The Optimal Monetary/Fiscal Economic Policy
It makes no sense to choose a system whereby one takes indirect measures with imprecise and delayed outcomes combined with negative side effects, instead of choosing a system whereby one takes direct measures with precise and immediate outcomes combined with no negative side effects. Astonishingly, while a direct system could have been chosen, our economic policy system has long been predominantly an indirect one, and that explains the repeated long recessions with high unemployment and the sub-potential growth the nation has endured over the past fifty years. Finally, some economists, including at the Federal Reserve, are starting to ask whether our economic policy system should be changed.
The task of economic policy is to foster sustained maximum potential economic growth with low unemployment while keeping inflation as low as compatibly possible, and to prevent long recessions and high unemployment. Manifestly, our indirect economic policy system consisting of raising or lowering interest rates to manage the nation’s economic performance has failed miserably since 1970. The reason should be clear. The logic of that policy is that raising interest rates will slow the economy in order to prevent overheating and inflation, while lowering interest rates will stimulate the economy in order to end recessions and high unemployment. The problem is that interest rate changes act with a lag and without precise outcomes, apart from potentially having serious side effects, such as creating bubbles (when interest rates are excessively low) and exacerbating economic downturns (when interest rates are excessively high). Moreover there are times when raising or lowering interest rates has little relevance to the economic situation and is therefore ineffective or even counterproductive. Two examples follow.
First, the expression “pushing on a string” reflects the inability of low interest rates to always stimulate an economy. We witnessed this situation in the aftermath of the 2008–9 financial crisis and recession, when lower interest rates were incapable of rapidly stimulating economic growth (through increased borrowing and spending) due to the over-indebtedness of consumers, the excess capacity of businesses, and the precarious balance sheets of many banks. The proper economic policy response would have been not extremely low interest rates (which, by the way, are very unfair to savers) but an immediate large tax rebate financed by the Federal Reserve through QE, putting money in consumers’ pockets in order to stimulate spending and to help families in financial difficulty keep current on their mortgages. Both the recession and the banking crisis would have been nipped in the bud had the 2009 $800 billion Obama stimulus consisted entirely of a tax rebate. How is that? $800 billion was the equivalent of a $5,000 tax rebate. A family of two taxpayers would have received two checks for a total of $10,000, plenty to avoid most mortgage defaults. The recession would have ended instantly and TARP would not have been needed. The Obama plan instead provided financial assistance to people who didn’t need it (v. new home buyers, new car buyers (v. “cash for clunkers”), and state and local governments). Consequently, it did nothing to quickly end the recession and the banking crisis.
Second, the expression “stagflation” (minted during the energy crisis 1970’s) reflected the rare and seemingly contradictory simultaneous occurrence of recession and inflation, which put monetary policy in a quandary. By not making the distinction between “cost-push” and “demand-pull” inflation, the Federal Reserve mistakenly opted for extreme monetary tightness and sky-high interest rates to deal with the high inflation of the 1970’s and early 1980’s which was caused by exploding energy costs, not by excess aggregate demand. The high interest rates deepened the recession while doing little to reduce inflation (since it was not due to excessive aggregate demand), and prolonged the energy crisis by raising the investment threshold for investments in new energy production and conservation. The proper economic policy response to the energy stagflation phenomenon would have been to keep the fed funds rate equal to -not far above!- the current inflation rate (essentially a neutral monetary policy stance) so as to not discourage investments in energy conservation and production, and to have a big tax rebate to prop up consumer demand which was plummeting.
Both the above examples highlight one essential truth: fiscal policy is much more adept at managing the economy than traditional monetary policy focusing on increasing or lowering interest rates. So what would be the optimal economic policy? It would consist of 1) having monetary policy being always neutral and on automatic pilot, with the fed funds rate targeted monthly by the Federal Reserve at the current inflation rate (the trailing 6-month CPI rate); 2) of having QE-financed tax rebates (instead of sharply lower interest rates) as the standard economic stimulus tool; and 3) having temporary income tax surcharges (instead of sharply higher interest rates) as the standard tool for preventing excess aggregate demand inflation. (It is not difficult for the Fed to calculate how much tax relief or tax increase is needed at any given point in time to prevent recession/unemployment or “demand-pull” inflation from developing. All it needs to do is check the unemployment and capacity utilization rates to gauge the amount of slack. As for “cost-push” inflation, the Fed does not have to be concerned with it since market forces eliminate it in due time, as proven by what has happened with oil prices since 1973.) How to implement this optimal economic policy politically? Very simply, any time the Fed thinks tax cuts or tax surcharges are necessary, it would ask for a meeting with the president and congressional leaders and their approval. Congress could pass a law requiring automatic approval with the option of subsequent congressional and presidential review.
