One-Sentence Macro Policy
By Arnold Kling
I believe the “zero bound” is perhaps the single largest “red herring” in the economics profession today.
If you understand that sentence, you know everything you need to know about Tyler’s case against fiscal stimulus.
In case you do not understand that sentence, let me unpack it. Let us start with the Keynesian assumption that the economy suffers from a lack of aggregate demand. As a cure, we could use monetary expansion, fiscal expansion, or both. The more we use fiscal policy, the more we crowd out private investment and the closer we get to the brink of a sovereign debt crisis.
So the argument for using fiscal expansion instead of monetary expansion needs to be pretty compelling. Consider two arguments:
1. We should be happy about a larger public sector and a smaller private sector.
2. At low interest rates fiscal policy is very effective (no crowding out) and monetary policy may be ineffective (liquidity trap).
When Tyler says that (2) is a “red herring,” he is implying that it is a stalking horse for (1).
[UPDATE: Scott Sumner says that the solution is to force the Fed to have an explicit target.
Let’s suppose the Congress instructed the Fed to target 2% inflation. Now assume Congress wants more growth because we are in a recession, but because inflation is currently 2% the Fed doesn’t want to ease. The fiscal authorities could instruct the central bank to aim for 2% inflation in the long run, but allow a bit more inflation during the current recession, at the expense of a bit less that 2% inflation during the subsequent years. In other words the Fed would still have some discretion, even though their long-run mandate would be 2% inflation.
I think it would be simpler just to set an inflation target and stick to it. In today’s environment, that would require a more expansionary monetary policy.]