Fiscal First: Will It Work?

December 22, 2008 3:00 PM

The usual grounds for optimism these days is the fact that the Obama administration is clearly going to propose a big fiscal package with two components: a large conventional stimulus (spending plus tax cuts), and a big housing refinance scheme, in which the Treasury will potentially become the largest-ever intermediary for mortgages.

These ideas are appealing under the circumstances, but this "Fiscal First" approach also has definite limitations, for both domestic and foreign reasons.

Most obviously, Congress will reasonably want to impose constraints on the amount of government debt that is issued, particularly absent a longer-term solution for Social Security and Medicare.

In addition, the administration's big deficit push relies critically on an "easy enough" monetary policy, which, at the same time, precludes "too much money, too soon." They need long interest rates to remain low, particularly for the housing scheme, to make sense. Rates have to come down for borrowers; at the same time as there is sufficient margin to cover credit losses, so it only works if the 10-year Treasury rate is roughly at current levels.

If the Fed eases "too much," then actual or expected inflation will jump. This would reduce real debt burdens and could help reflate the US and global economy more broadly, but the higher interest rates would compromise the fiscal/housing strategy. (If the Fed holds down long rates in the face of sharply rising inflation expectations, then we will have a crazy credit boom that makes all other bubbles seem relatively sensible.)

On the foreign side, all other governments have an incentive to free ride on the US fiscal policy. The dollar will tend to appreciate, on top of any strengthening due to safe haven–related developments. Both Europe and leading emerging markets can, in this scenario, hope to recover based on their exports. Sure, they like to criticize the United States for its role in placing everyone on fragile growth paths with increasingly hard-to-sustain debt paths, but almost everyone would like—in the short-term—to go right back there.

Again, if the US approach were more slanted towards expansionary monetary policy, this would tend to cause dollar depreciation and would force the hand of other governments. Either they would ease their own interest rates and potentially increase their supply of money or their export sectors and growth would suffer further.

Most countries around the world have limited capacity for fiscal expansion, but almost all could engage in a more expansionary monetary policy. This, of course, runs counter to 20 years of orthodoxy in central banking, but nothing is without risks. And that includes the first set of fiscal moves by the Obama administration in their global economic chess game.

This article was also posted on Simon Johnson's blog, Baseline Scenario.