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I agree with much of what Scott Sumner says in this post about liquidity traps and monetary policy. In essence, the idea of a “liquidity trap” is a distraction that reframes the real constraint for monetary policy. I won’t get into the liquidity trap & IS/LM stuff again as those conversations seem to go nowhere. But I think Scott rightly says that the real constraint for a central bank is not usually the economic environment, but the political constraints imposed on it. Specifically, he notes that central banks are not allowed to buy anything and everything and that politicians are generally fearful of the size of a central bank’s balance sheet. These are political constraints, not real constraints.

But that raises another interesting thought. If the Fed could just buy anything then what differentiates it from fiscal policy? I say not much. And here’s where the accounting, which Sumner hates so much, comes in handy. You see, when the Fed buys something on the open market like a US government bond it is just swapping cash for bonds. The private sector doesn’t end up with a higher net worth. Its balance sheet composition changes, but its net worth is the same (assuming no capital gains). But let’s say the Fed could buy something truly worthless, like say, “Roche’s Bag-O-Dirt” (copyright, Tom Brown). That is, what if the Fed offered $100 to anyone who could fill up a bag of dirt and deliver it to the front door of the Fed? Well, then we’re talking about a helicopter drop because the Fed is buying a totally worthless “asset” and just handing you $100 for it. The financial net worth of the private sector goes up by $100 and the Fed takes a bag of dirt and throws it in the incinerator. The Fed is not merely acting as an asset swapper or a lender of last resort. It is acting as a fiscal entity. The key difference is that this policy of buying bags of dirt is adding net financial assets to the private sector.

Of course, this is all a moot point because the Fed can’t do that at present since it is not legally permitted. But for all those “Monetarists” who support such a policy, well, they’re just Fiscalists masquerading as “Monetarists”. As I’ve said before, this isn’t just a Chuck Norris effect, it’s a Bruce Lee effect. As Bruce once said, “saying is not enough, you must do”. And we wouldn’t want to confuse Chuck with Bruce. After all, Bruce kicked Chuck’s ass and even tore his chest hair out. Confusing the two is a crime against humanity.

Source: The Liquidity Trap Myth And The Central Bank As A Fiscal Entity