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public-policy
textbook
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05 Sep 2021
Jeff Moyer and I worked throughout this year to update this textbook - in print next summer, just in time for Fall 2022.
Unexpectedly, my main challenge was in writing on monetary policy, and in trying to fairly describe the Fed’s actions during the coronavirus crisis. It is, of course, too early to tell what the Fed has wrought upon us, and the debates on what the central bankers’ actions mean for inflation, growth and social inequality rage fiercely.
I could write very little about policy effects (too early to tell) although my curiosity over what will happen over the next few years is extreme. However, I’m quite happy with my updates on both fiscal and monetary policy. See a sample below (footnotes are deleted here, but will be present in the published text). Buy it when it comes out! :)
[…]
For most countries, the global economic crisis triggered by the COVID-19 pandemic was the worst on record since the Great Depression of the 1930s. The United States was no different, seeing a massive rise in unemployment, a stock market crash, and the near-collapse of several economic sectors, most notably tourism and large parts of the energy industry. The federal government response, in turn, was of enormous scale, completely dwarfing the programs put in place during the 2007–2009 Great Recession. Both Congress and the Federal Reserve implemented a wide range of measures to mitigate the impact of lockdowns and economic collapse, pertaining to both fiscal and monetary policy.
Monetary policy refers to central bank activities with regard to money liquidity and lending; fiscal policy, by contrast, is a much wider domain, referring to all taxation and spending. In the United States, monetary policy falls under the purview of the Federal Reserve, an agency with a powerful if relatively limited mandate, while fiscal policy is the nearly exclusive domain of Congress. In early 2020, the Federal Reserve moved first, partly because putting out fires is part of its core mission and partly because it is an independent agency with a relatively non-partisan composition, and therefore much less subject to gridlock than Congress.
Throughout much of the twentieth century, central banks did little other than adjust interest rates and reserve requirements, looking to influence economic cycles through the availability of money. Adjusting the money supply — as well as its rate of flow — has a downstream effect on interest rates, growth, and inflation. Very simply put, the theoretical effect of increasing the money supply is lowered interest rates; this increases the affordability of both personal and business borrowing, resulting in corporate expansion and greater consumption. With increased activity, businesses hire more workers and pay higher wages, which results in higher personal incomes, faster velocity of money, and even greater liquidity. This virtuous cycle may end, however, with a rate of inflation that is too high, meaning, with rapid and generalized price increases. When this occurs, central banks usually “tighten” the money supply by taking money out of the system, causing a raise in inter-est rates and hopefully a reverse in the effects enumerated above. In brief, central banks are always engaged in a delicate balancing act with the aim of keeping inflation rates low and stable and markets functioning smoothly, in order to somewhat attenuate economic cycles and attempt to lessen the impact of recessions without considerably impeding growth.
Consequently, the first thing the Federal Reserve did in response to the pandemic was to cut rates to zero. As a matter of fact, this is an oversimplification of what actually takes place on such occasions: the Federal Open Market Committee, a twelve-member decision-making body, does not have the power to coerce banks to charge an exact rate: rather, it sets a specific interval as a target (it was 0.00 percent to 0.25 percent throughout 2020) and then it indirectly nudges the banks toward it by adjusting the money supply.
The problem was that within days, the Fed recognized that simply cutting rates would not be enough, especially since the practice can backfire if most investors flee to cash rather than stay in a market with very low yields. This is called a liquidity trap: if interest rates are close to zero, inflation negligible, and stock placements risky, then most everyone moves to cash and money velocity drops, resulting in an even more serious liquidity crisis. The Fed therefore moved aggressively to stabilize the financial markets through a large number of measures, the most impactful of which fall under the umbrella of quantitative easing.
Quantitative easing (QE) is the practice of large-scale financial asset purchases by central banks in order to inject money into the economy. Since the world of finance is replete with liquid metaphors, consider the following analogy: a thriving community, living in a Saharan oasis, has to live through a prolonged desert storm. Rumors start to spread that water could be running out, and that the natural ground water sources are being depleted. Households begin hoarding water, agriculture grinds to a halt, and before long the poorest begin to suffer with no work and water prices high. What can a local government do?
