The times are a’changing, as recent macroeconomic fashions are being abandoned and old verities are being restated.
Alan Blinder, an American economist, described as ‘one of the great economic minds of his generation,’ was an economic adviser to President Clinton and was a Vice Chair of the American Federal Reserve (central bank). He is known to many as the co-author of an extremely successful textbook.
He recent monograph Fiscal Policy Reconsidered is an important statement by a saltwater economist contrasting with the failure of the freshwater Austerians (those who advocate fiscal austerity). It argues that it is possible to have an effective fiscal policy (that varying government taxation spending and borrowing can be beneficial for the economy) and that monetary policy (what central banks do) may not be effective.
His position is summarised in a rejection of two standard neoliberal propositions.
- that sensible fiscal policy is impossible because Congress is too slow and too political;
- that fiscal policy is superfluous because monetary policy can always do the job.
I explain what this means by the New Zealand experience. Even so, some readers may find the column all a bit technical. Sorry. If anyone can simplify without losing the rational economics, please have a go.
Once Were Macroeconomics
In the 1960s and 1970s both propositions that Blinder rejects would have been thought odd. It was quite usual to change fiscal settings in order to change the direction of the economy – to protect the balance of payments, to change employment levels and to restrain inflation.
The prime minister commanded parliament so he did not have the difficulties that the US president has, but there were implementation lags; it took about six months to set up a change in income tax. Formulating the right policy response is not easy either.
One of the tricks in the fiscal system was that the tax system was progressive so that a rise in incomes from economic growth or inflation meant that tax revenues rose proportionally faster than the economy – a phenomenon called ‘fiscal drag’. That meant the main tax changes usually involved cutting rates, which are easier to get through parliament. The flattening of our income tax scale has reduced this progression with the consequence of less fiscal drag and a loss of the ‘automatic stabilisers’ which we thought important at the time, as does Blinder does today.
Spending changes were harder. I recall once in the late 1970s when Treasury officials had been instructed to increase infrastructural spending and were scrambling around to find projects which could be implemented immediately. Was that the time when the government gave a one-off increase in the family benefit because it could be done very quickly? An additional worry is how to wind spending down when there was too much expenditure pressure.
The difference between spending and current revenue has to be borrowed. Looking back all those years, I think we were a bit sloppy in our thinking. Debt is a burden on future generations. Today we might say that current spending and revenue should be equal over the business cycle but that the government may borrow for long term for investment. Nowadays, infrastructural investment is the big thing, but once a lot of government borrowing was for investment by state owned enterprises. In either case, assuming the investment is effective – it was not always – future generations had its benefit to offset the burden of debt.
The role of monetary policy in this macroeconomic framework was to support fiscal policy, not an alternative to it. Generally monetary policy was thought to take a long time to be effective; I recall about ten years. Moreover it worked through interest rates impacting on investment and consumer borrowing, not through the quantity of money, which Monetarists like Friedman thought. (One trouble was there were so many definitions of money and if you targeted one all the others moved differently.)
I’ve set down as briefly, and as non-technically, as I dare the standard macroeconomic framework of the times. There is no question that Muldoon misused it. The conventional macroeconomists of the day criticised him; so did the Monetarists.
Then Came Monetarism
In the mid-1980s, the Rogernomes abandoned the standard macroeconomics framework and imposed a monetarist one based on principles not unlike the two which Blinder criticised. It substantially reduced the significance of fiscal policy and put the weight of macroeconomic control onto monetary policy.
I recall that at the time it was suddenly assumed that monetary policy worked quickly – in months rather than years. I do not recall any empirical evidence to support that conclusion. We seem to have simply adopted the American monetarist framework including the idea that parliament could not manage fiscal policy. It was colonial cringe, taking over the imperial ideology with little thought of its local relevance.
One of the strange results was that the Treasury in charge of fiscal policy and the Reserve Bank in charge of monetary policy did not talk to one another, a matter not addressed until the late 1990s.
That said, a close reading of RBNZ statements indicates that their economists thought fiscal policy important – certainly more important than the public rhetoric. I think what was happening was that there were still conventional macroeconomists in the institutions who, while not dominant, continued to use the standard framework.
The Monetarists claim the great success of their framework was the squeezing out of inflation from double digits (above 10 percent a year) to very low levels. But the story is more complicated.
First, much of the inflation of the mid-1980s was from government policies (such as introducing GST, raising State Owned Enterprise prices and hiking the exchange rate). Once the new initiatives stopped you would expect inflation to fall.
Second, world inflation was falling so there were not the same external pressures on domestic inflation.
Third, Rogernomics and (later) Ruthanasia (deliberately) broke the linkages and protective mechanisms which enabled a price rise in one part of the economy was transmitted through the rest.
Fourth, inflationary expectations were reduced. This reduction could be attributed to the new monetary policy but equally Muldoon could say that his price freeze reduced expectations too. It was not so much the policy itself but that the public believed the policy.
Thence was the GFC
If you look at the economists who predicted something like the GFC would happen – they got neither the exact timing nor the magnitude correct, of course – they were using the conventional rather than the monetarist framework. The conventional framework has proved more helpful since the GFC. Indeed Monetarists have repeatedly said policies which involve enormous increases in the stock of money will generate inflation. They have not in the short run (although they may in the long run, as the conventional framework allows).
However, stimulation from monetary policy by itself has not led to a strong economic recovery. Again holders of the conventional framework are not surprised and there have been increasing calls for a fiscal stimulus, typically by government borrowing to spend on (infrastructural) investment.
This is the context of Blinder’s paper. Let me finish by saying that there is nothing in the conventional framework which says that fiscal and monetary initiatives should be ill-disciplined. They have to be applied with care and thoughtfulness and with a pragmatism rather than ideological fervour.