Benjamin Cole is a frequent commenter and a very persuasive writer. Now they have produced the first book applying market monetarist ideas to monetary policy during recent decades. I wrote the foreword:. Prior to the recession, the standard formula called for adjusting interest rates up and down in order to target inflation.
The hope was that a low and stable inflation rate would insure economic prosperity. We now know that this policy is not enough. The financial crisis and Great Recession that followed were not at all what they seemed to be at the time. The profession is beginning to come around to the market monetarist view of the importance of a stable growth path for nominal GDP, and this perspective casts a whole new light on the events of the past 5 years.
Did stocks sail higher than bonds? Was it better to own Apple or Google? A world in which monetary policy can be reduced to a simple rule or two seems very appealing. Unfortunately, we don't live in that kind of world. The straightforward implication of this is that the policy process must be sprinkled with a generous dose of judgment and flexibility and a willingness to adjust policy and policy targets as changing economic and financial developments warrant. This view as to what can realistically be expected of monetary policy should not be and need not be seen as running contrary to the underlying precept that persistent discipline in the money and credit creation process is and will remain a necessary condition for sustained noninflationary economic growth.
However, if a suitably flexible policy of monetary discipline is indeed a necessary condition for economic prosperity and stability, it does not follow that it is a sufficient condition to insure those results. Monetary policy does not operate in a vacuum. Thus, even if monetary policy alone can force, at least for a time, the result of price stability, the overall economic and financial environment within which that result is achieved will be quite different, depending on other circumstances, the most important of which is fiscal policy.
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Indeed, in the context of a fiscal policy outlook characterized by a secular pattern of large structural budget deficits, the economic and financial conditions associated with a persistently disciplined monetary policy are not attractive. On the one hand in those circumstances, a persistent discipline in monetary policy entails very high risks of stop-and-go growth patterns, relatively low capital formation rates, a shift in the composition of output toward the government sector, and periodic collisions between public and private borrowing needs with the ever present danger of collisions turning into crunches.
Given the importance of fiscal policy for economic stabilization and for the way in which monetary policy influences the economy, it would be useful to place the current and widely publicized deficit problem of the United States in some historical perspective with regard to its origins, its size, and its implications for the future. That historical perspective must start with an appreciation of the views about fiscal policy that were popular in the mids.
Every student of economics carefully digested the spoken and written word about inside lags, outside lags, and the relative size of various tax and spending multipliers in a context in which it was perceived that spending or tax policies could and would be quickly and easily altered to meet any cyclical contingency. In that setting, some suggested that the budget would at least balance in periods of high employment, so structural deficits would not occur.
Others almost seemed to suggest that the bigger the deficit the better, while still others suggested that the size of the deficit was largely irrelevant. That is partly because we are now faced with the prospect of a string of large structural deficits and partly because the dimensions and characteristics of the budgetary problem have changed materially from the situation of the mids and even the early s. Indeed, it now seems that the federal budget and our budgetary problems have taken on a structural and an institutional character that both reflect and contributed to the economic problems of the period.
That is, over an extended period of time, the character of government spending and tax policies seems to have developed a bias toward less discretion, larger deficits, and more inflation. A look back at federal budgetary trends over the past two decades or so reveals that these structural problems in our budgetary affairs became visible in the mids even though their roots may be traced further back.
For example, between the mid- s and the mids, budget outlays as a percentage of GNP tended to average around 20 percent, with deviations from that average being largely cyclical in nature see figure 4. Similarly, receipts tended to run at about 19 percent of GNP, with some cyclical ups and downs. Moreover, until the mids, the federal debt held by the public relative to GNP continued to trend strongly downward. Thus, until the mids the deficit problem, while very real, was of somewhat manageable proportions and in years of relatively high employment was not of overwhelming size in absolute or relative terms.
Beginning in the mids, however, the visible character of the budgetary situation began to change in ways that had its roots in the simultaneous occurrence of high unemployment and high inflation. In that setting, inflation no longer worked to reduce the deficit and may in fact now tend to increase the deficit. This was another of the insidious ways in which the costs of inflation took their inevitable and heavy toll on economic performance and prospects.
Moreover, in the face of high unemployment, the traditional spending side pressures on the deficit were ever present in a circumstance in which it was increasingly difficult to rationalize deficit-reducing measures even for the so-called out years.
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By the early s, these changed characteristics of the budget were deeply entrenched and were then coupled with a series of changes in tax and spending policies which, though they helped spur the economic recovery, also interacted with earlier developments to further alter the long-term budgetary situation. As a result of this long and complex series of interactions, we are now facing a situation in which the financial implications of the budget deficit and the ongoing costs of financing the federal debt have taken on an ominous character for the decade of the s.
