In part I of this post, I discuss the three approaches to macro-economic policy and their respective shortcomings and limitations. Those who argue against government intervention overlook the fact that the business cycle is caused by market distortions and the pro-cyclical influence of money. As a result, there are market forces at play that can confine individuals to economic circumstances beyond their control. On the other side of the macro-economic divide, liberals believe that active fiscal or monetary policy can smooth-out the business cycle, restore full employment and set the economy on sustained growth path. However, government intervention has not come without distortions of its own. Active fiscal policy caused inflation, which culminated in the stagflation of the 1970's. Over the last 25 years active monetary policy greatly abetted two asset boom-and-bust cycles. 4 years after the 2008-09 recession, monetary policy continues to be constrained by the lower zero bound prompting fears of stagnation. Such side effects, if left unchecked, can lead to massive economic disruptions and render government efforts to manage the economy a self-defeating exercise.
In part II, I outline a hybrid approach to government intervention which combines the best of active fiscal and monetary policy while minimizing their respective shortcomings and flaws. 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 requiring that all government spending is paid for
and all new government debt is coupled with the means for its
extinguishment. On the other side of the compromise, central banks are
granted authority to set consumption and investment credits thus gaining the ability to manage the money supply through monetary flows in the real economy rather than money balances held by the public.
First, let's discuss the monetary significance of the US federal debt. The federal debt is the raw material for money creation. All money in use today is created as a result of borrowing. Banks create money by substituting their liabilities for those of their borrowers be it consumers, corporations or governments. Why do we accept bank liabilities as money? For two reasons - bank deposits are insured by the federal government up to $250,000 and banks are required to keep a minimum level of reserves against their liabilities. Bank reserves are nothing more than deposits held at the Federal Reserve, which is the central bank of the United States. The reserves themselves are created when the Federal Reserve buys government debt or lends to commercial banks. Banks can exchange their reserves into cash upon demand. The Federal Reserve has unlimited capacity to meet such demands because it has the authority to print money. Ultimately, the moneyness of both paper bills and bank deposits is based on the credit of the US federal government, which in turn is backed by our obligation as citizens to pay taxes. To put it simply, we accept paper bills and bank deposits that can be converted into paper bills as money because we can turn around and use those same paper bills to pay our taxes.
Since the Federal Reserve can only purchase obligations of the federal government such as treasury bonds or government-guaranteed mortgage backed securities, the
federal debt is especially important in money creation. Buying and selling government obligations enables the Federal
Reserve to independently manage the level of reserves in the banking
system, which determines interest rates, lending activity and ultimately the money supply in the entire economy. It is only logical to assume that the institution tasked with managing the supply of money should also control the means for its creation. This, of course, is not the case. It is Congress, the body vested with spending authority, that controls the level of federal debt. I believe this arrangement should be re-examined. The decision whether to run a fiscal deficit, which results in more money creation, or a fiscal surplus, which reduces the money supply, is strictly a monetary one, and as such it should be controlled by the Federal Reserve.
Second, let's revisit the significance of the demand for money. The demand for money stands for the desire of the public to hold money balances. As I explain in Part I, the demand for money places a constraint on both fiscal and monetary policy because it is the one macro-economic variable that governments have no control over (technically, governments have a certain minimum level of control since the annual level of taxation sets a floor to money demand). When money demand is low, fiscal deficits cause inflation, which was the case in the 1970's. If, however, active monetary policy has suppressed long-term inflation expectations, low demand for money will prompt an increase in asset prices (see my post on asset bubbles). Faced with an asset bubble, monetary authorities are torn between raising rates, which hurts the real economy, or letting the bubble run its course, which increases the risk of instability. A fiscal surplus, on the other hand, can drain excess money supply and prevent an asset bubble without hurting the real economy.
