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This year marks the 100th anniversaries of two distinct institutionalinnovations in American economic policy: the introduction of the federal income tax and the establishment of the FederalReserve. They are worth commemorating, if only because we are at risk of forgetting whatwe have learned since then.
Initially, neither the income tax nor the Fed was associated with theexplicit concepts of fiscal and monetary policy. Indeed, it wasn’t until afterthe experience of the 1930’s that they came to be viewed as potentialinstruments for macroeconomic management. John Maynard Keynes pointed out theadvantages of fiscal stimulus in circumstances like the Great Depression.Milton Friedman blamed the Depression on the Fed for allowing the money supplyto fall.
Keynes is associated with a belief in activist economic policy aimed atensuring counter-cyclical responses to economic fluctuations – expansionarypolicies during recessions and policy tightening during upswings. Friedman, by contrast, opposeddiscretionary policymaking, believing that government institutions lacked theability to get the timing right. But both opposed pro-cyclical policy,such as the misguided US fiscal and monetary tightening of 1937:before the economy had fully recovered, President Roosevelt raised taxes andcut spending, while the Federal Reserve raised reserve requirements, prolongingand worsening the Great Depression.
After World War II, students and policymakers internalized the lessons ofthe 1930’s. But episodes in recent decades – for example, high inflation in the1970’s – overwhelmed much of what was learned. As a result, many advancedcountries today are repeating the mistake of 1937, despite facing similarmacroeconomic conditions: high unemployment, low inflation, and near-zerointerest rates.
The pros and cons of austerity nowadays have beenthoroughly debated. Austerity’s proponents correctly point out that permanentlyexpansionary macroeconomic policies lead to unsustainable deficits, debts, andinflation. Advocates of stimulus are right to note that in the aftermath of arecession, when unemployment is high and inflation is low, the immediateconsequences of policy contraction are continued unemployment, slow growth, andrising debt/GDP ratios. And pro-cyclicalists, both in the US and Europe, represent the worstof all worlds by pursuing expansionary policies during booms, such as in2003-07, and contractionary policies during recessions, such as in 2008-2012.
But, if counter-cyclicalists are right to favor moderating, rather than exacerbating, upswings and downswings in theeconomy, we still need to know what works best. Given recent conditions, ismonetary or fiscal stimulus the more effective instrument?
John Hicks addressed this question clearly in a once-famous 1937 article called “Mr. Keynes and the Classics.”Under the conditions that prevailed then, and that prevail again now (highunemployment, low inflation, and near-zero interest rates), monetary expansionis relatively less effective, because it cannot push interest rates below zero.Moreover, firms are less likely to respond to easy money by investing in newphysical capital and labor if they cannot sell what they already produce in thefactories they already have with the workers they already employ. Fiscalstimulus is relatively moreeffective inthese conditions, because it creates demand for goods without driving upthose rock-bottominterest rates and crowding out private-sector demand (as it would in normaltimes).
None of this should be controversial. Introductory economics used toemphasize the Keynesian multipliereffect: recipients of government spending (or of consumer spendingstimulated by tax cuts or transfers) respond to the increase in their incomesby spending more, as do the recipients of that spending, and so on. Again, themultiplier is much more relevant under current conditions, because it does notfuel higher inflation and interest rates (and thus crowd out private spending).
Unfortunately, many economists and politicians have forgotten much of whatthey knew (or have been blinded by new theories of policy ineffectiveness).Indeed, by the time the 2008-2009 global recession hit, even advocates offiscal stimulus had lowered their estimates of the multiplier. But thecontinuing severity of recessions in the United Kingdom and other countriespursuing fiscal contraction has suggested that multipliers are not just positive,but greater than one – just as the old wisdom had it. The InternationalMonetary Fund has responded by forthrightly confessingthat official forecasts, including its own, had underestimated the multiplier’ssize.
Of course, the effects of fiscal policy are uncertain. One never knows,for example, when rising debt levels might alarm international investors, whothen start demanding sharply higher interest rates, as happened to countries onthe European periphery in 2010. We are also uncertain about the magnitude ofthe negative long-term effects of high tax rates on growth. And monetary policyis much better understood than it was in the past. Indeed, a much-admired recent paper characterizedmonetary policy as science and fiscal policy as alchemy.
To be sure, the state of knowledge and practice at central banks is close tothe best that modern society has to offer, whereas fiscal policy is set in ahighly political process that is poorly informed by economic knowledge andlargely motivated by officials’ desire to be re-elected. But the problem withthe ancient alchemistsand their search for the philosopher’s stone was not that they were stupid orselfish people. Nor was their problem that political leaders refused to listento them. Rather, the state of knowledge at the time simply fell far short of themodern science of chemistry.
In this sense, the term alchemy could be applied to pre-Keynesians like USTreasury Secretary Andrew Mellon, whose prescription at the start of the GreatDepression was to “liquidate labor, liquidate stocks, liquidate farmers, [and]liquidate real estate” in order to “purge the rottennessout of the system.” It could also be applied to those today who favor returningmonetary policy to the pre-1914 gold standard.
This does not mean that either fiscal policy or monetary policy hasgraduated to the status of a science like chemistry, underpinned by naturallaws that generate precisely foreseeable outcomes. But surely we have learnedsince 1913 that fiscal expansion is appropriate under some conditions, even ifit is inappropriate under others.
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