the credit channel is still open to fuel demand increased through expectation of better times and more income. But when credit capacity is locked down at the end the long financial cycle, there is no way to increase demand, which is the signal to firms to invest, other than fiscal policy that targets transfers to the middle and bottom to ignite “trickle up.”

    While I admit that expectations play a role, they don’t without a perceived transmission mechanism, even if that perception is wrong, like the erroneous perception that increasing monetary base necessarily increases the money supply, which is “inflationary.”

    Where is the transmission mechanism that increases demand by lowering rates at the end of a long financial cycle when credit capacity is exhausted and incomes are stagnant? Without such a causal mechanism, why would monetary policy create the expectations that would prompt business to invest in the face of low demand? It’s like asking firms who wants to volunteer to walk the plank first. Yes, it’s the paradox of thrift as far as the firms setting on trillions in savings goes, but can monetary policy prompt all in? Otherwise, it’s not in the interest of anyone to go first alone to test the waters.

    The problem is that there has been too much credit money creation by the private sector in relation to government money creation so that debt overhand is creating a drag that has to be worked through over time, liquidated by liquidating “malinvestment,” or restructured — unless govt steps in and seeds the pot with increased NFA to offset domestic and external saving desire due to delevering, rebuilding balance sheets, and appetite for cheap imports.

  8. Asymptosis Avatar

    @Tom Hickey

    Right. All of that is what I tried to encapsulate in “pushing on a string and all that.”

  9. Detroit Dan Avatar
    Detroit Dan

    Thanks all! In addition to the pushing on a string thought, it seems to me that monetary policy is generally irrelevant. For example, the Fed usually justs adjusts interest rates depending upon the rate of inflation. The Fed follows; it doesn’t lead. Over the last 30 years, inflation has been driven down by the effect of globalization on wages. So, amidst all the bloviating about what the Fed will do and should do, the Fed has just reacted to the larger global forces. The larger global forces have replaced high priced American labor with lower cost foreign labor. Monetary policy may affected some short term stuff, but overall it was insignificant. Inflation has decreased over the past 30 years despite 30 years of interest rate declines, when the conventional wisdom is that low interest rates should increase inflation. We did get a housing bubble, however, so there’s that to be said for the effectiveness of monetary policy.

    Volcker tried to implement Milton Friedman’s idea that the Fed should control the money supply. This turned out to be beyond the power of the Fed and had to be abandoned permanently. (John Carney has a good write-up on this.) In the meantime, he jacked up interest rates so high that it did actually have an effect on the real economy. And the pain was greatly reduced when he brought interest rates back down to a reasonable level.

    Anyway, thanks again for responding to my venting…

  10. Asymptosis Avatar

    Dan, I think I’ve mentioned in this thread the turnaround when Volcker opened the taps in ’83. I just can’t ignore that. There are situations in which monetary policy seems to have twenty times the immediate leverage of fiscal.

    It seems quite probable that now is not one of those times, and that the current state of things might lead us to misapprehend the bigger picture.

    I really like your notion that declining inflation has been a result of globalization (plus, I think, the increasingly rapid dissemination of productivity-enhancing technology — even if most of the big inventions happened decades ago, their distribution took a while). And that the fed basically followed that deflation down. Makes me wonder about the notion of the Fed being the last mover in the game. Could, in fact be the last mover but over the long haul, they have no real choice. They gotta keep the payment system working…

  11. Tom Hickey Avatar
    Tom Hickey


    SR: “Dan, I think I’ve mentioned in this thread the turnaround when Volcker opened the taps in ’83. I just can’t ignore that. There are situations in which monetary policy seems to have twenty times the immediate leverage of fiscal.”

    Yes, but look at what he had to do to accomplish it. Inverting the yield curve is one thing, double digit interest rates spiking toward 20% was harsh. I am not complaining personally, since I cashed out all other assets and went into T-bills for the duration. It was a vacation from trading with free money being credited to my account.

    Certainly curtailing fiscal that harshly could have had an immediate effect too. So I am not sure that the Volcker example says all that much.

  12. Asymptosis Avatar

    No: I’m talking about when he eased. Unemployment started diving within months.

    But yes, it could be that the Fed only has that moxie when interest rates are that high.

  13. Asymptosis Avatar

    Oh and just to add, I can’t imagine any fiscal measure that would have had anything like that immediate and massive effect at that time.