A Monetarist's View of Fiscal Policy

If you really want to impress your friends and colleagues with your knowledge and sophistication about politics and business, then attempt to engage them in a debate over which is the best economic policy, monetary policy or fiscal policy. Monetary policy manipulates the economy, for lack of a better word, by increasing and decreasing interest rates and thus borrowing. Fiscal policy manipulates the economy by lowering or raising both taxes and government spending. In high school, when I first learned the differences, I immediately became a monetarist, one that favors monetary over fiscal policy, because I viewed monetary policy as that which can be implemented immediately to deal with market forces. Monetary policy is exclusively applied by the Fed chairman and they determine this policy by fiat. Fiscal policy must be created through the legislative process and it can take much longer to create. While I continue to believe this to be true, the last eight years have also shown me the limitations of monetary policy.

Steve Chapman, on the other hand, is clearly a monetarist. I do, however, believe that his piece is more propaganda than reality. Let's examine.

There are only two drawbacks to the proposals offered by both the right and the left. First, they would cost a lot of money, either in lost revenue or additional federal expenditures, further bloating our gargantuan national debt. That cost would be worthwhile if it were essential to stave off a total economic collapse. But there is a second problem: These plans are not likely to work.

Shoveling cash into various public programs sounds like a surefire way to boost total demand and thus juice the economy. But the money doesn't sprout from trees in Tim Geithner's backyard. Any funds it wants to spend, the government will have to borrow. The people who lend the money will no longer have it to spend. So the total amount of spending may not change much, if at all.

Timing is another glitch. Putting crews to work on roads and bridges doesn't happen overnight -- plans have to be approved, bids have to be solicited and contracts have to be signed. The Department of Transportation says that even with projects that are primed and ready, only one-fourth of the money gets spent in the first year. By the time an infrastructure program gets rolling, the downturn will almost certainly be shrinking in the rearview mirror.

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Tax cuts also promise disappointment. The Bush administration claimed its 2001 tax cut had a tonic effect on a weak economy, but it turns out that most of the money went to increase savings or reduce debt, not to unleash spending. Likewise with this year's tax rebates.

Even some experts who favor keeping tax rates low doubt that extending the Bush tax cuts beyond 2010 would do anything for the economy right now. "As a tool for dealing with this crisis, I don't know," Nobel Laureate economist Robert Lucas of the University of Chicago told me. "It's misleading to advertise them as an anti-recession device."

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Everyone wants to do something. But holding off on a fiscal stimulus package wouldn't exactly mean doing nothing. Monetary policy has historically had a more potent and predictable effect on the economy than fiscal policy, and in recent months Ben Bernanke has been spraying money with a fire hose -- cutting interest rates, boosting bank reserves 15-fold since August and taking radical steps like buying up short-term commercial debt.

All those steps will pay off, but they take time. Adding fiscal measures would probably be superfluous. If you want to go to the 10th floor on an elevator, punching the button over and over won't get you there any faster. We can throw a lot of money at the recession, but in the end, what we'll get is no hastening of recovery and a big stack of bills.

Now, I am no proponent of increased government spending as the form of fiscal policy. I agree with Chapman that a lot of government spending can also take years to implement. Government spending is only one form of fiscal policy though. Tax cuts, in my opinion, is much more fruitful economic stimulus using fiscal policy.

Chapman dismisses tax cuts by saying that the Bush tax cuts of 2001-2003 went mostly to savings. I would take issue with this characterization. He offers no evidence or proof of this theory. Furthermore, there is a certain lack of logic to it. If the tax cuts went merely to pay down debts, why would he favor monetary policy? Monetary policy is supposed to stimulate borrowing. If Bush's tax cuts stimulate paying down debts, people weren't going to then turn around and borrow more were they?

Then, Chapman invokes the cryptic "some experts" to claim that extending the Bush tax cuts won't have stimulating effect. I don't who Robert Lucas is but I do know that he doesn't hold a monopoly on sound economic forecasting. Just because he thinks that extending the Bush tax cuts won't work, doesn't actually mean it won't work.

Chapman's biggest propaganda is in claiming that monetary policy has "historically had a more potent and predictable" outcome. Where is his evidence of this? The Fed has been furiously dropping rates since last September and in the meantime the economy has only gotten worse. Furthermore, Chapman's characterization of tax cuts as "throwing money at the problem" is a total distortion. By giving people and businesses a tax cut you aren't throwing any money anywhere. You are letting folks keep more of what they have earned. That's why I support tax cuts as the best sort of stimulus. The characterization that a tax cut is throwing money at something is totally without merit.

Chapman also says nothing about the relationship between Greenspan's furious drop of the Fed Funds Rate and the current crisis we are in. I have surmised that when Greenspan dropped the Fed Funds Rate below 1%, this started the ball rolling on the current mess, and I am not the only one. While I agree that my theory is only a theory, if you are going to hold up monetary policy as the beacon good economic stimulus, you need to address its role in the current crisis at least. For Chapman to not say anything at all is the sort of selective evidence that propagandists are known for.

Finally, Chapman says nothing about the stimulating effect of Reagan's tax cuts in the early 1980's. If fiscal policy is inherently counter productive, why was it so successful then? Again, Chapman fails to address something that is inconvenient to his argument.

The debate between monetary and fiscal policy is an excellent one to have, but it should be done honestly and Chapman's article is rank propaganda.