Free Market Economists and Monetary Policy

Bryan Caplan asks why free market economists tend to favor monetary policy while economists favoring big government tend to favor fiscal policy. He argues that there is no reason why free market economists might not favor tax cuts.

The assumption, of course, is that the problem is recession and that it is being caused by real expenditure being less than the productive capacity of the economy. On the other hand, one could ask why free market economists don't address inflation by calling for cuts in government spending rather than monetary restraint.

I think the best answer is "truth." Economic understanding leads to support for free markets and also an understanding that any problem with an imbalance between productive capacity and real expenditure is due to an imbalance between the quantity of money and the demand to hold money. While changes in taxes, government spending, and budget deficits might impact the demand to hold money in a way that can correct imbalances, changing the quantity of money goes directly to the heart of the problem.

As Caplan points out, hard core Austrians and libertarians often dismiss both monetary and fiscal policy. While some of them lack a sound economic understanding, many do understand the situation. If the quantity of money is not changed, then the market process that corrects an imbalance between the demand to hold money and the quantity of money is a change in the price level. Money prices, including the prices of resources, such as the wages paid to labor, must decrease enough to raise the real quantity of money to match the demand to hold money. At the same time, this reduction in the price level will raise real expenditures on goods and services enough to match the productive capacity of the economy.

The debate, then, between those free market economists who favor an expansion in the quantity of money and those who oppose such changes depends on whether the problems associated with moving to a lower price level are worse than the problems created by monetary institutions that generate an increase in the nominal quantity of money when needed. While there may be exceptions, most agree that the market system would work imperfectly, but government intervention, which would include some regime that allows for changes in the quantity of money, has its own dangers. Just as the more moderate free market economists accept government provision of national defense, despite the possibilities for abuse, many also accept an increase in the quantity of money engineered by a government central bank, despite the dangers. (Strawman? Read some hard core Austrians and libertarians.)

The anti-market economists, on the other hand, focus on special cases where the market process fails to work. The arguments against "monetary policy" may not always apply equally well to increases in the real quantity of money generated by a lower price level, and vice versa, but every rhetorical trick in the book is used. If prices and wages fall in proportion, real wages don't fall and employment doesn't rise. Like the need isn't for the real quantity of money to rise to match the supply. There is no shortage of money. No one wants to borrow. You can't push on a string. Like the problem is with loans rather than an imbalance between the quantity of money and the demand to hold it.

And what is the solution from the anti-market perspective? An increase in government spending--a more extensive provision of government services. Nearly as good is an expansion of transfers to the poor. And while tax cuts are supposedly of doubtful use, if the tax system is made more progressive, to further reduce the relative burden of government on those with lower incomes, that just might do the trick.

Sure, all of this will work only to the degree that those who fund these expenditures, transfers, or tax cuts by purchasing government bonds at least partially pay for the bonds by reducing their desired money balances. Or, of course, in reality, the bonds are purchased by the central bank, so that the quantity of money is rising to meet the demand to hold money after all. The true nature of the problem is all hidden in order to implement a political program that big government economists favor at all times--an expanded welfare state.

Still, this doesn't explain why free market economists don't advocate tax cuts to expand real expenditures when they are too low relative to productive capacity and cuts in government spending to shrink real expenditures when they are greater than productive capacity. Isn't the problem with the tax cuts obvious? Given government spending, tax cuts result in an increase in the budget deficit and a higher national debt.

While supply side economists, new classical ricardian equivalentists, and hard core Austrians and libertarians may consider budget deficits and government debt to be nonissues or a lesser evil, many free market economists, particularly those with a "Virginia School" background, are very skeptical of government borrowing. Are we supposed to advocate higher taxes later? Or is it lower taxes in the recession and then lower government spending to balance the budget and pay off the accumulated debt after the recovery?

Perhaps. But this looks too much like some kind of political strategem aimed at shrinking the size of government. Tax cuts to create jobs! Look at the the national debt. We are going bankrupt. Cut government spending! (Unfortunately, the Karl Roves of the world don't always get on board with the second half of the plan.)

In my view, making clear the cost of taxes so that voters can compare them to the benefits of government spending is important. If budget deficits and national debt are used smooth fluctuations of tax revenues and government spending, it is that much more important that any changes in the demand to hold money associated with those fiscal changes are offset by changes in the quantity of money to maintain money and real expenditures. That reducing government spending to balance the budget or reduce the national debt would be associated with lower money expenditures and recession is one of the worst possible institutional frameworks for a sound fiscal policy. (Don't cut government spending, you are destroying jobs. A correct response would be that we just need to lower wages and prices, and real expenditure would be maintained. But that is not a political battle worth fighting)

Most importantly, the "problem" with recession just isn't that taxes are too high and government debt too low, causing too little real expenditure. The problem is that the real quantity of money is too low relative to the demand to hold money. The alternative solutions are a lower price level or a higher quantity of money. Fiscal policy is just a distraction--and it is clear that both left and right have reasons why they might want to create just such a distraction.