What's the Best Fix?

The changing structure of the U.S. economy has also led to a bias in favor of monetary stimulus over fiscal stimulus. In an economy where consumers don't have much debt and are mostly buying goods and services produced by their neighbors, as was the case in the 1930s, creating make-work jobs has a quick and significant impact. But in an economy where consumers and businesses have lots of debt and where they buy a lot of goods and services made by foreigners, as is the case today, monetary stimulus would likely pack more of a punch. To the extent lower interest rates filter into the broader economy—through mortgage refinancing, or lower rates on consumer debt—monetary stimulus can improve everybody's financial well-being without boosting deficits.

That's the theory. The problem is that in this downturn, massive monetary stimulus hasn't worked its efficient, elegant magic. The Fed has reduced the short-term interest rate it controls from 5.52 percent in September 2007 to 0.25 percent today, effectively lowering the price of short-term money by 95 percent. But the cuts haven't translated into proportionately cheaper money for the economy at large. As I pointed out last summer, banks used the cheap funds to patch up their own balance sheets and prepare for further losses. What's more, the favored version of fiscal stimulus—tax cuts and rebates—hasn't worked, either. The rebate checks sent out in the spring of 2008 were eaten up by higher food and gas prices.

That leaves two possible solutions. One has never really been tried in a sustained manner. Having exhausted its traditional tools of regulating interest rates, the Fed could print money and use it to buy assets from banks and financial institutions. The second solution—a big stimulus package fueled by government spending—hasn't been tried in 75 years. The main concern about the package as currently envisioned it not that this type of stimulus won't work, it's that, as Paul Krugman frets, it might not be big enough.

Critics of fiscal stimulus would have us think that policymakers face an either/or choice—either fiscal or monetary stimulus. The reality is that the situation calls for an "all of the above" approach. Fed Chairman Ben Bernanke warned Tuesday that fiscal stimulus alone won't do the trick. In general, I think analogies between the current economic situation and the Great Depression are overblown. But there's one comparison that holds true. Just as in the 1930s, the financial and political powers that be have screwed things up so powerfully that the usual tools and established orthodoxies aren't of much use.

© 2009