There is a debate raging in academic as well as political circles as to the appropriate macro-economic response to the Great Recession. Four years into the recovery, the US is still faced with mediocre growth and high unemployment despite unprecedented monetary expansion by the Federal Reserve in the form of QE. The European periphery, which has been subjected to unmitigated dose of fiscal austerity, finds itself in a true depression with unemployment in Spain and Greece upwards of 20%. We also have the example of Japan, which has been mired in stagnation for more than 20 years with monetary policy fully constrained by the lower zero bound.
Unlike the physical sciences, which rely on experimentation as the arbiter of truth, the study of the economy is limited to observation and interpretation. As a result, divisions among economists have persisted for years if not decades, and the policy debate has degenerated into ideological warfare. Disagreements in the academic community have only fostered partisanship and stark divides among policy makers, hence the lack of effective and timely policies to deal with the aftermath of the global recession.
In part I of this post I will attempt to summarize the three main approaches to macro-economic policy and their respective limitations and shortcomings. In part II, I will expand on a proposal I first touched upon in a previous post titled "How to overcome secular stagnation and the lower zero bound." The idea is to shift control over fiscal deficits and surpluses from spending authorities (Congress) to monetary authorities (Federal Reserve). Such proposal requires a political compromise. On one side, governments self-impose a spending constraint in the form a constitutional amendment requiring that all federal spending is paid for and all new federal debt is coupled with the means for its extinguishment. On the other side of the compromise, central banks are granted authority to set certain taxes thus gaining the ability to manage the money supply via fiscal deficits and surpluses. Such framework will address the main shortcomings of active fiscal policy such as government waste, poor timing and inflation. Also, it provides the Federal Reserve with powerful new tools which are unconstrained by the lower zero bound and can affect real economic activity without causing asset booms and busts.
The case for government intervention.
Macro-economics emerged as a distinct field of study around the time of the Great Depression when economists began to ponder the capacity of governments to create conditions for sustained growth and full employment. The Austrian school of thought rejects attempts by government to manage the economic cycle based on the philosophical objection that government intervention necessarily benefits one group over another. Only an economy based on free markets and voluntary exchange can maximize value for all participants. Freshwater economists would agree with the Austrians, but for other reasons, namely that economic participants are rational and markets are efficient. Austrian economists believe that the business cycle is driven by malinvestment. Accordingly, economic downturns serve an important market function in correcting misallocation of resources. Unemployment and recessions are the result of market distortions caused by government intervention. For example, active monetary policy leads to artificially low interest rates and malinvestment, which is the ultimate trigger for a recession (the recent housing bubble and subsequent crash being exhibit A to this argument). Government wage controls and unions cause downward wage rigidity, which leads to unemployment during economic downturns.
As I discuss in the post titled "Why both Fama and Shiller are correct!", the business cycle is driven by two market distortions neither of which is caused by government. First, rational individuals do not necessarily produce rational macro-economic outcomes. As a result, risks in the economy do not offset perfectly but rather tend to compound, which ultimately leads to malinvestment on a macro scale. The second force is money. Money
and the fractional banking system exert tremendous pro-cyclical influence on the economy as to
exaggerate normal market fluctuations into full-blown business booms and
The intermediation of banking divorces the act of saving from the act of borrowing. Furthermore, banks can extend credit by simply creating money as they substitute their liabilities for those of their borrowers. As a result borrowing and savings do not necessarily have to equal. An excess of borrowing generally causes the economy to expand. If the economy is already at full capacity, an excess of borrowing would simply lead to inflation. An excess of savings causes the economy to contract. During good times banks expand the supply of money to meet loan demand while the public allocates away from money into riskier assets. Since money is denominated in itself, excess money supply pushes asset prices higher, which leads to even more spending and investment. The opposite occurs in an economic downturn. As loan demand declines, banks shrink the supply of money. At the same time demand for money goes up as people attempt to allocate away from risky assets into cash. The shortage of money pushes interest rates higher and depresses asset prices. This initiates a deflationary spiral as observed at the onset of the Great Depression.
Market purists have to acknowledge that even if you were to remove governments completely, the economy would still be subject to significant fluctuations as was the case in the 19th and early 20th centuries. Under the gold standard, expansionary pressures in boom times were kept in check by the limited amount of bank reserves in the form of gold. However, deflationary pressures during economic downturns ran unabated causing untold hardship, misery and deprivation, which ultimately led to the collapse of the gold standard during the Great Depression. The credo of free-market capitalism is that people should be free to succeed or fail based entirely on their own merit, enterprise and hard work. Clearly, there are market forces at play that deprive individuals of their free will and instead, confine them to economic circumstances beyond their control.
On the other side of the macro-economic divide, liberals (or progressives) believe that governments do have a role to play in the economy. They believe that active fiscal or monetary policy can mitigate the business cycle and set the economy on a sustained growth path and full employment.
Active fiscal policy.
