The U.S. economy in 1999: Goldilocks meets a big bad bear?

Monthly Review, March, 1999 by Fred Moseley

Could expansionary monetary policy save the U.S. economy from recession (and the world economy from a deepening depression)? If such a recession in the United States were to threaten, it is almost certain that the Fed would adopt an aggressively expansionary monetary policy, as it did last Fall, in order to lower interest rates and thus stop the slide of the economy into recession. Almost all mainstream economists seem to think that such expansionary monetary policy would be successful, i.e., would enable the U.S. economy to avoid a recession. This confidence in the Fed's powers, already very high, was bolstered further by the recent success of expansionary monetary policy in calming fears, alleviating a credit crunch, and generating the stock market recovery. However, this success came at a time when the U.S. economy was still growing briskly due to strong consumer spending. If the U.S. economy were instead slowing down and threatening to fall into recession (due to the combined effects of declines in net exports and investment spending, which would reduce household incomes and hence consumer spending), would expansionary monetary policy be successful in these more difficult circumstances?

In particular, would expansionary monetary policy be able to avoid a credit crunch in the bond markets and the resulting collapse of investment spending? The Fed has more control over the ability and willingness of banks to increase lending than it does over investors in the bond markets. It remains to be seen whether the Fed's traditional policy tools will be successful in the bond markets under conditions of a declining economy.

Furthermore, would expansionary monetary policy be able to rally the stock market again, if the economy were slowing down and profits falling? Success would be less likely under these circumstances because of the already very high valuations of stocks at the present time. If profits are falling as a result of a declining economy, then either price-earnings ratios will rise even higher (above today's very high levels) or stock prices will have to fall along with profits. At some point, it seems likely that the stock market bubble will burst, and there will be very little the Fed can do about it.

The ability of expansionary monetary policy to avoid recessions and depressions is a long-standing debate in macroeconomics. Keynes argued in the 1930s that expansionary monetary policy is often unsuccessful in conditions of recession or depression; often it is not enough to persuade lenders to lend and businesses to invest in a deteriorating economy with increasing risks. In Japan, expansionary monetary policy has been applied relentlessly in the 1990s (so much so that interest rates at one point fell below 1 percent!), but has clearly failed to overcome the severe credit crunch or revive investment spending. Expansionary monetary policy has also so far not been able to stop the slide of the U.K.'s economy into recession. It appears that we will soon witness a historic and very important empirical test of the effectiveness of expansionary monetary policy in the United States to save its economy from recessions and depressions.