When demand for money is high, central banks can, at best, offset deflationary pressures by supplying sufficient reserves (think QE over the last 4 years). However, monetary policy cannot prompt a real economic recovery because it is constrained by the lower zero bound. The only option left to central banks is to keep printing even after money demand has been satisfied in the hope that higher asset prices and inflation will eventually compel people to spend and invest in the real economy. This, of course, raises the risk of future asset bubbles and higher inflation. Instead, high money demand and the lower zero bound call for active fiscal policy. Sufficient fiscal deficits can absorb the savings glut and expand the money supply through monetary flows in the real economy rather than money balances that people can turn around and stuff in their mattresses and bank accounts.
When applied in unison, active fiscal and monetary policy can complement each other and work to minimize their respective flaws. However, since they are controlled by separate government entities, that type of cooperation is rare. Furthermore, the budgetary process, which sets fiscal policy, is entirely political in nature. Unlike central banks, which measure their actions against objective yardsticks such as price stability and full employment, politicians respond to partisanship and pressures by vested interests and narrow constituencies. Deficit spending is the crack-cocaine of politics. When times are good, it is all too easy to lavish constituents with government spending without imposing the costs of higher taxation - think two wars, a medical prescription drug benefit and large tax cuts all charged to the nation's credit card during the go-go days of the housing bubble. When times are bad, bashing government deficits and preaching the virtues of austerity is the tried-and-true playbook for gaining political leverage - think the rise of the tea party, multiple threats of default over the debt ceiling and insufficient fiscal stimulus to power a real recovery.
Fiscal deficits and surpluses are too important to be left to the vagaries of politics. Politicians have to realize that there is no free lunch. As I discuss in part I, there are two core problems with public spending. First it lacks a mechanism for loss recognition due to wasteful use of resources (think bridge to nowhere). If wasteful public projects are funded with borrowed funds, the outcome is depressed productive capacity and inflated financial claims, which ultimately leads to inflation. However, if government spending has to be paid for through taxation, that problem is eliminated because each spending program will have a built-in mechanism for extinguishment of the associated financial claims. Such requirement is very much like funding a start-up with 100% equity. The second core problem with public spending has to do with preferential distribution which shifts incentives in the real economy away from productive use of resources and toward government lobbying, cronyism and corruption. Fiscal deficits are great enablers of preferential distribution because they allow governments to benefit one group without imposing upfront costs on another. On the other hand, if such costs could no longer be financed with debt, all vested interests will be brought into the budget process including those who will bear the costs. Such representation is the key to limiting preferential distribution associated with government spending and fostering a competitive and free market place.
Now, let's discuss how the spending constraint could work in practice. First, all government insurance programs have to be self-funded, which will eliminate potential deficits and preferential distribution due to mispricing of the underlying risk. This is already how the FHA Insurance Fund operates. It has authority to set mortgage insurance premium and does not have to rely on the budget appropriation process. What this means is that Social Security, Medicare and Medicaid, Extended Unemployment Benefits, SNAP and the myriad of other government insurance programs should be removed from the budget appropriation process and granted authority to set their own taxes and insurance premiums. The role of Congress will be limited to mandating a certain level of benefits and a minimum net worth requirement. If such programs experience a deficit, they can close the gap by raising their respective insurance premiums and taxes, borrowing in the market or petitioning Congress to change their benefit mandate. The second step is to restore PAYGO, the rule in effect from 1991 through 2002 which required that all direct government spending is paid for. Spending projects will be judged on their merits, and if the benefits are sufficient to pay for the costs, such programs should be approved as part of the budget process and put into effect.
The next set of reforms deal with the Federal Reserve. First, the Federal Reserve is granted authority to set a federal sales tax on consumption, a federal credit for capital investments and the capital gains tax In a normal economy, the Fed
will set the sales tax at 0%. If the Fed wants to spur spending, it could
lower the tax to say -5%, turning into a sales credit. If the Fed wants to prevent the economy from overheating, it could raise the sales tax to 5%.