After massive government
spending during World War II pulled the US
out of the Great Depression and justified Keynesian views, fiscal policy became the primary tool for managing
the economic cycle. The idea was that fiscal deficits financed through government borrowing would absorb an excess of savings thus bringing the economy back to full employment. In other words spending by government could fill the output gap caused by an economic downturn. However, active
fiscal policy led to higher inflation and the stagflation of the 1970’s, which prompted economists and policy makers to look for answers elsewhere.
There are two fundamental problems with active fiscal policy. First, governments are not necessarily good allocators of resources. In the private sector, if an investment does not produce the expected return, the associated losses have to be recognized immediately and the respective financial claims have to be liquidated. In the public sector losses due to wasteful use of resources are never recognized, nor are the respective financial claims ever liquidated. If the government borrows or prints $2 billion to build a bridge to nowhere, the productive capacity of the economy is not improved in any way; however, the $2 billion financial claim persists basically in perpetuity (unless, of course, the government ran a $2 billion surplus in order to liquidate such claim). As a result, active fiscal policy tends to suppress productive capacity relative to outstanding financial claims, which is the perfect recipe for inflation.
The second problem has to do with the distributive effects of government spending. Here the Austrians have it right. Unless a government program is designed as a self-funded insurance pool (such as the FHA Insurance fund), government spending (including tax expenditures) tends to benefit one group over another. This shifts incentives away from productive investment and toward government cronyism. Rather than investing in the real economy, corporations hire armies of lobbyists and tax attorneys. Governments with concentrated power to allocate resources without the appropriate controls against waste and preferential distribution run the risk of depressed productive growth, cronyism and corruption.
Active monetary policy.
After Fed Chairman Paul Volker defeated inflation in the early 1980's, monetary policy took center stage as the tool of choice for managing the economy. When times are good, central banks will offset the natural tendency of the money supply to grow by raising rates and draining reserves. In a downturn, they will reverse course by lowering interest rates and injecting money in the economy. Monetarism is the leading macro-economic school of thought, which has supplied policy makers at central banks around the world for more than 30 years. Active monetary policy is a much more precise and timely tool for
managing the economy because it has the capacity to directly neutralize
the pro-cyclical influence of money. Monetary policy is also better at suppressing inflation, the primary downfall of fiscal deficits. Furthermore, independent central bankers are unconstrained by the unwieldy budget process, which allows them to act quickly and in sufficient measure. Some would argue that monetary policy does not suffer from the distributive effects of fiscal policy since interest rates apply equally to everyone in the economy; however, the disproportionate rise of the financial sector over the last three decades may not be a mere coincidence.
Unfortunately, active monetary policy has not come without side effects and limitations of its own. As I explain in the post on asset bubbles, the dot.com and housing booms were a direct side effect of active monetary policy. Simply, the Federal Reserve has a limited tool set. It can only control the supply of money, but not what people do with that money (a.k.a. the demand for money). In a downturn the demand for money would increase, and the Fed would promptly oblige by loosening monetary policy and printing more reserves. However, on the upswing the Fed would not withdraw the money supply quickly enough since it gets its cues from inflation and unemployment in the real economy. Money balances on the other hand are predominantly concentrated with large corporations and the wealthy who have a lower marginal propensity to spend and invest. As a result, money balances first begin to churn in an asset bubble.
The demand for money is also behind the second limitation of monetary policy - namely the lower zero bound. As I explain in my recent post on secular stagnation, the 2008 financial crisis was so severe as to push the equilibrium rate of interest at which savings equal borrowing into negative territory. In plain English, people are afraid that they will be poorer in the future so they stash their money for a rainy day. And here comes the catch of the lower zero bound. People can arbitrage their negative expectations by simply holding cash at 0%. The Federal Reserve cannot take rates negative because people will switch to cash. Keynes described this condition as infinite liquidity preference. Central banks can print as much money as they want, but the public will mop-up those supplies because they are arbing negative required returns. Keynes correctly theorized that until negative expectations of the future persist, only borrowing by the government can absorb an excess of savings and bring the economy back to full employment.
The fact of the matter is that both fiscal and monetary policies are
constrained by the demand for money, which stands for the desire of the
public to hold money balances either in the form of cash, bank deposits
or money market mutual funds. This is the one macro-economic variable
that governments have no control over (technically, annual taxation sets a floor to money demand). If fiscal deficits inflate
the money supply above the level demanded
by the public, the result will be inflation. While active monetary
policy is a much better tool to deal with inflation and the pro-cyclical
influence of money, the money balances central banks supply in response
to a recession become the fuel for another asset boom and bust cycle.
In times of severe financial crisis such as the Great Depression and the
2008-09 recession, demand for money becomes practically infinite.
Regardless of how much money central banks print, the public stuffs the new money supplies in mattresses and bank accounts with no
impact on the real economy. In part II of this post, I will advocate for a new hybrid approach to government intervention that combines the best of fiscal and monetary policy thus giving rise to powerful new tools while eliminating the respective flaws of monetary and fiscal policies when applied separately.