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.



  1. The biggest distortion of monetary policy appears to be to try and hold the currency at a higher value than it otherwise would be.

    That seems to lead to a favouring of imported items over domestic production and over time the economy becomes more and more dependent on the kindness of others.

    I can't see monetary policy as anything much more than an 'implicit government import subsidy' and I'm struggling to see why a government would do that.

    What do you think?

  2. Neil, If a govt holds interest rates at any level other than the free market rate, that obviously makes the relevant currency more (or less) attractive, which in turn distorts the relationship between exports and imports. Good point: I didn’t think of that.

    But I don’t think governments make a HUGE effort to make this export and import effect an objective: it’s more of an unintended side effect (as indeed are all the distortions I’ve referred to).

  3. Governments do, foolishly, make huge efforts to keep their currencies strong. Lerner would of course agree that a strong currency, in the hands of a rational government using functional finance, is an unalloyed benefit. But the thing is that strong currencies are results of a strong economy, not a cause. Keeping your currency strong by monkeying with interest rates, making them high, is very destructive to the real economy, causes unemployment, inflation and financial instability (Minsky). Lerner urged floating exchange rates, and that governments should err on the side of having their currencies depreciate, and never try to protect their value. Misguided high interest rates/strong pound policies were the bane of the UK economy for decades.


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