How to Think About Stimulus

Scott Sumner and Tyler Cowan, among many others argue that creative monetary policy is a better instrument than fiscal stimulus. They argue that policies such as paying interest on excess reserves or setting a nominal GDP target would be better remedies than fiscal stimulus. Paul Krugman and Brad DeLong argue for fiscal stimulus. Is there a way to think about the differences without resort to ideology?

It seems to me that there are two ways people think about the current crisis. One is that we suffer from a huge precautionary demand for savings. Everybody is risk averse, they all want liquidity, and nobody will spend. John Cochrane has articulated this view quite clearly here. If this is the diagnosis then paying interest on excess reserves or other creative forms of monetary policy (quantitative easing) may be sensible. This could unlock the monetary system and revive spending.

The advantage of the monetary policy approach is that it is easy to turn off. So if you believe that the recession is due to this huge risk aversion this is a big advantage. If attitudes return to normal there will be a lot of liquidity out there, but we won't have spending programs in the pipeline that are hard to turn off.

The alternative view, I think, is that the end of the bubble has led to a large destruction of wealth (or realization that it was not there). Between the collapse in housing prices and the stock market a huge share of wealth has been destroyed (more than 45% if we go by the stock market alone). So households must increase savings -- from the former level of zero -- to something like 8% of GDP (we are not there yet, but we will be). So if saving rises something else is needed to make up the gap. It is not net exports -- the currency is not depreciating, so we are not more competitive, and the rest of the world is in a bigger slump than we are. So it is either a huge increase in investment or government spending. It is hard to believe that investment is going to rise significantly when our export markets are deteriorating and when incomes are declining. So it must be the government that has to fill the gap.

Now the anti-stimulus view would be that if we unlock the monetary system banks will lend and firms will invest. The gap can be made up by investment spending rather than government spending. Perhaps that is the case. It is a logical argument. Personally, however, I do not see it. It is not the cost of capital that is hurting investment now but sour prospects.

In any event, it seems that there is a rational argument for both approaches. What is crucial is to figure out which explanation of the causes of the slump is correct.