Almost universally on such occasions, the leadership attempts to keep the water flowing at all costs: they freely distribute water and make public promises in order to restore confidence, and within some time, and at some expense, fear subsides and water starts flowing again. Quantitative easing is much the same play but with a significant advantage for the central banks, since unlike water, fiat money can be created out of thin air.
The practice is relatively recent, with the term having been coined in the mid-1990s, and implemented at scale on only two occasions: in response to the Great Recession of 2008 and to the COVID-19 crisis a dozen years later (with few exceptions, notably in Japan during 2001–2005). It is the subject of much debate, especially given the scale of the monetary expansion of 2020: more than a quarter of all dollars in existence on January 1, 2021, had been printed within the previous twelve months.
The Federal Reserve purchased securities very aggressively during 2020, adding more than $2.7 trillion to its balance sheet (an approximately 70 percent increase over the $3.9 trillion held in early 2020). As recently as 2007, the Fed balance sheet had been well under $1 trillion. Corporate bonds represented more than a quarter of the spending, in a completely unprecedented move for the U.S. central bank, critiqued by some as a nationalization of financial markets.
Other major programs included the following:
• The Primary Market Corporate Credit Facility, which allowed the Federal Reserve to buy new bonds and provide loans
• The Secondary Market Corporate Credit Facility, which allowed the Federal Reserve to purchase exchange-traded funds and corporate bonds
• Repurchase Agreement (or “Repo”) Operations, through which the Federal Reserve increased by an order of magnitude the amount of money available for overnight institutional lending (from $100 billion to $1 trillion in daily repo)
• The Commercial Paper Funding Facility, through which the Federal Reserve lent at a rate significantly higher than the repo market, with losses covered by the U.S. Treasury
• The Primary Dealer Credit Facility, through which the Federal Reserve offered no-interest loans to the “primary dealers,” the large financial institutions acting as gatekeepers to the financial markets
• The Money Market Mutual Fund Liquidity Facility, through which the central bank essentially guaranteed redemptions of short-term loans
• The Main Street Lending Program, through which the central bank lent to companies too large to qualify for the programs of the Small Business Administration
• The Term Asset-Backed Securities Loan Facility, to backstop losses of holders of asset-backed securities (e.g., student loans, auto loans, credit card loans)
• The Municipal Liquidity Facility, through which the Federal Reserve lent directly to state and local governments, including to public agencies (e.g., the New York Metropolitan Transportation Authority)
By early 2021, it seemed like the Fed’s response to the coronavirus crisis could be quantified as somewhere in the $3 trillion to $6 trillion range, in service to a nation-state with a gross domestic product of just above $20 trillion.
There is much controversy with regard to the socioeconomic effects of quantitative easing, especially in its “infinite” form, and most acutely as it concerns inequality. The last decade has seen a flurry of research work on the subject, with supporters claiming that QE reduces inequality by attenuating economic contractions, and opponents pointing out that its main effect seems to be equity price appreciations. As shares are held very unevenly, stock market booms favor the richest.
Officially, the Federal Reserve has engaged in four rounds of Quantitative Easing during the first two decades of this century: QE1 (2008–2010), QE2 (2010–2012), QE3 (2012–2014), followed by a tapering of activity until the “infinite” QE4 of 2020. The same years (2008–2020) saw a rapid increase in American inequality, as well as a significant drop in life expectancy and various other socio-economic outcomes.
The extent to which Federal Reserve policies are related to wider social developments remains much debated. In any case, even if the Federal Reserve Board wished to influence social indicators, it has no legal mandate and no tools through which to achieve wider goals. The central bankers are somewhat akin to the hedge-hog from the famous essay by philosopher Isaiah Berlin (“a fox knows many things, but a hedgehog knows one big thing”), in that liquidity is their only play.
