Stimulus policies are no substitute for supply-side reforms

A lot of pro fiscal stimulus arguments in the USA and the UK come from the classical zero lower bound (ZLB) assumption, in which conventional monetary policy is said to be ineffective when interest rates hit zero (the lower boundary). This means that the central bank is basically ineffective in its further monetary operations to kick-start the economy, since it cannot lower rates to negative levels (this is not to be confused with real negative interest rates).

Low interest rates signal that the government can borrow more since its repayment conditions will be more favourable in times of historically low bond yields (at least in the USA and the UK). This is an example of a counter-cyclical economic policy, one that tries to stimulate the economy out of a recession, and within its scope it is viewed as acceptable to increase the deficit and raise public debt in order to get the economy growing in the short run.

Keeping interest rates too low for too long can however lead to serious systemic instabilities in the longer run. Furthermore, given the type of shock that triggered the crisis, it is doubtful that either short term (fiscal) stimulus or long term interest rate signalling (monetary stimulus) will be particularly effective at promoting recovery.

Near zero rates tend to punish savers and asset-holders (usually older people), which affects their consumption. On the other hand, those who are supposed to borrow (the young) are facing tighter borrowing constraints and high unemployment rates. A combination of these two effects is likely to disable a significant recovery of consumption.

The recent economic history of Japan arguably demonstrates the dangers of keeping interest rates too low for too long. The Japanese central bank has kept rates at zero persistently for the last 16 years. It should also be noted, however, that Ben Bernanke has criticised Japan’s monetary policy on the grounds that it was too slow, its communication policy unclear, and that it was afraid to raise inflationary expectations (this caused Japanese inflation to hover around zero for the past 20 years, with several deflation periods).

Was Japan hit by a one-off aggregate demand shock which could have been easily addressed with monetary or fiscal stimuli? Not likely. It is true that Japan’s economy was hit by an aggregate demand shock in the early 1990s, but the shock reflected structural problems in the economy which were largely hidden due to the previous boom in the 1980s. Japan didn’t fail to react with fiscal or monetary stimulus; it failed to reform.

The arguments that monetary or fiscal stimulus came too late are not very sound in this case. After all, they did eventually occur. The fact that they were late meant that there was no immediate, short-run bounce-back of the economy. There was a reverse of the negative trend in 1996 and 1997, but this period, and all others, was characterised by sluggish growth, much like the West is experiencing today. So it would appear that the monetary and fiscal efforts could only produce short-run effects when the economy required supply-side reforms. The case study of Japan suggests stimulus policies may not be effective.

There is clearly a danger that current policies in the West will have similar results. Monetary policy will continue to keep interest rates low and deploy unconventional measures, while an ambiguous fiscal policy that combines high spending with higher taxes will keep economies locked in a lower equilibrium.

In this context, there are important lessons from another economy that entered a crisis in the early 1990s which was correctly interpreted as an aggregate supply shock and productivity slowdown. That country was Sweden and its structural reform response was highly successful.