Monday, 28 March 2011
Fiscal or monetary measures on their own are distortionary.
Apart from the reasons for combining fiscal policy (FP) and monetary policy (MP) given here, I’ve just thought of another reason: each of the policies on its own is distortionary.
A fiscal policy (FP) measure typically consists of government increasing spending by £X and covering that with £X of additional borrowing. A monetary policy (MP) measure typically consists of changing interest rates or quantitative easing: both the latter involve government in buying or selling its own bonds to the market. “Combining” the two consists of the government / central bank machine creating an extra £X and spending it. Alternatively, if inflation looms, it might be appropriate to do the opposite: have the government / central bank machine raise taxes, rein in money and “unprint” or extinguish the money.
Let’s take MP first. Raising interest rates is type of MP, but this works only via entities that engage in a significant amount of borrowing or lending, and that is distortionary.
QE is a monetary policy. But it works mainly via boosting asset prices, that is, it works only via the rich, and that is distortionary. In fact it is worse than that: it’s near disastrous because of the low propensity of the rich to spend extra income (or capital gains). Indeed more than one article has been published recently claiming that the current US high unemployment levels are largely attributable to the rising inequlity.
Now let’s take FP. Some FP measures are relatively undistortionary, e.g. a payroll tax change. Granted a payroll tax change is distortionary in that works only via those in work, e.g. pensioners are left out. But that is not much of a distortion because about half the population goes out to work.
Plus the latter sort of defect could easily be rectified in countries with a state pension, and by temporarily altering the state pension. (The state pension in the U.K. is “temporarily altered” in Winter to help pensioners (and others) if it is sufficiently cold.)
But if a payroll tax reduction and pension increase are funded by increased government borrowing, a distortion creeps in: the increased borrowing raises interest rates, and as pointed out above, interest rate changes are distortionary.
Therefor FP changes should be implemented in a “monetarily neutral environment”. Or put another way, MP and FP should be combined, if distortions are to be minimsed.
The above is another argument that supports Abba Lerner’s “money pump” and Modern Monetary Theory. That is, in a recession, the government / central bank machine should simply increase its net spending.