Monday, July 26, 2010

Monetary Policy Dominates

Scott Sumner once used the analogy of arm wrestling with his daughter to describe why monetary policy always dominates fiscal policy.  Scott explained that no matter how hard his daughter tried to win the arm-wrestling contest he would always apply just enough pressure to offset her efforts and keep her in check.  Likewise, no matter how expansionary or contractionary fiscal policy may be, at the end of the day the Fed has the ability to offset such actions and place aggregate demand where it so chooses.  This point is vividly illustrated in the article titled Money Dominates by Steve Hanke. Read it.


  1. Wouldn't a reduction in payroll tax have a powerful stimulus effect on the economy ? More powerful than the Fed doing yet another bout of QE ? Have you seen the Romers article in the AER on the power of tax cuts?

    However, I would agree it is just a temporary and piecemeal policy. Fiscal and monetary policy to return the economy to what, 2007 ?
    We already tried monetary policy to wallpaper over the cracks of a country in decline and it gave us a housing bubble and financial collapse.

    Thoroughgoing financial, political and educational reform are the real keys. How bad things have to get in America before genuine reform occurs I don't know. Britain went through 30 years of decline before the voters said enough is enough.

  2. I think we can all agree that fiscal policy will be ineffective if the monetary authorities deliberately choose to fully offset it with monetary policy (as they generally did do during the 1980 to 2008 period). But Hanke provides no evidence that the Fed is deliberately choosing (or would deliberately choose) to offset fiscal policy today. He takes a case developed by using examples of deliberate monetary policy and extends it, without any logic, to the behavior of money and credit in the presence of a central bank that is apparently not deliberately offsetting fiscal policy.

  3. ECB, yes I agree with you on the payroll tax issue. And you know I am also symptathetic to your views on financial reform. In my ideal world we would eventually--after there has been a meaningful recovery--go to a productitivity norm typle of nominal income targeting rule.

    Andy, the Fed may not be deliberately trying to offset fiscal policy today but to to the extent it is passively allowing demand expectations to decline it effectively is doing just that.

  4. You have to compare two alternative fiscal policies and ask if the Fed would act differently in such a way as to render the net effect on demand identical. Suppose the US Congress passed another fiscal stimulus bill. Would the Fed act differently depending on whether it is passed? I doubt it.

  5. From a narrow macroeconomic viewpoint, monetary policy (viewed as fiddling with interest rates or money supply) is more potent that fiscal policy (viewed as deficits/surpluses). But there are always microeconomic side-effects to macroeconomic policy actions and these can be hugely significant. For that matter there are microeconomic policies (eg, the minimum wage and government regulation) that can have big macroeconomic effects.

    The problem with macroeconomics is that it deals with ill-defined or unmeasurable aggregates as if they were well-defined or measurable. So we hear things like monetary policy is more potent than fiscal policy that are in a certain narrow sense true but obscure the real issues.

  6. I was tempted to say Hanke was being disingenuous, but why not just call him a liar? The time for fiscal stimulus is at the 0 bound, which we are very close to now. The prime rate in Japan in 1990 - as a 15 second Google search revealed - was 6%.

    Misrepresenting Krugman and Keynes is great sport in certain circles. But it does nothing for one's credibility. Except for inside the circle, of course.

    And it's not either - or. Surely a combination of fiscal and monetary actions will have more of an effect that either on its own.

    And to ecb's point, targeted policies will have much more of an effect than, frex, across the board tax cuts, which have already proven to be ruinous, or dropping money from helicopters.

    Banks have ceased functioning as financial intermediaries,and the M1 multiplier is below 1. How about attacking those conditions? Eliminating interest on reserves might be a start.