Asked for my take on John Taylor’s WSJ opinion piece today. Here was my quick reaction:
I find articles like this frustrating, because they recount a bunch of coincident occurrences and (implicitly) assume causation. “This then that (so this must have caused that, right?)” I much prefer empirical studies that try to establish causation — and fortunately there are loads of such studies on these topics. Obviously there are challenges even there, but they are way more convincing than Taylor’s narrative.
As for the content, I completely agree with the need for a simpler tax system, broader tax base and lower marginal tax rates (corporate, income, maybe capital gains too). Taylor writes as if tax complexity, permanent big government, Keynesian fiscal policy, and expansionary monetary policy all go hand in hand. That’s not right — I oppose the first two, cautiously favor the third, and strongly favor the fourth. Moreover, Taylor gives the impression that because Reagan did well in the 80s, current Republican policy is what we need now.
But in fact I find current Republicans on exactly the wrong side of some of these issues. The right way to interpret Reagan’s monetary policy is that it was smart given the circumstances — not that we should be all-contractionary-all-the-time. In the current environment, smart monetary policy is expansionary. Unlike the contraction in the 80s, which was driven by supply side forces (e.g. high oil prices), much of the current problem is insufficient demand (which explains why inflation is so low), and expansionary monetary policy helps correct that. I think Milton Friedman would agree here. But many Republicans are criticizing Bernanke’s (somewhat) expansionary monetary policy, and rather than taking advice from economists and standing up to those critics, too many Republican leaders are deferring to them. (Here’s an interesting article on Romney suggesting as much.) Gingrich says similar things, and Ron Paul, much as I love his tenacity and independence, is the worst of all of them on this point.
Upshot: yes, let’s go for simplicity and broad-based, low-marginal-rate taxes. But let’s not confuse that with contractionary short-run monetary and fiscal policy, as many current R’s seem to be doing.
I am a PhD candidate in Business Economics at Harvard. I'm interested in normative economics, tax policy, and bicycle touring.
Dear Ben,
Do you know whether, historically, there is a long-run relationship between debt/GDP ratio and monetary policy? I infer from your post that you think expansionary monetary policy is a good idea under present conditions, but you view monetary policy as a short-term tool which has to be suited to the time and place. (On that, I have nothing to say, because I am poorly informed.)
I do know my own fears, though. The fear of many contemporary conservatives — including poor little me — is that over the long term, the enormous outlays contemplated by current law will require either implausibly high taxes, implausible cuts to services, or inflation.
I think much of the hostility to short-run expansionary monetary policy stems from that long-run fear, but I am not sure whether the experience of other badly-run countries suggests that the long-run fear is a reasonable one.
So, naturally, I turn to an expert.
Yours from the winepress of law,
Jamie
Hey Jamie,
Thanks for reading! You’re right to be concerned about long-run debt, but that’s really a concern for fiscal policy, not monetary policy. Expansionary monetary policy involves the Fed keeping interest rates low, which spurs investment, but (if implemented excessively or at the wrong times) causes inflation. This actually isn’t a problem for the debt — in fact inflation makes the debt easier to pay off (imagine the case of hyperinflation: old debts become very easy to pay off in real terms).
Expansionary fiscal policy (raising spending, or reducing taxes) is a trickier issue, because (as you point out) we don’t want to create insurmountable debts. It might still be worth pursuing, e.g., if such expansionary policy has multiplier effects which spur economic growth, but the risks are greater.
Does that clear things up at all?
-Ben
Dear Ben,
Alas, it doesn’t clear things up. Perhaps the reason is that when I said “monetary policy” I was being very unclear. You might have thought I meant (to be read in a knowing, throaty voice) “open market operations, and their ilk, which are aimed at keeping interest rates at the proper level,” but rather I meant something more general. As I understand it, in the United States, monetary policy is usually conducted indirectly by the Fed. But there is no reason why that need be so. One could also increase the money supply directly by shouting “start the presses!” at the relevant fellow at the mint. This, too, would be monetary policy, as I understand it.