It is crucially important to understand the merits of QE in general, and of QE-financed tax rebates and QE-financed infrastructure spending in particular. Regarding QE in general, it is freshly printed money by the Fed to purchase newly issued or outstanding Treasury bonds. As we have seen, contrary to conventional economic wisdom, QE is not inflationary per se. We have had over $3 trillion of QE between 2010 and 2013, yet inflation has remained at historical lows all the way through 2017. The reason? QE (printed money) is not inflationary unless it is excessive and brings about excess aggregate demand. In times of recession (and of low capacity utilization and high unemployment in general) QE has the effect of stimulating the economy without producing inflation, so long as it is properly calibrated in order not to produce excess aggregate demand. Of great importance, QE-financed Treasury debt is only “virtual” debt, not real debt, so long as the Fed keeps those bonds until maturity, at which point they expire and evaporate in thin air. They do not constitute a burden on either current or future generations of taxpayers. The reason is that the Fed is a government agency, and it returns all interest and capital payments on its Treasury bond holdings back to the U.S. Treasury annually. Contrast that with Treasury bonds held by private investors who do not return interest and capital payments back to the Treasury. That’s why Treasury bonds held by private investors are real debt, whereas Treasury bonds held by the Fed to maturity are “virtual” debt.
The merit of QE-financed tax rebates as the standard stimulus tool, apart from their instant effectiveness, is that they are fair since each and every taxpayer receives the exact same stimulus check from the U.S. Treasury. There is no discrimination as there is with “targeted stimulus” which benefits only certain categories of taxpayers. So there will never be complaints from any taxpayer, and there will never be political obstacles to QE-financed tax rebates. As for QE-financed infrastructure, the question of fairness may well arise when the financed projects seem to be “pork”, i.e., favoring particular interest groups and not being in the national interest. But at least such financing will not burden current or future generation taxpayers.
One upshot should be that budget deficits must be properly understood and not obsessed about, so that economic policy decisions are not misguided. Due to the misunderstanding of -and consequent aversion to- public debt financed by QE, we have underinvested in critically important infrastructure (including education), even in military expenditures necessary for an optimal national defense. And we have hesitated to provide enough stimulus to prevent long recessions and high unemployment. We have consequently underperformed economically, socially, and in national defense. At the same time, we have actually greatly increased public and private indebtedness through repeated deep recessions, through periods of excessively high interest rates, and through a growth policy based on stimulating borrowing. We should finally stop obsessing about Treasury debt, since it will be substantially reduced through the combination of 1) sustained economic growth, 2) the absence of prolonged recessions and high unemployment, 3) a neutral monetary policy, and 4) the proper use of QE.
The optimal economic policy proposed here would result in great, sustained economic and social prosperity, particularly if combined with greatly improved public education. A big improvement in public education absolutely requires a truly enlightened and ambitious public high school curriculum, which should include four years of logic/critical thinking, ethics, psychology combined with “group therapy” and “good parenting” classes, as well as a four year course on the United Nations Universal Declaration of Human Rights and the history of human rights violations. Of critical importance is providing individual assistance for students with academic or psychological difficulties. Also of great importance is providing year-round (including during weekends and summer vacation) well-organized after-school activities in the arts, sports, and vocational training. All the above would lead to a nation of very well educated and well-adjusted “Renaissance” citizens while eliminating the high school dropout epidemic. The combination of optimal economic policy and greatly improved public education would lead to the virtual elimination of poverty, violence, crime, addiction, gender discrimination, religious discrimination, national origin discrimination, sexuality discrimination, abuse of power, sexual harassment, racism, social and political discord, vulnerability to “fake news”, and of ignorant politicians. It would lead to much, much lower taxes. The great mystery is why it’s taking us so long to identify and implement the logical economic and social policies we so desperately need.
January 16, 2018
© Edward Sonnino 2018