This brings us to fiscal policy. By far, the greater share of responsibility with regard to taxation and spending lies in the hands of Congress: “The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States…” (United States Constitution, Article I, Section 8, Clause 1). In other words, the power of the purse is vested in Congress, with the executive and judicial branches playing a much less important role in budgeting.
Under the initial shock, Congress reacted swiftly, passing the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) nearly unanimously, although it was at the time the largest economic bill in U.S. history, equivalent to more than 10 percent of gross domestic product.
This set of measures attempted to target nearly every section of American society, notably providing:
• Economic Impact Payments of up to $1,200 per adult and $500 per child
• Economic Injury Disaster Loans and a Paycheck Protection Program (PPP), through which small businesses could access funds to pay eight weeks of payroll costs and benefits
• Loans through the Economic Stabilization Fund to larger businesses, states, and municipalities
• Enhanced unemployment benefits, through the Federal Pandemic Unemployment Compensation (FPUC), providing the unemployed with $600 per week in addition to their state aid allocations
• Direct payments to health-care providers and medical equipment manufacturers
• A wide variety of grants, loans, tax credits, deferrals, and deductions, as well as a foreclosure and eviction moratorium to prevent a homelessness crisis (more than a quarter of all rental units were concerned).
The money was spent relatively quickly, with small business loan funds exhausted in mere days, and with federal unemployment payments ceasing at the end of summer 2020. Congress stalled during the months preceding the general election of November 3, 2020, while electoral concerns took center stage and each side campaigned heavily. Unfortunately, the election turned out to be close, provoking chaos in Washington, DC, including public spats between President Trump and various members of Congress. While fighting election results in courts, Trump also brawled publicly with Republican majority leader Mitch McConnell on the topic of the much-delayed relief bill (McConnell was highly averse to the idea of further direct payments; Trump, on the other hand, considered them a necessity).
The second stimulus bill (the Consolidated Appropriations Act, 2021) did finally come into effect, however, on December 27, 2020. It was, again, the most expensive spending measure ever enacted, at $2.3 trillion, as well as the longest, at 5,593 pages. Members of Congress had no opportunity to review it, as they gained access to it only shortly before the vote, but nonetheless Congress approved it overwhelmingly. (It should be noted that only around $900 billion was targeted at coronavirus relief during this second act, with the rest of $1.4 trillion representing a regular omnibus spending bill for the 2021 fiscal year.)
The merits of congressional actions in response to the coronavirus crisis will no doubt be debated for decades to come, although a number of both successes and failures became apparent almost immediately. One example of the former could be the engagement of hospitals, pharmaceutical companies, and medical manufacturers: U.S. healthcare facilities generally held up well, and U.S. companies produced multiple vaccines in record time, placing the country at the international vanguard of fighting the pandemic. In the medical field, ample funding could perform miracles, likely because the infrastructure already existed.
On the other hand, millions of unemployed people suffered as their applications went unanswered for months on end, as state unemployment systems buckled under the onslaught of new filings. Not able to reach state agents by phone or mail, many Americans had to turn to informal online forums such as Reddit to attempt to check their own eligibility and obtain help with filing. A year into the crisis, unemployment assistance remained out of reach of millions. The federal government does have guidelines with regard to application response timeliness, insisting that states should respond to most applicants within three weeks; during 2020, all but three states failed to meet the guidelines, often by months.
The coronavirus pandemic performed an unusual stress test on American institutions. Important questions have arisen with regard to the powers of the Federal Reserve, the ability of the two-party system to quickly respond to challenges, and state-federal coordination in times of duress. Most notably, an unelected committee of seven people—the Board of Governors of the Federal Reserve System—and principally its chair, Jerome Powell, were responsible for more money injections into the economy than the Congress of the United States. The fiscal policy side of the coronavirus response amounted to around $3.1 trillion at the time of writing; the monetary policy side, while difficult to quantify with precision, will have amounted to more…
