Stiglitz: We need more stimulus, not quantitative easing

I'll have a column this weekend on what Fed Chairman Ben Bernanke needs to do to make a second round of quantitative easing work. As part of my reporting for the column, I called Nobel Prize-winning economist Joseph Stiglitz, who's been very skeptical of further action from the Fed. The column, in part for reasons relating to my assessment of the politics of the issue, ends up taking a different position than Stiglitz, but I thought it worth publishing his interview in full, and he graciously agreed. An edited transcript follows.

Ezra Klein: You’re skeptical of further action from the Federal Reserve. Why?

Joseph Stiglitz: The Fed, and the Fed’s advocates, are falling into the same trap that led us into the crisis in the first place. Their view is that the major lever for economic policy is the interest rate, and if we just get it right, we can steer this. That didn’t work. It forgot about financial fragility and how the banking system operates. They’re thinking the interest rate is a dial you can set, and by setting that dial, you can regulate the economy. In fact, it operates primarily through the banking system, and the banking system is not functioning well. All the literature about how monetary policy operates in normal times is pretty irrelevant to this situation.

EK: But didn’t quantitative easing work in 2009?

JS: But think of the various channels through which monetary policy will operate now. The one that traditionally is the focal point is investment. Remember that quantitative easing’s effect on interest rates, after all, is only .2 or .3 percent. So broadly, there are two categories of firms right now: the large enterprises flush with cash -- they’ve got about $2 trillion, and a slight change in the investment rate won’t change their investment policy. Then there are the small and medium-sized enterprises that are cash-starved, and here, the funds need to be channeled through the banking system, and that part of the banking system is still sick. So if normally it might have a small effect, now it’ll have a smaller effect. So that channel is blocked.

Then there’s a second channel, which is the mortgage market. Those interest rates will go a little lower. But again, it won’t directly affect very much. We have too much capacity already. Those lower interest rates will move some money around, taking it from the elderly who hold long-term government debt and put it into the hands of people with mortgages. That’s just redistribution.

Third, it will have a very small effect on equity prices. But that won’t have much effect on either consumption or investment. People recognize that this is a temporary intervention and the government won’t maintain it for long, so they won’t run to spend that money. There might be some help on collateral prices, but that won’t be much.

Then there’s competitive devaluation, which is that lower interest rates could lead to a lower exchange rate. But for that to work, other countries need to allow it to work. And they’re saying that they won’t, that they’ll get into currency wars with us, and that may be worse.

EK: What about people who say that the right thing to do now is to put monetary and fiscal policy together, so the government spends and the Fed buys bonds to make sure the spending doesn’t raise interest rates?

JS: People who say that are living in a peculiar world. In normal times, people would worry about fiscal expansion driving up interest rates and government spending crowding out private spending. In those times, monetary policy could undo this crowding-out effect and increase the effectiveness of fiscal expansion. But all the evidence is that as government spending went up during the last two years, interest rates didn’t go up, and are not likely to go up now. We are not in a crowding-out situation. You can’t talk about crowding out with interest rates at 2 percent.

EK: And presumably, if you did a fiscal expansion now, you could always bring in monetary policy later if interest rates did rise.

JS: My view is that if it turns out that that’s wrong and fiscal expansion brought interest rates up, monetary policy would have to be brought to bear. But the way I’d think about using monetary policy first is in a cost-benefit analysis. The likely benefit of monetary easing is very low for all the reasons I’ve said. Now, if it were costless, you might say, sure, the Fed messed up, it feels guilty, it wants to show it’s worried about unemployment, so why not let it do what it can do? But this is not costless.

The first cost is the potential of currency wars, which we talked about. The second cost, which people haven’t talked about, is that the reason the private market for mortgages has dried up is that everybody knows the moment the government withdraws from the mortgage market, the effect will be that there will be a capital loss on the mortgages -- and the same thing goes for our long-term bonds. Now we don’t use mark-to-market accounting, so we’ll pretend they don’t occur, but they will have occurred. We’ll have experienced a loss. The third point is that to avoid recognizing the loss, the Fed is likely to do silly things, like rather than buying and selling government bonds, they’ll pay interest on deposits banks make to the Federal Reserve in order to absorb the liquidity.

There are two problems with this. First, it’s costly, as we’re now paying interest when we didn’t before. Second, we don’t know how well this will work. And because it’s uncertain, you might say that the financial markets, recognizing we’re going into uncharted territory, will request a risk premium. That’ll hurt the U.S. Treasury and would be bad for the economy. So this is not costless. If it were the only instrument, you might say we have no choice. But it’s not. Fiscal policy is a choice, or it should be a choice. By putting fiscal policy off the table, we’re moving down the cost-benefit curve to something much riskier and much less cost effective.

EK: Why are you so confident that more fiscal policy will work?

JS: The point is the stimulus did work. They made a very big mistake in underestimating the severity of the downturn and asked for too small of a stimulus, and they didn’t do enough in the design. About 40 percent was tax cuts, and we all knew that wasn’t going to be very effective. But it worked; without it, unemployment would’ve peaked between 12 and 13 percent. With it, it peaked at 10 percent, and that was an achievement. A better, bigger stimulus would’ve gotten it still lower. The severity of the recession was too big to be dealt with by a stimulus of that size. I’d also note that one-third of government spending is at the state and local level, and you’re seeing cutbacks there, which is why we’re losing jobs. If you look at the net stimulus -- federal and state and local -- the full stimulus was extremely small, particularly when you see how much was tax cuts.

EK: And part of the argument here is that the channels by which fiscal policy operates are more straightforward than the channels by which quantitative easing operates, right? If the Fed buys long-term Treasury bonds, other things need to happen before anyone gets a job. If the government decides to build a bridge, people who build bridges, and people associated with the building of bridges, get jobs.

JS: Right. We know from the historical experience that unemployment benefits get spent almost dollar-for-dollar, and infrastructure spending actually gets spent, and you get new assets to boot.

EK: So if I understand your argument as a whole, it’s that we should be doing fiscal policy, and the Federal Reserve should basically announce that they won’t let interest rates rise, but shouldn’t step in before they’re specifically needed.

JS: Exactly. And one more thing: It would be good if more of the spending shifted to investment. Borrowing increases debt and investing increases assets. If markets were rational, they would look at this and say our fiscal position was actually getting stronger. I joke that one of our advantages is that we’ve underinvested in the public sector for a decade, and so we have many high-return investments to choose from.

Photo credit: Andrew Harrer/Bloomberg News.