The alternative to a massive fiscal stimulus

The Fed still has ammunition:

The news coming from these reports the Fed doesn’t mention the word deflation in the statement, but did highlight the prospect for inflation to persist below rates that best foster economic growth and price stability in the long-term. That’s central bank code for a period of deflation! … I believe there are some members of the FOMC that want to move slowly on the plan to buy long-term Treasuries, since in doing so the Fed is basically “monetizing” the debt, trading government IOUs for Federal Reserve IOUs, that could ultimately be destabilizing for the dollar and U.S. inflation down the road. –Scott A. Anderson, Wells Fargo

Scott Anderson is commenting on the Fed's recent Open Market Committee meeting.

Fed speak is interesting - inflation to persist below rates that best foster economics growth - is, as Anderson points out is code for deflation. The primary responsibility of the Fed is to maintain the stability of the currency. In the extreme inflation and deflation, a lack of currency stability, is de-stabilizing in general. Simply put, in periods of high inflation no one wants to hold money. It loses value quickly. At some point the currency fails. It no longer serves as a medium of exchange. With deflation you get the opposite. People prefer to hold onto their money. The value of money increases as prices fall. Money and short term T-bills, with interest rates near zero percent, become perfect substitutes. This "flight to safety" or risk-aversion inhibits economic growth as consumption falls and private sector borrowers are starved... have to pay significantly higher interest rates.

In short deflation is a big problem. The housing market has gone (is going) through a rapid correction. Prices have fallen. Equity has been lost and the impact on consumption followed. Inflation reduces the value of debt while deflation increases your debt load. Consider someone with an income of $40,000 who purchases a $100,000 house with a 10% down payment. If prices and wages double in the next ten years then the value of the homeowners mortgage debt falls. He or she is not doing badly - a house worth $200,000 and an income of $80,000 - even if there has been no real appreciation of the house and no real increase in income because the real value of his debt has fallen. If prices and wages fall, again so there is no real change - a $20,000 income buys what $40,000 did ten years ago, the homeowner is poorer because the real value of his mortgage debt has increased. In short, deflation has a greater negative impact than inflation when it comes to consumption.

What the Fed is considering, buying long-term debt, is a way to facilitate active fiscal policy via money creation instead of through borrowing. It will lower long-term interest rates in the short run. The downside to such accommodation or "monetization" of the debt is, as Anderson points out, inflation down the road. The current deflation, and its associated problems, suggests that it might be a risk worth taking.

Roughly this is focus of the current macro economic debate. On one side there are those who favor the very large fiscal stimulus, a level of deficit spending double that which we saw in the eighties and those who favor greater reliance on aggressive monetary policy - the Fed's ability to lower long-term interest rates via money creation. Given the options I'd go with the more aggressive monetary policy.