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While the broad origins and dimensions of the current budgetary problem are widely recognized, there are two specific aspects of the budgetary situation which can help illustrate the manner in which a long history of events and policies is now influencing the size of the deficit. They are the changed size and importance of so-called tax expenditures and the future implications of interest on the deficit itself and on economic prospects. Tax expenditures, in the words of the United States Budget in Brief, p. They arise from special exclusions, exemptions, or deductions from gross income, or from special credits, tax rates, or deferrals of tax liability.
Tax expenditures are so designated because they are one means by which the Federal Government carries out public policy objectives; in many cases, they can be considered as alternatives to direct expenditures. For example, investment in capital equipment is encouraged by the Investment tax credit; a program of direct capital grants could also achieve this objective.
Similarly, State and local governments benefit from both direct grants and the ability to borrow funds at tax- exempt rates. In short, tax expenditures are an alternative to direct government spending, but they may also be thought of as foregone tax collections or a form of entitlement program in which the test of entitlement is any one of a myriad of possible circumstances. Regardless of how tax expenditures are labeled, to the extent they are increasing, they tend to add to the deficit and to the Treasury's external financing requirements in much the same way as do direct spending programs and tax rate reductions.
Tax expenditures are of interest and importance not only because of their implications for the deficit as such, but also because, in the aggregate, they are suggestive of opportunities to reduce the deficit by broadening the tax base. Further, aggregate tax expenditures, viewed in the light of conventional budget totals, probably provide a better picture of the overall size of governmental presence in economic affairs.
Historically comparable data on tax expenditures are not easy to come by, in part because the calculations needed to make such estimates are inherently difficult. Moreover, even the data that are available must be treated with care, particularly when aggregated relative to the budget or to GNP. However, the data limitations notwithstanding, the growth and sheer size of tax expenditures speak for themselves see figure 5.
For example,. Thus, tax expenditures are now a major factor contributing to the overall federal budgetary problem and in the aggregate are larger than any single line item in the budget even though they do not directly appear in the budget. Indeed, while each individual tax expenditure was designed to serve some wholly reasonable public policy objective, the cumulative weight of all such expenditures is now a major element in the overall budget dilemma. In the final analysis, the extent of the deterioration in the budgetary situation may be best captured by what has happened and what will happen to the size of the federal debt and by the interest costs of financing that debt.
Of course, a rising level of federal debt is not new, or unique to the United States. However, during most of the postwar period, the rising level of the federal debt was not a matter of pressing concern to most, in part because the debt relative to GNP declined at a fairly steady rate and partly because interest costs as a percentage of GNP or as a percentage of total federal outlays were fairly constant and not at overly alarming levels.
However, coincident with the structural deterioration in the budget deficit and the inflation-induced higher level of interest rates, the picture regarding the federal debt and the costs of financing that debt began to change. As mentioned above, this unhappy outlook for federal debt and interest costs will materialize even if interest rates trend down from their current levels throughout the decade.
All of the preceding estimates of the outlook are essentially based on economic assumptions which call for 1 steady growth in real output at a rate of about 4 percent between and , 2 inflation holding in a range of between 4 and 5 percent over the decade, and 3 interest rates trending down modestly over the period. The financial implications of these prospective deficits and their implications for monetary policy are difficult to anticipate in part because we are facing a situation that is without precedent.
The financial implications of the prospective deficits truly are uncharted territory. However, while there is room for debate about particulars and quantities, there can be little doubt that the overall financial implications of the deficit outlook are not good. Given an appropriately disciplined noninflationary monetary policy, the aggregate supply of credit is relatively fixed on a year-to-year basis. Relative to GNP, it can be augmented only by higher rates of savings by individuals, businesses, or other economic agents such as state and local governments or by increased capital inflows from abroad.
In the current circumstances, it would seem highly imprudent to assume or conclude that the next few years will bring any sizable increase in credit flows from higher saving rates or from increased capital inflows from abroad. In either case, the prospective deficits are simply so large that it is highly unlikely that they can be financed year in and year out in the context of a smoothly functioning economy and smoothly functioning money and capital markets.
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At the outset of this essay, it was suggested that a review of developments over the past fifteen years could help clarify a vision of the future in which the mistakes of the past could be avoided and prospects for lasting prosperity accordingly enhanced. In that spirit, the experience of the past points to several broad considerations which should play a major role in our thinking about the future of the economy and about future economic policy,.
Both experience and economic theory tell us that moving in the directions outlined above should distinctly improve the odds that the solid economic performance of can be extended well into the future. Those odds can be enhanced further by a renewed commitment to less regulation, freer markets at home and abroad, and strengthened cooperation among labor, management, and government.
However, experience also tells us that there is no perfect guide to the future.
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Economic relationships are not carved in stone, and economic institutions are not fixed in time. Thus, a pragmatic view of the future is one that must be sensitive to the limitations as well as the value of various economic theories without losing touch with institutional reality. Stay Informed. Add email to start Economic Theory. The Road to Serfdom. Aid, Trade and Good Governance: can we make poverty history? Economic Affairs. Economic Affairs Vol
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