Investment credits could work in a similar fashion giving the Fed a
powerful tool for managing investment activity on a macro-level by varying the size of the credit. Another tax that should be controlled by the Fed is the capital gains
tax. Currently, there is a lot of uncertainty as to future tax levels
which hampers investment. However, should the tax percentage payable on
capital gains be fixed at the time the capital is acquired
regardless of when it is sold, such tax uncertainty will be removed.
More importantly, during a recession the Fed can lower the capital gains
tax which will immediately raise returns and spur investment when the
economy needs it the most.
The second set of Fed reforms deals with control over the federal debt. Today that control resides with the US Treasury. Congress passes a debt ceiling authorization which gives Treasury the latitude to issue new federal debt up to the debt ceiling. This, of course, is an exercise in tautology since Congress has already approved spending levels and taxation as part of the annual budget. Under the proposed regime, control over the federal debt will shift to the Federal Reserve, meaning that the debt ceiling authorization will go to the Federal Reserve, which in-turn can direct Treasury when to issue new debt. As a result, the Federal Reserve will be in a position to determine the size and timing of fiscal deficits and surpluses, which creates the perfect unison between fiscal and monetary policy. The debt ceiling also takes on completely new significance. It provides the boundary for the maximum amount of reserves the Federal Reserve can inject into the economy at its own discretion. This creates a check-and-balance that Congress can exercise over the Federal Reserve. Basically, Congress retains ultimate control over both fiscal and monetary policy.
Such hybrid approach to government intervention creates a host of new possibilities and tools. For example, in a recession the Federal Reserve will not have to rely on outsized moves in interest rates which act to inflate money balances held by the public that can later fuel an asset bubble. Instead, the Fed can lower sales taxes and increase investment credits. This will encourage real economic activity and expand the money supply through fiscal deficits rather than money balances stuffed in mattresses and bank accounts. If the economy is overheating or demand for money is low, the Fed can raise taxes and drain excess money supplies through fiscal surpluses. This is especially important today should the demand for money begin to decline in the aftermath of QE and trillions of excess reserves on the Fed's balance sheet.
Also, turning the sales tax into a sales credit can eliminate the restrictions imposed on monetary policy by the lower zero bound. The Fed cannot lower rates below zero, but it can begin to pay people to spend which effectively raises the cost of holding money. A side benefit to a negative sales tax during a severe recession is that it will deflect political charges that the Fed bailed out Wall Street but failed to help Main Street!
Europe could implement the hybrid approach through VAT Credit funded by
the ECB. Currently, all EU-member countries are subjected to
one-fits-all monetary policy. ECB could use the VAT Credit to customize
policy to circumstances specific to each country. For example, during
the boom days prior to the crisis, the ECB could have raised rates to
prevent overheating in the periphery while increasing the VAT Credit in
Germany to spur domestic consumption. Conversely, today the VAT and Investment credits
would go to Spain, Italy and Greece. In effect, this will expand the supply of much needed
euros and help these countries overcome the ravages of the Great Recession.
Emerging economies can also benefit from this approach. The biggest threat to their economic stability are unpredictable foreign capital flows, which often respond to monetary policy and conditions abroad rather than to domestic priorities. By increasing sales taxes when foreign money is easy and abundant, an emerging economy can absorb excess money supply and mitigate both trade and fiscal deficits. When those capital flows inevitably dry-up, sales taxes would be lowered to cushion the impact on domestic consumption.
On a more philosophical note, shifting control over fiscal deficits to the Federal Reserve will have a profound impact on the government's role in the economy. As I discuss in Part I, the two main objections to the public sector are wasteful use of resources and preferential distribution. Since the Federal Reserve will use tax policy to generate deficits, the corresponding resources will be used by the private sector, which eliminates the first concern. Furthermore, taxes apply equally to everyone. The Fed will not have capacity to discriminate between market participants as to who gets a higher or lower sales tax or investment credit. This eliminates preferential distribution and re-aligns economic incentives away from government spoils and toward innovation and productive use of resources. This sets the stage for a new paradigm, which I call market positivism - a belief in a free market ideal along with the positive role that governments can play in the economy.