Saturday, July 7, 2012

The "Conservative" and "Liberal" Solutions

I strongly support a monetary regime that creates slow steady growth in spending on output, and I believe that such a regime is possible.   In other words, the monetary regime can and should keep spending on a stable growth path even if there are adverse fiscal and regulatory policies.  Obviously, undesirable fiscal and regulatory policies have undesirable consequences, but the least bad environment remains slow, steady growth of spending on output.

However, the U.S. has a regime where the central bank likes to make periodic changes in the short and safe interest rate in order to target inflation and the output gap.   Some conservatives are proposing that the output gap be dropped as a criterion, so the policy interest rate would solely be adjusted to maintain a stable inflation rate.   Of course, the theory is that output gaps will push inflation away from target, and so targeting inflation automatically tends to close output gaps too.

What is the conservative approach to generating recovery?    Improve the tax and regulatory climate for business.  If business believes that they will be able to earn and keep more profit in the future, this will raise credit demand, even given expectations about depressed future sales.  Credit demand currently depends on expectations about both future sales and the future business and regulatory climate.  Improving one, given the other, should result in increased credit demand.   Given the Fed's target for the interest rate, any increase in credit demand is supplied through added money creation, and tends to generate more spending on goods and services.

Unfortunately, the increased aggregate demand will tend to increase inflation.   With an inflation targeting central bank, this would require an increase in the policy interest srate, which would offset the effect of the higher credit demand on spending.   Of course, if inflation is currently running a bit below target, this would not be a problem.

Fortunately,  the pro-business tax and regulatory changes have another effect.  Not only does they tend to raise the demand for credit, they also enhance productivity, which implies an increase in aggregate supply.   Now, if nominal aggregate expenditure continue on an unchanged growth path, the result of the improved supply condition would be a more rapid expansion of output and slower inflation.    But with inflation targeting, instead the enhanced productivity allows for more rapid growth in nominal expenditure.  

So, the improved tax and regulatory environment raises both credit demand and productivity, allowing for a more rapid recovery of spending and production at a given target for the policy rate and a given target for the inflation rate.   Also, the recovery in expenditure would be self-reinforcing.   That is, when firms borrow more and spend more because an improved business climate , the resulting increased sales spur further increases in credit demand.  When all of this happens, it is almost certain that the policy rate would need to increase, so that spending on output doesn't grow faster than justified  by the increases in productivity.  

Therefore, with an improved tax and regulatory environment a rapid recovery can be generated even if the central bank targets some short and safe interest rate to keep inflation at a low and stable rate.   What could go wrong?   The resulting increase in credit demand and enhancement of productivity might be too small to generate a "sufficient" recovery.

What is the "liberal" approach to economic recovery?   The government should borrow money and spend it on expanded social services and "public goods."   The public goods would include subsidies for private goods that provide external benefits.    This provides a demand for credit by the government and given the target for the policy rate, this is expansionary.    New money is being created for the government to spend.   While it is conceivable that the public investments would add to productivity, (certainly some could,) the typical investment is supposed to improve the quality of life for at least some segment of the population.  Enhancing  the ability of firms to produce the sorts of private goods whose prices are included on price indices is of secondary interest.

If inflation is currently below target, the inflationary impact of added spending on prices isn't much of a problem.   Increased government spending and borrowing will raise credit demand at the target for the policy rate and spending on output.   Inflation will pick up back to target at the same time real output and employment recover.   However, if inflation is on target, then it is essential, from the "liberal" perspective, that the "output gap" count as a weighting factor, so that higher inflation would be permitted, at least temporarily.   The gap of inflation above target would be accepted because it would reduce the gap of real output below potential.    Better yet, the central bank could just raise its inflation target.

Both the "conservative" and "liberal" solutions involve policies that they support anyway.   The sluggish recovery is being used as an excuse for their preferred policies.   Also, the policies of each are anathema to the other.   Conservatives don't want to increase the size of government.   One reason is that they are opposed to the changes in taxes that would be needed to pay for it sooner or later.   Liberals don't want to improve the tax and regulatory environment for business, since creating such burdens to provide benefits to favored groups (the poor and working class) is central to their purpose.  

Probably most Market Monetarists favor an improved tax and regulatory environment for business and oppose having the government borrow more to fund additional social services and public goods.    Of course, as more and more "liberals" have listened to the call for a target growth path for spending on output, it is possible that there are growing numbers of "Market Monetarists" who support increased regulation and provision of government services.

If there was an improved tax and regulatory environment for business, along with a return to a growth path for nominal GDP starting above its current level but no higher than that of the Great Moderation, then the demand for credit would grow both because of the improved monetary regime and the improved business climate.  Nominal and real interest rates would rise more quickly than if "anti-business" policies the  polices remain in force.    The improved productivity would result in more of the expansion in spending on output generating added production, and less creating inflation.    That the increase in inflation would be smaller means that nominal interest rates might rise less quickly and real interest rates more quickly.   I think most Market Monetarists would consider this a good thing.

On the other hand, if the liberal approach of expanding the size of government occured in combination with an appropriate target growth path for nominal GDP, then the added demand for credit by government, combined with growing private sector demand due to expectations (and realized) growth in spending on output, would result in nominal and real interest rates rising faster than if the only change was an improved monetary regime.   Unfortunately, the increase in the size of the public sector, given any growth path for nominal GDP, will probably result in a higher growth path of the price level (of private goods,) and higher inflation at some point.    That implies higher nominal interest rates than otherwise--at least for a time.


Using a target policy interest rate to target inflation makes pro-business regulatory and tax reform look to be the only way to generate a more rapid recovery.   It creates the needed spark to credit demand, and prevents spending growth from pushing up inflation.   Maybe it is no surprise that Market Monetarists have trouble interesting conservatives in a new monetary regime that can keep spending growing at  a slow steady rate despite existing "anti-business" tax and regulatory policies.

Using a target policy interest rate to target inflation and an output gap makes an increase in the size of government look to be the only way to generate a more rapid recovery.   It creates the needed spark to credit demand, and we just have to put up with higher inflation.   Maybe it is no surprise that Market Monetarists find that "liberals" keep on insisting the monetary policy is chancy, that it needs to be enhanced by debt-funded government spending, and that it only works by generating a higher inflation rate.

Maybe Market Monetarists need to appeal to a third force.   Don't hold the economy hostage to the century long class warfare between the reds and blues?

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