Several commenters have sent me this excellent AEI piece by John Makin. This quotation caught my eye.
Additionally, Japan’s new government’s proposal to double the consumption tax as a way to promote growth has been appropriately chastised by the opposition Your Party leader Yoshimi Watanabe, who retorted: “Boosting the economy with a tax hike? That is an obscene stretch.” Japan is threatening to repeat its disastrous experience of 1997, when a consumption tax hike threw the economy back into a sharp slowdown followed by intensified deflation.
He’s right of course. But it’s also true that Japan has big long-term fiscal problems. Some pundits have discussed the idea of easier fiscal policy in the short run combined with tighter policy in the long run. Nice idea, but that’s just not how modern democracies work. Instead, how about returning to the ideas of Robert Mundell?
Back in the 1970s the US suffered from stagflation–a combination of high inflation and sluggish real growth. Demand-side economists weren’t able to offer any appealing policy choices. Mundell (who is the father of supply-side economics) argued that we needed tight money combined with supply-side tax cuts. The basic idea is that in macroeconomics you can’t kill two birds with one stone. You need two stones of different size and shape to kill two birds. Monetary policy differs from fiscal policy is two ways:
1. Monetary policy has a more powerful impact on nominal aggregates like inflation and NGDP.
2. Some types of fiscal policy can boost the supply side of the economy.
So Mundell recommended tight money to stop inflation and cuts in MTRs to boost real growth. The tax cuts were spread out, but when they took full effect in January 1983 the economy took off, recovering rapidly from a severe recession with all sorts of “malinvestment” problems (such as the permanent loss of millions of rust-belt jobs.)
Today the two problems are fiscal imbalances and weak AD, i.e. weak NGDP growth. If we try to end fiscal imbalances through austerity, then the AD problem gets worse. But if we follow the Mundellian approach we would try to strike a Grand Bargain, easier money combined with smaller budget deficits. Here’s how it might work:
1. Fiscal policy leaders agree to cut the budget deficit by X amount.
2. In return, the Fed commits to return the US to a core price level trajectory rising 2% per annum from September 2008.
Right now the US is 1.4% below the 2% core inflation trajectory, so we need 2% growth plus another 1.4% catch-up. That is far more than markets currently expect over the next few years. In fact, the likely inflation rate over the next year is only about 1%, or perhaps a bit higher. If the Fed made this commitment, it would mean that the combined effect of fiscal austerity and monetary ease would be much more expansionary that current policy is expected to be. How can that be? Very simple; monetary policy has a much more powerful effect on NGDP growth than fiscal policy.
There are huge potential gains for the fiscal authorities. Under current trends, the fiscal problems in the US will paralyze the Obama administration for the next 6 1/2 years. They will be constantly fighting battles with an increasingly Republican Congress. In contrast, this Grand Bargain would reduce the budget deficit in two ways; directly through cuts and tax increases, and indirectly as the Fed’s more expansionary policy would boost NGDP growth and lower the cyclical part of the deficit.
There are also huge potential gains to the Fed. Reading between the lines it is clear that lots of people at the Fed are worried about AD. There is a sense that AD growth is falling short of their expectations and their goals. But big institutions have trouble changing course and admitting errors. A Grand Bargain would give the conservatives an out. They could agree to ease policy and yet still console themselves that the increased fiscal austerity made future hyperinflation less likely (as they wouldn’t be pressured to monetize massive public debts.) And they could still claim to be adhering to their implicit 2% inflation target.
In a subsequent post I will provide evidence that the Fed understands that it does need to move, and I will suggest how they can do so. In the meantime, check out this depressing article in the Telegraph:
Perhaps naively, I still think central banks have the tools to head off disaster. The question is whether they will do so fast enough, or even whether they wish to resist the chorus of 1930s liquidation taking charge of the debate. Last week the Bank for International Settlements called for combined fiscal and monetary tightening, lending its great authority to the forces of debt-deflation and mass unemployment. If even the BIS has lost the plot, God help us.
When the BIS was created in 1930 it was the progressive’s great hope. They suggested that it might be able to coordinate central bank practices to reduce gold hoarding and make monetary policy easier. Alas, it did not succeed. But it is still shocking to see that once progressive institution calling for both fiscal and monetary tightening. In some ways we have even regressed from the 1930s.
Update: The commenter Karen found this very good example, which I had forgotten:
The Grand Bargain sounds like a similar “deal” President Clinton made with then Fed Chairman Greenspan. It has been a while since I read the book “The Maestro” but if I remember correctly, Bob Woodward recounts a conversation early on in the Clinton years (coming out of early 90’s recession) where Greenspan convinced Clinton of the need to keep deficits low and if he did so Greenspan agreed to keep interest rates low. (I know this isn’t necessarily loose monetary policy but in retrospect it seems to be what was implied.) The Grand Bargain seemed to have worked until one side stopped keeping the bargain
PS. If you suffer from depression, make sure to take your medication before reading the entire Telegraph article.
PPS. By the way, in the long run we also desperately need some revenue neutral supply-side reforms to our tax code. Unfortunately, we are currently moving in the opposite direction.
HT: Benjamin Cole and John Salvatier
Tags: Robert Mundell