Wednesday, September 16, 2015

Sometimes to go Left you have to turn Right - the PQE vs CBI debate

There's a debate going on right now about Corbynomics. On one side, you have supporters (Richard Murphy's blog) arguing for PQE (QE for the People) in the form of government investment in infrastructure to be funded by the central bank. On the other side, you have mainstream econ and the center-Left who support fiscal stimulus but want such spending to be funded with government bonds (Tony Yate's blog). Their biggest concern is central bank independence (CBI) and the slippery slope of fiscal monetization.

At its core, this debate is about control - more specifically, who controls money.  In this fractious debate, those who seek more control are less likely to get it hence my response: to go Left you have to turn Right! 

I've been an advocate for vesting central banks with counter-cyclical fiscal authority in the form consumption and investment tax credits (link to Money Demand Targeting). Here are some of the key benefits to having central banks control both monetary and fiscal counter-cyclical policy:

  • Tax cuts are the preferred form of fiscal stimulus by the Right, which means such plan can find support across the political spectrum.
  • Consumption and investment tax credits can enable the central bank to pursue full-employment policies without reliance on inflation target.  Accordingly, such new regime can enable zero inflation target, which should appeal to hard-money types.
  • Across-the-board tax credits are non-preferential as they affect all economic agents equally. It is precisely because of the prospect of unequal distribution that fiscal policy is within the domain of democratically elected politicians. The expectation is that the political process is best equipped to reconcile the multitude of interests that could be impacted by fiscal policy resulting in fair distribution of the associated costs and benefits. Whether that is the case is a whole different question. The important thing is that consumption and investment tax credits are by definition non-preferential as they apply equally to all economic agents. Accordingly, such credits can be administered by technocrats at the central bank within well-defined parameters.
  • Vesting the central bank with tax credit authority resolves the coordination problem between fiscal and monetary policy. A counter-cyclical fiscal authority should have a clear mandate that does not conflict with the goals of the central bank. In other words, if the goal of such fiscal authority is full employment or NGDP growth target, the pursuit of such goal should be non-inflationary. Having two distinct institutions, one charged with monetary policy and one charged with counter-cyclical fiscal policy, can give rise to a coordination problem or even policy conflict[1]. Furthermore, there will be a lot of overlap as both institutions will have to assess output gaps, the level of full employment, inflationary pressures, etc. A strong argument can be made that monetary policy has sufficient capacity to smooth-out economic fluctuations as long as the time preferences of private agents are positive. It is only when agents have negative or zero time preferences and interest rates are constrained by the zero lower bound that monetary policy loses its effectiveness. Equipping the central bank with new tools that can work at the zero lower bound seems the straight-forward solution.
  • Consumption and investment tax credits make the perfect counter-cyclical tools. They have immediate effect on the economy as opposed to fiscal spending, which is subject to significant time lag as government programs and infrastructure spending take time to develop and implement. Consumption and investment tax credits are also preferable to income tax cuts or heli drops because agents have the option to save the extra cash under such forms of stimulus, which reduces the short-term boost to the economy. Last but not least, investment and consumption tax credits can lift the time preferences of private agents, which resolves the core problem affecting a depressed economy - low time preferences as economic agents fear declining or stagnating incomes. Armed with tax credit authority, central banks will no longer be constrained by the zero lower bound and will be in position to achieve steady economic growth at full employment with neither inflation nor asset bubbles.
It is important to note that this is not an argument against government spending on infrastructure, education, healthcare or other priorities. Quite the opposite - if such programs are expected to generate returns in excess of growth expectations by the private sector as measured by interest rates, they should be undertaken without regard to the business cycle. If successful, such investments can drive long-term growth and enrich society as a whole. However, this is an argument for funding government deficits in the bond market. The interest rate on government bonds represents the opportunity cost of the real resources borrowed by the government. If the government cannot generate returns in excess of such interest rate, the real resources will be better deployed by the private sector.

There are definitely concerns with vesting unelected officials at central banks with taxing authority in the form of tax credits. The argument is that there should be no taxation without representation (link to
twitter exchange with Frances Coppola). However, such program will never be outside of political control as the legislature will set the parameters within which the central bank can operate. In particular, the legislature can establish a debt limit in respect to the program, which sets the cumulative fiscal deficits that can be generated as a result of the tax credits. Also, the legislature can put a floor on the negative tax credit say -3%. In other words, if the central bank wants to cool-off an overheating economy, it can impose a sales tax not to exceed 3%. On a side note, this is what counter-cyclical fiscal authority is all about - running deficits in bad times and surpluses in good times.

[1] Historically, the Phillips Curve has been unstable. A return of high-inflation, high-unemployment environment may result in conflicting policy objectives between a counter-cyclical fiscal authority and the central bank.

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