Tuesday, 11 February 2014

Merging Monetary and Fiscal Policy.

Summary. The advantage of merging monetary and fiscal policy is that monetary policy negates the defects of fiscal policy and vice versa.

Several economists and groups advocate merging monetary and fiscal policy: e.g. Milton Friedman and Positive Money (PM). Also most advocates of Modern Monetary Theory seem to favour the merge.
What that means, to illustrate, is that when stimulus is needed, government and central bank (GCB) simply create money and spend it, and/or cut taxes.
For Friedman see here in particular the paragraph starting “Under the proposal…”, p.250). And as Claude Hillinger, another advocate of the merge put it, “An aspect of the crisis discussions that has irritated me the most is the implicit, or explicit claim that there is no alternative to governmental borrowing to finance the deficits incurred for stabilization purposes. It baffles me how such nonsense can be so universally accepted. Of course, there is a much better alternative: to finance the deficits with fresh money.”

Separating politics from economics.
The above merge has an apparent problem, namely that the decision as to what the TOTAL SIZE of a stimulus package should be (economics) might seem to get mixed up with the ACTUAL FORM of the package (e.g. whether it should take the form of increased public spending or tax cuts, which is obviously a political decision. In fact, as is explained in PM literature, those two can easily be kept separate.

Monetary policy is distortionary.
For example, in the case of interest rate cuts, stimulus is channelled into the economy only via increased borrowing and lending and investment. That makes no more sense than channelling stimulus into the economy just via extra car production and more restaurant meals. Plus a recent study by the Fed claimed that interest rate adjustments don’t work too well.
As to quantitative easing (the other main form of monetary policy), that is also distortionary: it channels money into the pockets of a small section of the population, namely the asset rich. And the recent bout of QE failed in one of its objectives, namely to boost investment. But even if it did boost investment, that would still be distortionary. Moreover, QE caused flows of hot money into developing countries: yet more distortion.

Fiscal policy on its own means crowding out.
As to using fiscal policy alone to impart stimulus, that suffers from a well known defect, namely interest rate crowding out, though there is not much agreement on the actual extent of that defect .
Ergo . . . why not combine monetary and fiscal policy? Each deals with the other’s defects.  That is, in the case of fiscal policy, it’s the additional government borrowing which to a greater or lesser extent raises interest rates and negates the stimulatory effect of additional government spending (or reduced tax). But under the combined system, there is no borrowing and thus no crowding out.
As to the defect in monetary policy, namely that it is distortionary, that can be dealt with by having the fiscal element of the combination implemented in a non-distortionary manner. E.g. raising or reducing taxes on everyone’s income would involve little distortion.
The only difference between PM and Friedman here, is that Friedman thought the automatic stabilisers alone would deal with fluctuations in demand, and hence that no DISCRETIONARY changes to demand would be needed. In contrast, PM advocates “discretion”. And indeed, a substantial majority of economists are with PM on that one.

The merge assumes national debt shrinks to nothing.
A “no fiscal policy on it’s own” objective would actually mean the national debt shrinking to nothing eventually while the monetary base would expand so as to keep it roughly constant relative to real GDP. Now that might be unconventional, but would it be a disaster? Well not according to Friedman (see the above link to the relevant paper of his). Plus Warren Mosler advocates a “no government debt” policy (see 2nd last paragraph here). Plus I attacked the whole idea of government debt here.

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