Looking at the wrong “gun”

It´s become conventional wisdom to say the monetary policy “gun” is out of ammo. This “conventional wisdom” is captured in today´s piece by Burton Malkiel:

Monetary policy, which has driven short-term rates to near zero and 10-year Treasury rates to 2.5%, appears to be out of ammunition.

In fact, the “gun” that has run out of ammo is the fiscal policy “gun”. Right or wrong, this is what the S&P downgrade indicates. And Robert Barro, notwithstanding what Krugman thinks, has suggestions about how to “load it back up”:

The way for the U.S. government to earn back a AAA rating is to enact a meaningful medium- and long-term plan for addressing the nation’s fiscal problems. I have sketched a five-point plan that builds on ideas from the excellent 2010 report of the president’s deficit commission.

Update: I think I summarized it better in my comment to David Glasner´s last post:

In late 2008 when the monetary “gun” was declared out of ammo by the ones who “held” that “gun” (Bernanke even said that it was “now up to the Treasury”), all ran for the fiscal “gun”. But that particular “gun” tends to jam and even backfire.

It seems that after the dissapearence of the Soviet Union western countries, US included, decided that “more government” would be a nice thing to have!

Update 2: And there´s this statement by David Levey, former Managing Director of Moody´s that Scott Sumner reproduces:

On Saturday, I sent the following statement via email to several publications (NYT, WSJ, Bloomberg, FT). It is intended to describe why I would vote to maintain the US Aaa credit rating, were I still in my former position. At this time, I have no connection with Moody’s nor any non-public knowledge of what its analysts think about the rating or what they intend to do.

This statement is not a defense of the Administration in its war of words with S&P. I am not a supporter of the Obama team’s economic policies, which have added to the debt and the regulatory burden on the economy. As I see our current situation, the Federal Reserve, with its too-tight monetary stance since the summer of 2008, has allowed nominal GDP to fall far below trend, causing a collapse of output and employment — as described by the monetary bloggers Scott Sumner, David Beckworth, Bill Woolsey, and David Glasner. Had the Fed acted properly, (by, for example, setting a nominal GDP level target) the recession would have been much shallower and fiscal stimulus might not have been undertaken. As it was, the collapse of nominal GDP drove the “fiscal multiplier” to zero, leaving us with more debt and nothing to show for it. Monetary policy always “comes last”.

The solution to avoiding the predicted debt explosion will have to come primarily from major reforms of entitlement programs. Tax-rate increases within our present system are counter-productive and will retard growth. If there is to be some contribution from increased revenue, it should come from structural reforms which reduce the taxation of saving, support entrepreneurship, and eliminate loopholes and exemptions that distort consumption and investment decisions. Despite sharing their fiscal concerns, I see the S&P downgrade as premature for the reasons given below.

David H. Levey

Managing Director, Sovereign Ratings, Moody’s Investors Service (1985-2004)

.  .  .

STATEMENT

The recent S&P downgrade of the credit rating of US Treasury bonds is unwarranted for the following reasons:

1) The US dollar remains the dominant global currency and no viable competitor is on the horizon. The euro is heading into dangerous and uncharted waters while deep and difficult political, economic and financial reforms will be required before the renminbi could become fully convertible for capital flows and Chinese government bonds a safe reserve asset.

2) US Treasury bills and bonds, along with government-guaranteed bonds and highly-rated corporates, will for the foreseeable future remain the assets of choice for global investors seeking a “safe haven”, due to the unparalleled institutional strength, depth and liquidity of the market. Although there are several advanced Aaa-rated OECD countries with lower debt ratios and better fiscal outlooks than the US, their markets are generally too small to play that role. Since ratings are intended to function as a market signal, it makes little sense to implicitly suggest to investors seeking “risk-free” reserve assets that they reallocate their portfolios toward these relatively illiquid markets.

3) Despite the above positive factors for the US, it is certainly the case that the US long-term debt outlook is deteriorating under the pressure of rising entitlement costs and an inefficient, distortionary tax system. Failure to reverse that trajectory would eventually make a downgrade unavoidable. But the recent discussions signal to me that — finally — public awareness of the fiscal crisis is growing and beginning to influence Washington. There is still a window of time — perhaps as much as a decade –within which structural reforms to spending programs and the tax system could reverse the negative debt trajectory.

4) The bottom line is that the global role of the dollar and the central position of US bond markets make somewhat elevated debt ratios more compatible with a Aaa rating than is the case for other countries, another version of the US’s “exorbitant privilege”. But that extra leeway is finite and serious reforms to entitlement programs, particularly Medicare, must be made in a reasonable time horizon. If not, global investors will eventually conclude that our political system is incapable of making the needed changes and turn away from US assets, regardless of the institutional strengths of US markets.