Monetary alchemy, fiscal science

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

2013 marks the 100th anniversary of the US federal income tax and the establishment of the Federal Reserve. Jeffrey Frankel asks, in a recent VOXEU communique (Jan. 29^th), what lessons have we learnt about macroeconomic policy since then? This note assesses the postwar lessons and argues that fiscal expansion is much more likely to be effective in the short term than any monetary expansion stimulus. Indeed, compared with fiscal policy, monetary policy seems more alchemy than science.

It took time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy respectively. It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macroeconomy. John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression. Milton Friedman blamed the Depression on the Fed for reducing money supply.

In subsequent debates: Keynes was associated with support for activist or discretionary policy. The aim was a countercyclical response to economic fluctuations; and Friedman opposed activist or discretionary policy, believing that government institutions – were unable to time their interventions effectively.

After the second world war, the lessons of the 1930s were incorporated into all macroeconomic textbooks and, to some extent, permeated the beliefs and actions of policymakers. But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by other major economic phenomena, such as the high-inflation 1970s.

The austerity-versus-stimulus debate continues with proponents of austerity point out that the long-term consequences of permanent expansionary macroeconomic policy – both fiscal and monetary – are unsustainable deficits, debt and inflation. Conversely, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt-to-GDP ratios that go up rather than down. Less thoroughly aired recently is the question of whether, given recent conditions, monetary or fiscal expansion is the more effective instrument.

Under the circumstances that held in the 1930s and again today – conditions of high unemployment and low inflation but also of near-zero interest rates – stimulus in the specific form of fiscal expansion is much more likely to be effective in the short term than stimulus in the form of monetary expansion. Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero.

Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries.  Introductory economics textbooks talk about the Keynesian multiplier effect: the recipients of federal spending – or of consumer spending stimulated by tax cuts or transfers – respond to the increase in their incomes by spending more as well. Again, the multiplier is much more relevant under current conditions than in more normal situations.

A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others. Needless to say, the effects of fiscal policy are subject to substantial uncertainty. Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter. One might even dramatize the contrast by speaking of ‘monetary alchemy and fiscal science’.

Eric Leeper characterized monetary policy as science and fiscal policy as alchemy. It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to the best that modern society has to offer. It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state of economic knowledge and largely motivated by politicians’ desire to be re-elected.

Alchemists were not stupid or selfish. Rather, alchemy fell far short of modern chemistry. The term alchemy could be applied to pre-Keynesians like US officials whose Depression prescription was “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate ... it will purge the rottenness out of the system”. But in light of all that was learned in the 1930s, it would be misleading to characterize the current state of fiscal policy knowledge as ‘alchemy’.  Perhaps, someone in Washington might learn something.

http://www.voxeu.org/article/monetary-alchemy-fiscal-science