More on Stabilization Policy

Mark Thoma had an interesting post on stabilization policy in the form of changes in tax rates. He makes the following points:

(1) Changes in tax rates to 'lean against the wind' during the business cycle should be temporary.

(2) Changes in tax rates to 'lean against the wind' should be consistently applied. Cut taxes when output falls below its potential, but also increase taxes when output exceeds its potential.

(3) As a result of (1) and (2), the budget should balanced over the business cycle. There should be no sustained budget deficits.

(4) Political realities make (1) - (3) difficult to implement in practice. Always count on a politician to cut taxes when the economy weakens, but never expect one to increases taxes during an unsustainable economic boom. Throw in the upward spending bias of most politicians and sustained budget deficits become an almost certainty.

(5) The number of steps in implementing even a thoughtful countercyclical fiscal policy makes this form of stabilization policy almost intractable. If anything, the implied lag in implementing fiscal policy could make it destabilizing rather than stabilizing. (However, automatic stabilizers do provide timely but limited countercyclical aggregate demand management. See related post on structural versus cyclical budget balances here.)

For all these reasons fiscal policy typically plays second fiddle to monetary policy when it come to stabilization policy. However, given the challenges the Fed the ECB have had with credit markets some observers like Martin Feldstein and Lawrence Summers are suggesting fiscal policy supplement monetary policy. Over at the WSJ, David Weasel provides a good overview of this view. Meanwhile, Greg Mankiw tells us that monetary policy is up to the task now at hand and that Congress and the White House (i.e. fiscal policy) should do "absolutely nothing."