Bad policies lead to bad theory
By Scott Sumner
In the past, I’ve argued that bad economic policies led to the development of Keynesian economics. The two major culprits were tight money during 1929-32 and the NIRA (which both dramatically raised real wages.)
If Irving Fisher’s “compensated dollar plan” had been adopted in the early 1930s, the US economy would have recovered quickly, and pundits would have seen that as confirmation of Fisher’s theory that business cycles were primarily a “dance of the dollar”, in other words, caused by monetary shocks. Because this policy was not adopted (until much later, in a watered down form by FDR), and because the NIRA delayed the recovery, the capitalist system became seen as inherently unstable and prone to long periods of depression. Keynesian economics was born.
If Fisher’s compensated dollar plan had been adopted, he would have been correct.
Now we are seeing something quite similar play out. In previous posts, I criticized the view that the recent sub-2% inflation shows that the Fed may not be able to hit a higher inflation target. The claim is silly, as the Fed is actually raising rates to hold down inflation, but seems to be widely held nonetheless. Here’s The Economist:
Ben Bernanke, chairman of the Federal Reserve during the crisis, proposed a clever approach: when the economy next bumps into the ZLB, the central bank should quickly adopt a temporary price-level target. That is, it should promise to make up shortfalls in inflation resulting from a downturn. . . .
If credible, that promise should buck up animal spirits, encourage spending, and drag the economy back to health. Raising inflation targets would reduce the frequency and severity of ZLB episodes. . . . Less clear is whether a central bank could fulfil its promise. The Fed has failed to hit its 2% inflation target for the past five years, after all. Mr Bernanke’s proposal would do little good if markets doubted a central bank’s ability to fulfil its promise to deliver catch-up inflation.
The constraints facing central banks suggest better hopes for the second way forward–greater reliance on fiscal policy.
When we think of the cost of the Fed failing to hit its inflation target during recent years, the obvious place to look is employment. The job market recovered more slowly from the Great Recession that would have been the case with 2% inflation, on average, during 2008-2017.
But now I wonder if there isn’t an even greater cost to monetary policy failure. It has created the incorrect perception that monetary policy is ineffective, even when not at the zero bound. This despite the fact that there are no serious Keynesian models where monetary policy is ineffective at positive interest rates. So strong is the profession’s belief in central bank infallibility that they have distorted theory to match so-called stylized facts (of monetary impotence) that do not in fact exist.
BTW, the same issue of The Economist says:
The IMF reckons that the optimal tax rate on higher incomes, assuming the aim is revenue maximisation, is 44%. Britain’s highest rate is already 45%. So the IMF study does not really provide much ammunition for Jeremy Corbyn, the leader of the Labour Party, the main opposition, who wants to raise it to 50%. It is a better argument, perhaps, for Bernie Sanders, the Democrat, since the top American tax rate, before any Trump cuts, is only 39.6%.
Where to begin. The phrase “assuming the aim is revenue maximization” certainly caught my attention. When governments maximize revenue from a tax, the marginal cost of the final dollar raised is infinite. It’s a bit odd for the normally sober Economist magazine to be assuming that public policies with infinite marginal costs are sensible. And you can’t fix the problem by assuming that the marginal benefit of additional consumption for the rich is quite low, as what is being discussed is an income tax, not a consumption tax. Rich people do not consume all of their income.
But the bigger problem is that the Economist is wrong in assuming that America’s top income tax rate is 39.6%. The top federal rate is 43.4%, and with state and local income taxes included the figure is certainly well over 44%.
I eagerly anticipate the Economist’s next issue, where they correct their mistake and point out that the IMF study actually calls for tax cuts for the rich in America.