Which is Best, Monetary Policy, Government Spending, or Tax Cuts?

Keynes did not have much faith in the ability of monetary policy to lift an economy out of a recession:

The Remedist, by Robert Skidelsky, NY Times Magazine: Among the most astonishing statements to be made by any policymaker in recent years was Alan Greenspan’s admission ... that the regime of deregulation he oversaw ... was based on a “flaw”... The “whole intellectual edifice,” he said, “collapsed...”

What was this “intellectual edifice”? ... Greenspan must have believed ... that financial markets always price assets correctly. Given that markets are efficient, they would need only the lightest regulation. ...

Today, [John Maynard] Keynes is justly enjoying a comeback. For the same “intellectual edifice” that Greenspan said has now collapsed was what supported the laissez-faire policies Keynes quarreled with in his times. Then, as now, economists believed that all uncertainty could be reduced to measurable risk. So asset prices always reflected fundamentals...

Keynes ... starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes.

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? ... People fall back on “conventions”.... The chief of these are ... that the future will be like the past... Above all, we run with the crowd. ...

But any view of the future based on what Keynes called “so flimsy a foundation” is liable to “sudden and violent changes” when the news changes. Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic.

Keynes’s prescriptions were guided by his conception of money... The “desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” ...

It is this flight into cash that makes interest-rate policy such an uncertain agent of recovery. If the managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think that cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on ... loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending..., and that was for the government to spend the money itself. Spend on pyramids, spend on hospitals, but spend it must. ...

Keynes’s ... purpose, as he saw it, was not to destroy capitalism but to save it from itself. He thought that the work of rescue had to start with economic theory itself. Now that Greenspan’s intellectual edifice has collapsed, the moment has come to build a new structure on the foundations that Keynes laid.

You can take this a step further. Even if the central bank could lower the loan rate, with such a pessimistic and uncertain future outlook, will firms be induced to build new factories and install new equipment? Will consumers suddenly buy more cars and houses, or purchase new appliances on revolving credit as they worry about keeping their jobs and see their housing equity plummeting? Maybe a few, but not enough to matter much to the overall economy. Will the fall in the interest rate cause financial capital to flow out of the US in search of higher returns elsewhere thereby causing the dollar to fall and increasing net exports? Not if every other economy is suffering similar problems and hence cannot offer more attractive investment opportunities.

In short, as you go through the individual right-hand side items in AD=C+I+G+NX, it's hard to make an argument about how, in recession conditions, a fall in  the loan rate - if one can even be brought about - can generate substantial changes in C, I, or NX. That leaves G. Some people argue that we can stimulate C by changing taxes, and that may be true, but then we have to worry about getting the design right so that the tax change isn't mostly saved rather than flowing into new consumption. There is not as much uncertainty with G since it is part of aggregate demand - when the government purchases a new desk, there's no uncertainty about its effect on the demand for desks (there is some uncertainty about the total impact through the multiplier, which incorporates crowding out and crowding in, but estimates of multipliers in recessions of less than one are rare, they are often closer to two, so we can be pretty sure of at least a one-to-one impact and be fairly hopeful for an even larger effect).

Thus, the tax cuts versus government spending choice comes down to an argument about whether potential inefficiencies that are generated with government spending are more costly than the higher level of uncertainty about the impact on aggregate demand associated with tax cuts. Right now, providing a stimulus to the economy that we can count on is what is needed most, and I am willing to sacrifice any potential inefficiency associated with government spending to purchase the increased certainty in terms of stimulating aggregate demand that government spending provides (and that is true even if the multiplier is only 1.4 as in Ramey, that just advises us about how much spending is needed to be relatively sure the impact is of a particular magnitude).

One reason I am not as concerned with the efficiency aspect as others is that I believe there are a lot of public goods - goods the private sector won't invest in on its own due to market failures - that we need to repair or put into place that are crucial to our long-run growth potential. Cutting taxes won't bring these goods about, only the government can accumulate the needed funds - some of these investments are sizable - and then supply these public goods. For this reason, I don't think government spending loses to tax cuts on either the efficiency or certainty margins.

The only potential basis for tax cuts, then, as I see it, is to provide an immediate boost to spending - a cut in the payroll tax starting Monday morning would potentially do that - but that choice is mainly a consequence of waiting too long to do anything. Many of us have been saying monetary policy won't work and calling for infrastructure and other government spending for months and months now, and had that spending been put into place long ago (instead of, say, one shot tax rebates that theory says are ineffective) immediacy would not be the issue at present. But we did wait, it seems we can't be convinced to buy recession insurance in advance - we have to see the disaster in front of us before acting - and tax cuts may therefore be needed as part of the recovery package. But that does not mean that, in general, tax cuts are preferred, only that if you wait this long to act, and fierce resistance to government action until the carnage is evident may make waiting too long inevitable, you may have no other choice but to use tax policy as part of any attempt to revive the economy.