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Tuesday, January 15, 2008

Monetary versus Fiscal Policy

This is Axel Leijonhufvud on "Keynes and the Effectiveness of Monetary Policy." According to this, Keynes held monetary policy in higher regard as a stabilization tool than I thought. However, as noted below:

All Keynes’ arguments ... dissolve entirely under the eyes of anyone convinced that, when everything is said and done, the fact remains that the improvement or augmentation of “Land, Buildings, Roads and Railroads” are not activities highly sensitive to changes in the rate of interest.

In such a case, fiscal policy is needed. There's been lots of talk about fiscal policy today (see DeLong, Chinn, Bernstein and Mishel, and the CBO Blog for openers). Here's how I see it. Monetary policy is very good at slowing down an overheated economy, but it is not always so good, for the reasons just stated, at stimulating a lagging economy. It might do the trick, lower interest rates and other measures might provide the needed stimulus, but it wasn't all that long ago that some of the smartest people in this business argued that money had little if any effect on the real economy - some still do - and there are still uncertainties about the extent to which monetary policy can revive a lagging economy, especially an economy in a fairly steep downturn. I don't think it's a given that monetary policy will work.

Unfortunately, a serial approach won't work either. If we wait to see if monetary policy will work, and if it doesn't then turn to fiscal policy, it will be too late for fiscal policy to do much good (Bernstein and Mishel note there are have been long lags in the employment response over recent business cycles so even a late response could still help with employment. Perhaps, it depends upon where the lags are, but in any case sooner is still much better than later).

So why not shoot with both barrels? Implement both monetary and fiscal policy measures as soon as possible, hope like heck one of the two works because there's no guarantee either will do enough to matter, and if the economy recovers and begins to overheat due to the dual stimulus, use monetary policy to cool things down. As I said, using monetary policy to temper an overheated economy seems to be the one place we are pretty sure policy can be effective, and monetary policy can be reversed fairly quickly (of course, fiscal policy should also be reversed). And even if we do provide too much stimulus for a time, if we put extra people to work, build a few more roads and bridges, give rebates to struggling families when less would have sufficed, measures such as that, well, I can think of worse mistakes to make. So the danger of overstimulating the economy isn't as large as the danger of failing to provide adequate stimulus, thus, why not use both types of policies?

Anyway, here's the introduction and the conclusion of a paper by Axel Leijonhufvud detailing Keynes views on the use monetary versus fiscal policy as stabilization tools. (It's an old paper, it was written 40 years ago, but what Keynes said hasn't changed since then, though interpretations of his work do get updated. Notice the difference over the last 40 years exhibited in the first sentence where it is asserted that fiscal policy is the preferred stabilization tool among Keynesian economists, we hear just the opposite today from many in the Keynesian camp; also, I left it out, but the main theoretical argument is in section IV of the paper.):

Keynes and the Effectiveness of Monetary Policy, by Axel Leijonhufvud, Economic Inquiry, Volume 6, Issue 2, Page 97-111, Mar 1968: The Keynesian tradition in macroeconomics, particularly in the United States, has been associated with a decided preference for fiscal over monetary stabilization policies. In the development of this school of thought, certain arguments to the effect that monetary policy is generally ineffective have historically played a large role. By no means all the major contributors to the Keynesian tradition can be tarred with this brush. But, of those who have been outspokenly pessimistic about the usefulness of monetary policy, the vast majority would certainly be popularly identified as “Keynesians.” Since the proposition that monetary policy is ineffective has in this way become associated with his name, it is of some interest to examine the case originally made by Keynes.

Since abounding faith in fiscal measures and a withering away of interest in monetary policy was one of the most dramatic aspects of the so-called “Keynesian Revolution,” there is, I believe, a tendency to impute these views, as well as the analytical tools with which they were propounded, to the General Theory. It is of course true that this work, on the one hand, expressed doubts about the efficacy of banking policy and, on the other, argued for public works programs and for “a somewhat comprehensive socialization of investment” [8, p. 378]. But Keynes’ position on the issue was a good deal less clear-cut than one would gather from standard textbook expositions of the “Keynesian system.” The position on these policy issues advocated in the General Theory, moreover, was not at all “revolutionary” in the sense of making a distinct break with Keynes’ own past ideas. On the scales of his personal judgment, there had been only a subtle shift away from reliance on monetary policy and in favor of direct government measures. The extent of this shift has been much exaggerated.

The exaggerated popular view of the extent to which Keynes’ magnum opus downgraded the usefulness of monetary policy reflects an over-simplified and mechanical interpretation of his contribution which is deeply embedded in the “Keynesian” tradition. This paper seeks to restore some perspective on the issue. The motive for this attempt is the one common to most doctrine-historical essays: Misconceptions of where one has been and of the path followed to the present most often mean ignorance of where one is, and where one is going. ...



All Keynes’ arguments, of course, dissolve entirely under the eyes of anyone convinced that, when everything is said and done, the fact remains that the improvement or augmentation of “Land, Buildings, Roads and Railroads” are not activities highly sensitive to changes in the rate of interest. If the major components of aggregate expenditures are in fact highly interest-inelastic, that would pretty well settle the matter and one’s interest in the more complicated case made by Keynes would then be merely “academic.” Among the “elasticity-optimists,” furthermore, some may well feel that his theoretical framework is not the most appropriate one for organizing the empirical questions bearing on the substantive issue, or even that it tends to be positively misleading for such purposes. Those, finally, who both tend to agree with Keynes on the interest-elasticities and find his theoretical framework useful, will presumably disagree with his empirical or political judgment on several of the points discussed above. The substantive issues, of course, remain untouched by the clarification of Keynes’ views on them attempted here.

We may conclude that Keynes weighed fiscal vs. monetary policies on the basis of a more complex set of considerations than is apparent from the standard “Keynesian” textbook discussion and also that his views were quite different. It is especially important to consider carefully the nature of the case for government spending and against Central Bank action that emerges from the analysis of Section IV. It is a case against reliance on monetary policy for the pursuit of certain objectives under certain conditions, i.e., in this instance, for the reversal of a “cumulative” process triggered by a disequilibrium diagnosed as being of a particular type. It is not a case for the general uselessness of monetary policy. On the contrary, the analysis makes very clear the great power for good or evil that monetary policy is seen to retain within Keynes’ theoretical framework. For it is still as vital as ever that the Central Bank acts vigorously so as to hold market rate continuously in the near neighbourhood of an appropriately defined natural rate. The main prescription of the Treatise is not affected by the finding that there are conditions to the correction of which fiscal measures are better fitted than monetary measures. In the context of Keynes’ theory, the diagnosis of disequlibria, on the lines sketched in Sections III and IV, is thus seen as a prerequisite for the choice of an appropriate mix of fiscal and monetary policies in a particular situation.

    Posted by on Tuesday, January 15, 2008 at 08:27 PM in Budget Deficit, Economics, Monetary Policy, Policy, Unemployment | Permalink  TrackBack (0)  Comments (15)


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