Monetary policy in the time of (financial) cholera

I was on CBC’s The House this weekend on the US economy and its implication for Canada and the federal budget. My co-commentator was Chris Ragan, of McGill and CD Howe. We are in general agreement as far as diagnosis goes, though he seems more optimistic than I about Canada’s ability to stay clear of the Tasmanian devil that is the US financial system right now.

But Chris thinks that all the heavy lifting should be done by monetary policy, arguing that fiscal policy comes on too late. I’m more sympathetic to the notion, expressed by Paul Krugman and others, that monetary policy is increasingly ineffective given the nature of problem: insolvency, not illiquidity; a whole category of assets based on sub-prime that no one wants to hold, a kind of financial cholesterol clogging up the financial system. Some kind of bailout seems ever closer as the crisis deepens.

To the extent that this financial crisis spreads to the real economy, we (Canada) will need to limber up our fiscal policy. If that happens, the first place to start is by running a deficit – a deficit will happen “naturally” due to weakening macro forces given the razor thin surpluses in Ottawa looking forward. The trick is not to start cutting spending for the sake of a balanced budget under any circumstances (Chris agreed with me on this one). For most other countries, who have been running deficits for a few years, this is not news, but in Canada the deficit holds a dark place in the national psyche. Politicians just do not want to go there, policy be damned. Yes, matching US interest rate cuts needs to be part of the Canadian strategy lest the dollar appreciate even more against the greenback, but monetary policy needs some back-up if things keep unfolding as they have.

I have resisted quoting Krugman given his already large presence online. But let me cite just one passage then add some Canadian content:

Right now, Ben and co. are trying desperately to get a grip on the economy’s problems. One big part of their loss of grip is that cuts in the interest rates they can control aren’t translating into reductions in the interest rates that matter for the economy. In particular, they know that the most important channel through which monetary policy affects the economy is housing — and the Fed’s cuts have not succeeded in producing easier mortgage credit, because the financial system has been falling apart.

(As an aside: I find it somewhat annoying, now that Paul Krugman has his own blog, that some of the biggest US econobloggers like Brad deLong and Mark Thoma repeat verbatim on their blogs everything that Krugman has just posted on his blog. If you want to add some commentary, fine, but let folks go to Krugman’s blog themselves (rss, anyone?). I say this only because, gentle reader, you really should be going to Krugman’s blog if you are not already, as his contains the most up-to-date analysis of the continued woes of the financial markets and sub-prime debacle.)

The Canadian content: I was looking at interest rates the other day and the same key problem is cropping up in Canada. The Bank of Canada is now in rate cutting mode but key interest rates in the economy are, if anything holding steady or going up. The Bank controls the overnight rate, and at 3.5% it is down a full percentage point since November, but both one- and five-year mortgage rates, for example, have dipped very slightly since the start of the year and are much still higher than any point in the past seven years. The Bank’s rate cuts may help ease some cash flow problems for the chartered banks, but they are not clearing out the cholesterol, and do not appear to be rippling through the rest of the interest rate structure as determined by the market.

Ragan’s point is that fiscal policy may not do so either, and he is right. He makes the standard argument that fiscal policy is too slow to respond and can get politically loaded. I think if we focus on getting money into the hands of people who need it, it can ease the pain, though it does not directly deal with the heart of the financial crisis. As for infrastructure spending, I think we should be drawing up plans because this recession has the prospect of being longer and deeper; maybe so, maybe not, but it is prudent to prepare for the worst, and if we focus our efforts on retooling for a more carbon neutral economy there would also be long-run benefits beside the short-term propping up of employment.