Evan Soltas
Jun 12, 2012

Fiscal vs. Monetary Policy

Joe Weisenthal of Business Insider, usually at some unholy hour before dawn, tweets "What'd I miss?" to elicit suggestions for news coverage. I've been busy with the end of high school for the last week, and since I managed to tune everything else out, I am really behind the economics news cycle -- please write me a comment to this post if you have any topics you'd like to see me tackle.

I've been trying to think about how to write about why I am very uncomfortable with discretionary fiscal policy as a tool of macroeconomic stabilization.

Looking at it broadly, fiscal policy is suboptimal for stabilization because government expenditure and revenues has other goals against which stabilization must trade off, and they have notable rigidities.

Government doesn't tax and spend solely so that it can run surpluses or deficits. Sometimes, when economists talk about the need for discretionary stimulus, it's easy forget that fiscal policy is far and away not the primary function of either government expenditures or tax policy. It is fundamental that you can't target two variables at once -- and this fact urges us to look for the trade-offs between static functions of government and the cyclical nature of fiscal policy.

For this reason, I worry that cutting tax rates to effect stimulus generates uncertainty which has non-negligible effects on firm activity and private investment. (In this respect, there could very well be a conservative argument for government expenditures, and not tax cuts, as stimulus -- changes in the tax code have a much more direct impact on a broader set of firms than do changes in government expenditures, so if you fear policy uncertainty, call for discretionary spending, not tax policy.) Then again, I'm aware that the evidence linking policy uncertainty to economic activity is weak, and that if you ask businesses what their biggest problem is, they say sales, not uncertainty.

These trade-offs between structural and cyclical policy don't quite exist in monetary policy as they do in fiscal policy. While I find it pretty easy to see how large changes in spending or tax rates could inhibit private economic calculation at the firm level, monetary policy does not appear subject to the same trade-offs. Everything but the most extreme and irresponsible of monetary policies -- read: hyper-inflationary monetization of debt due to lack of central bank independence -- seems to me unlikely to affect in the slightest money's structural function as the medium of exchange. (Ok, some of my Austrian friends beg to differ here, but I think everyone else can see my point.) In other words, monetary policy is a primary and independent function of the tool -- money -- in a way that fiscal policy can never be. There are negligible, if any, trade-offs between monetary policy and money's structural purposes. It follows, then, from Ricardo's basic principle of relative comparative advantage that monetary policy should do the stabilizing, whereas fiscal policy should be managed for the longer-term ends.

Second, there are very real rigidities with fiscal policy. This post was originally going to be about the "ratchet effect" and other theories as to why government has grown. The "ratchet effect," like the tool itself, says that government expenditures are a lot easier to increase than to cut, just like you can tighten, but not loosen, with a ratchet. And indeed, a quick look at the data seems to support the idea that government spending and tax revenues tend to jump upwards like a step function. However, the "ratchet effect" is not the whole story.

Most importantly, the "ratchet" story simply doesn't work for federal non-defense expenditures, which have grown steadily for the last 60 years in the United States. (There does appear to be a defense-spending "ratchet.")

Now we've got to look for other explanations. First, I think Tyler Cowen's paper "Does Technology Explain the Growth of Government?", first introduced to me by Bryan Caplan's blog, is helpful.

But recently, I've been drawn by the idea that in non-defense expenditures, and particularly in transfer payments, the "ratchet" exists at the program-level, rather than in expenditures. That is, once you create or expand Social Security, Medicare, etc., they tend to be hard to eliminate or shrink in terms of eligibility or generosity, regardless of their expense. Therefore, the constant growth of social expenditures doesn't disprove the presence of a ratchet -- it merely implies that it doesn't exist at the spending level.

The best example of a transfer policy ratchet may be the French retirement age. Very easy to lower, sure -- but now-ex-President Nicolas Sarkozy spent nearly all of his political capital increasing it from 60 to 62, only to be undone by new President François Hollande. Politically, it doesn't matter how much the policy costs; what matters to the public is the two-digit number.

In the United States, a great example of this is Social Security's disability program. Only a week after I started this blog, I wrote a post about a then-new study by David Autor which made it unambiguously clear that the SSDI program was growing unsustainably in enrollment which did not correspond with any increases in need. Here we see gradual growth in government expenditure, generated by a "ratchet effect" rigidity -- enrollment can passively increase, but it takes real, politically-difficult legislative action to cut enrollment.