The question which is troubling me has the following setup, on which I think we pretty much agree. The fiscal policy of the United States is pretty clearly disastrous, over the long term — on this, there is a general consensus, so my relative ignorance doesn’t trouble me. This has led to an increasing ratio of debt to economic output, which is forecast to grow worse over time. Now — again, as I understand things — the only three nonviolent ways to fix a bad debt problem are to tax, cut spending, or inflate the currency to pay off accumulated debt.
The specific question is historical: *** Have countries in a roughly analogous position attempted to monetize their debt? *** (The Confederacy comes to mind, but the analogy strikes me as far too rough.)
The motivation for the question is political: I think much of the hostility to short-run expansionary monetary policy stems from the long-run fear of hyperinflation as a solution to the problem of accumulated debt. But, as my question implies, perhaps that fear is unreasonable.
Jamie
I should add one thing, Ben. The obvious answer here is: “Of course that fear is unreasonable! We have an independent central bank, which would never — ever ever! — do something as rotten as that!”
I am not convinced by that answer, because I think that independent agencies are largely a legal fiction. Independence granted by law can be withdrawn by law, and so on.
Hi Jamie,
Thanks for clarifying. There are certainly plenty of historical examples of countries that have turned to hyperinflation to monetize their debts: Germany, Argentina, Zimbabwe. Does this mean the US should be hesitant to use monetary policy to escape the current recession? I don’t think so.
There are two potential reasons to think we could face hyperinflation. First, the Fed could turn to inflation in an attempt to monetize the debt. Call me unreasonable, but I am not worried about this threat. Given the Fed’s history and constituents, I’m confident the Fed understands the costs of hyperinflation enough to avoid it like the plague, if given the choice. And given public sentiment and political rhetoric surrounding the issue of inflation, I’m not worried about the Fed being pressured into hyperinflation against its will. On the contrary, external political pressures are pushing for contractionary, rather than expansionary policy.
The second potential cause of hyperinflation is accidental: the Fed might shoot for 5% inflation to get out of the recession, and, as Ken Rogoff puts it, “overshoot” to 30 or 40 percent. Given the low current level of inflation, however, and the high unemployment rate, I’m not really worried about this outcome either. In fact, inflation has been below the Fed’s understood target of 2% for much of the last few years — if anything, we seem to be systematically undershooting.
Perhaps you’re reaction is: “Ben, I’m happy you’re not worried about the Fed intentionally hyperinflating to monetize the debt, but *I still am*!” Fair enough. I don’t think there’s a lot more I can say, other than to note that capital markets seem to agree with me, judging by the record low interest rates on US bonds. Investors believe America can meet its debt obligations without defaulting or monetizing it — I’m inclined to agree.
Ben
Hey Ben,
On the topic of expansionary monetary policy, I was curious what your thoughts were on Scott Sumneresque nominal GDP targeting where the Fed would define the dollar as a fraction of a nominal GDP futures contract and make dollars convertible into futures contracts.
This would seem to accommodate Keynesian concerns about aggregate demand shortfalls and monetarist / Austrian concerns about central banking discretion. But, I’m from expert in this field and Scott Sumner is a pretty persuasive guy – especially to someone like me whose macro education is solely undergraduate. So I’d be curious what criticisms you’d have, if any.
Best,
Milad
Hi Milad, thanks for reading! And thanks for your question — I did receive your email asking about this last month, I’m very sorry I haven’t gotten back to you already. I was actually thinking this topic might merit a separate post — partly because it’s a big topic in its own right, and mostly because I want to read up some more. I’ll try to put one together shortly. A quick preview though: I find the idea of nominal GDP targeting pretty attractive, in that it effectively imposes a true dual mandate on the Fed (as suggested in my above post, right now I think the “control inflation” mandate is given too much weight relative to the “maintain full employment” mandate).
My main question wrt NGDP targeting: I’m not sure I fully understand how it interacts with fiscal policy. I’ve seen some arguments suggesting that NGDP targeting would render fiscal stimulus useless; but I’ve seen others say that a policy of NGDP targeting would require additional restraint from fiscal policy makers. Maybe these points aren’t mutually exclusive, but my main question is this: what if fiscal policy makers overspend irresponsibly while the Fed pursues an NGDP target?
Upshot: I want to read a bit more and get back to you.
EDIT: *But, I’m very far from expert in this…