Balance In All Things

"When economists write textbooks or teach introductory students or lecture to laymen, they happily extol the virtues of two lovely handmaidens of aggregate economic stabilization -- fiscal policy and monetary policy." - Arthur Okun

In 1977 when I got my three credits in economics, I learned that the government had two tools to use for managing the economy: monetary and fiscal policy. Maybe they don't teach this anymore. Maybe that is the problem.

A Policy Ignored

In his recent "big piece," Paul Krugman says economists have been ignoring fiscal policy. "They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed."

Not everyone agrees with Krugman that economists ignore fiscal policy. Don Marron (Seeking Alpha, Sept 8 2009) writes:

"Back in graduate school, I was indeed taught that monetary policy was the preferred tool for addressing economic weakness (e.g., because of policy lags and concerns about the political economy of what passes as fiscal stimulus from the Congress). In my years in Washington, however, I have met many economists, of the left, right, and center, who believe in fiscal policy as well. Indeed, in policy circles, the idea of fiscal stimulus was active in 2001, 2003, 2008, and 2009, each of which witnessed tax cuts (and, in the most recent case, spending increases) that were partly or wholly passed in the name of stimulus. One can debate the merits of those acts, but the concept of fiscal stimulus has been alive and kicking."

Marron's observations are important. But of the four fiscal policy events he lists, only the last one is the sort of fiscal policy to which Krugman refers. The others are fiscal policy "light." Tax cuts to stimulate growth. That's the sort of policy that used to be called "the new economics" in the days of JFK and LBJ. Economics from the days when economists figured "potential" output, and government ran deficits intended to push output up to its potential.

It is difficult to understand why such a policy is still used today, long after the obvious failure of the "full employment budget." I think the wonks don't know what else to try.

Yeah, PK defines fiscal policy as "changes in government spending or taxes." But he also says, "Fiscal stimulus is the Keynesian answer to the kind of depression-type economic situation we’re currently in." The Keynesian answer includes massive stimulus spending. (Krugman has called for a second stimulus, $500 billion more, on top of this past February's $787 billion.) For Krugman, there is much more to fiscal policy than tax cuts.

Krugman says economists have been ignoring fiscal policy. But Krugman ignores it, too. He uses the word "fiscal" exactly twice in the big piece. Once, to point out that fiscal policy is generally ignored. And once, to say it's useful in an emergency. By contrast, the phrase "monetary policy" occurs four times, the word "money" six times, and the fragment "monet" nine times.

The word "behavior" also appears nine times in the piece. Krugman says behavioral economics is the next great leap forward:

[Economists] will have to acknowledge the importance of irrational and often unpredictable behavior....

Economics, as a field, got in trouble.... [The profession] will have to reconcile itself to a less alluring vision.... There’s already a fairly well developed example of the kind of economics I have in mind: the school of thought known as behavioral finance.

What’s probably going to happen now — in fact, it’s already happening — is that [behavioral] flaws-and-frictions economics will move from the periphery of economic analysis to its center.

It is like a pebble in my shoe, Krugman's fascination with human behavior. I cannot ignore it. "Flaws and frictions" can only complicate matters, dragging economic thought further from a clear understanding of the problem. Back in 1936, Krugman's mentor Keynes wrote The ideas... are extremely simple and should be obvious. The "best framework we have" is simple and obvious.

A Conflict Ignored

The best economy we have grows more slowly than we want, with prices that rise more quickly than we want. So we use stimulative fiscal policy and restrictive monetary policy at the same time. Do you see the conflict in that? We restrict the quantity of money at the same time we encourage spending. Driven by policy we spend more, even though we don't have the money. This is the main reason we use so much credit.

Perhaps these conflicting policies occur not at the same time, but each in its turn. Sequential alternation of policy produces the same result. And that, in the Arthurian view, is how we got into this mess in the first place. We do more spending with less money. To do it, we use more and more credit. But I'm still waiting for somebody with economic credentials to embrace these ideas or blow me out of the water. I wait, and the economy gets progressively worse.

Krugman says fiscal policy has been ignored. I say fiscal policy is not the only thing ignored. The interactions of policy are also ignored. Economists figure they know the simple facts. No one wants to spend extra time thinking about the basics. No one is on the lookout for unintended consequences. This is how policy becomes dogma.

The economy we have is a result of policy. That would be often said if times were good. It is no less true when times are hard. The purpose of policy is to influence conditions. I say simply that economic policy has worked. Existing conditions are the result of policy. Our excessive debt is the result of fiscal stimulus to spending, on top of a monetary policy designed to fight inflation, continuously applied since the 1960s.

More accurately: Existing conditions are the result of policy and human nature. But there is nothing to be done about human nature. If we want to improve conditions, we will have to improve policy.

To Improve Policy

In a previous post I said:

If the quantity of money goes up more than total debt goes up, financial stress is relieved.

In that earlier post those words sound inflationary. It need not be so.

Picture the economy in your mind. Above it, put a circle. Make the circle just the right size to hold the money needed for the economy. Not too big; that would be inflationary. But not too small either; that chokes off growth.

Now start it up and let it run. It's a good economy, so it grows. As it grows, the circle gradually increases in size. It grows in proportion as the economy grows, and prices are stable. Nice job.

Now, let the economy run. Focus on the circle. Think of it as a pie chart, part red and part green. This circle that represents the money we spend is partly credit-in-use, and partly government greenback and non-credit money. Idunno, make it half and half.

As the economy grows in your mind, the circle grows too, and prices are stable. You can run it for 20 years and still keep prices stable. Now let's take this scenario and tweak it.

You know it works. You know it keeps prices stable. Okay, let's run it again. We won't change the size of the circle because we know it is good. But we'll change the pie chart part. We'll make the red a little bigger each year, and the green a little smaller. As the Federal Reserve restricts the growth of M1 money, the circle tries to shrink. But Congress comes up with one of Don Marron's tax cuts, passed in the name of stimulus. And that restores the circle to the size we want.

As the years go by, we notice the green half is getting smaller and the red half is getting bigger. We're using more credit, and accumulating more debt. Gradually, the cost of debt service creates a drag on the economy. Money goes to pay interest and repay principal, instead of to the purchases and investments that add to output.

At the same time, the extra cost of this money is working its way into prices. It starts pushing prices up, just a little, two or three percent a year.

Before you know it, another one of Don Marron's tax cuts is needed, to boost economic performance. It works, but at the same time the Fed has to respond by restricting the green a little more, to fight the inflation. The circle starts to get vicious.

Then along comes Arthur and says, "Your circle is the wrong color." Too much red.

The solution, my solution, is to tweak the pie chart part. Restore the balance between the red and the green. Reduce our reliance on credit, and increase our reliance on the non-credit dollar.

This solution does nothing to change the size of the circle. It does nothing inflationary. It only changes the balance of cash and credit in the stuff we use for money.