Hard Money Advocates Are Their Own Worst Enemy

by: David Beckworth
Hard money advocates have been taking a beating in the blogosphere over the past few days, compliments of Matthew Yglesisas, Paul Krugman, Mike Konczal, and Ryan Avent. These critics make some good points about the hard money view. Here is Avent's critique:

The hard money approach is atrocious economics. I don't think it's outlandish (or even particularly controversial) to say that the biggest difference in the outcome of the Great Recession and the Great Depression was the change in central bank approach to policy. An economic catastrophe was averted. What's more, hard money is a great force for illiberalism. Sour labour market conditions fuel anger at the institutions of capitalism and free markets. And when countries are denied the use of normal countercyclical policies, they quickly reach for illiberal alternatives like tariff barriers.

These points are often overlooked by hard money supporters. There is, however, an even bigger problem for them. Most hard money advocates are in the GOP, which also happens to be calling for fiscal policy restraint. The belief is that hard money and sound government finances are necessary for a robust recovery to take hold. The problem is that the hard money approach -- which means tightening monetary policy -- makes it next to impossible to stabilize government spending. It also makes it likely the economy will further weaken.
How do we know this? First, in almost all cases where fiscal tightening was associated with a solid recovery, monetary policy was offsetting fiscal policy. Last year there was a lot of attention given to a study by Alberto F. Alesina and Silvia Ardagna that showed large deficit reductions were often followed by rapid economic expansion. Further digging by the IMF and by Mike Konczal and Arjun Jayadev found, however, that this was only true when monetary policy was lowering interest rates. Fiscal tightening coincided with a recovery only because monetary policy was easing.
Second, a key lesson of recent years is that monetary policy overwhelms fiscal policy. Thus, from 2008-09, when monetary policy was effectively tight, the easing of fiscal policy didn't quite pack much of a punch. Similarly, in late 2010/early 2011, when there was not much fiscal stimulus but some monetary policy easing under QE2, there was some improvement in the pace of recovery.
Third, another lesson from the recent crisis and the Great Depression is that if tight monetary policy is dragging down the economy, it opens the door for more active fiscal policy. Imagine if the Fed had been able to stabilize nominal spending more effectively and thus prevented the economic collapse in late 2008/early 2009. It would have been a lot harder to justify the large fiscal stimulus package. The same is true for 1929-33. Had the Fed not been passively tightening monetary policy at that time, there would have been far less political support for fiscal policy and government intervention in the economy.
All of this indicates that calls for tight monetary and tight fiscal policy simply don't make sense for the GOP. Such an approach would most likely cause the cyclical budget deficit to increase even if the GOP successfully lowered the structural budget deficit. More importantly, with tight monetary policy there would probably be no recovery to show for the budget deficit cutting. This would make it politically tough to do further fiscal reforms.
If the GOP wants to meaningfully address budget problems it needs to soften its stance on monetary policy. Otherwise, it risks becoming its own worst enemy.