Thursday, January 9, 2014

The liberal argument for a balanced budget constitutional amendment (Part I).

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 busts.  

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 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.


  1. I like your writing and general approach, but you lost me at "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." This seems to betray ignorance of what "federal debt" is in a country such as the United States. In my opinion, federal debt is equivalent to money for the purpose of an analysis such as yours. It is perfectly liquid and guaranteed, as is money, by the U.S. government which can and does create money at will to satisfy all debts. Furthermore, your analysis of monetary policy suffers because of this misunderstanding of what federal debt is.

    As Frank N. Newman , former Deputy Secretary of the U.S. Treasury, puts it:

    "I even try to avoid using the expression “borrow” when the treasury issues securities; the treasury is providing an opportunity for investors to move funds from risky banks to safe and liquid treasuries."

    If you at least consider this perspective, then you will consider the possibility that enforcing a balanced budget is equivalent to eliminating the creation of new base money to match growth in the real economy. So all new money would then have to be created by the private sector with the inevitable result that there will be cascading defaults at some point, if the money supply is not backed by an institution with the power to create money to pay off its obligations. This is the reason that fiat currencies have evolved and become overwhelmingly dominant around the world today. Without a backstop, depressions, mass unemployment, and war were regular events...

    1. I agree that federal debt and money are equivalent. The point I am trying to make is that the decision whether to expand the money supply via fiscal deficits or to shrink the money supply via surpluses is strictly a monetary one, and as such it should be controlled by the Federal Reserve. Instead, we give control over the federal deficit to the spenders in Congress when times are good and to the budget cutters when times are bad.

      I envision a new monetary system where the Fed will cut consumption and investment taxes during an economic downturn causing a fiscal deficit. When times are good and risks are skewed toward inflation, the Fed will increase taxes to cool the economy off. The primary benefit to this approach is that it enables the Fed to manage the money supply through real monetary flows rather than money balances that people stuff in their mattresses or churn in an asset bubble.

      As I explain in the post, the core issue with the public sector is that losses from bad investments are never recognized and the respective claims are never liquidated. In the long run this leads to inflated financial claims (federal debt, which is equivalent to money) and inflation. That's where the spending constraint on Congress comes into play. By requiring Congress to find the means to pay for federal spending, that risk is eliminated. I am not advocating at all that we eliminate the federal debt. All I am saying that control over the debt should shift to the Federal Reserve. It is only logical that the institution tasked with managing the supply of money should also control the means of its creation.

    2. I'm all in favor of automatic fiscal stabilizers, as you suggest. Unemployment and inflation should be the targets, not the size of the deficit. This is called functional finance and was proposed by Abba Lerner back in the 1940s.

      With regard to recognizing losses from bad investments, this can also be a problem with private investment, as we saw with the U.S. central bank accepting collateralized debt obligations from big banks and insurance companies at face value in 2009. I would guess that these private bailouts swamped the value of all the bridge-to-nowhere type investments in the public sector going back 100 years.

      I live in Detroit and the landscape here is littered with abandoned private investments. We could really use more public investment to clean this up, since the private sector won't do it.

      Anyway, you have a wonderful blog here and I appreciate exchanging ideas with open-minded and intelligent folks, even if they don't see things exactly the same way I do (c:

    3. Agreed! I appreciate the positive feedback.