What's Best for the Economy: 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 rates 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.

Comments

[Laura Harrison:]

Why is so little attention paid to the desirability - perhaps need - for any stimulus (be it monetary or fiscal, tax cuts or government spending) to be coordinated internationally? The Keynes of "The General Theory" and after certainly believed in the importance of this, as Markwell's book on Keynes and international forces makes clear. Brilliant though Skidelsky's writing it, it would be good to supplement it with reference to Moggridge's biography of Keynes ("An Economist's Biography") and/or Markwell's book ("Keynes and International Relations"). The case for the international context, including the importance of international economic institutions like the IMF and World Bank and for free trade, is really important to make at this stage, when the world needs the Obama administration to provide effective US economic leadership (just as Keynes looked to FDR for this in the 1930s and during the wartime design of the post-war international economic order).

2008 Dec 14 07:07 AM

[prudentinve...:]

The argument that government spending, even if wasteful, is good for the economy is like the argument that a kid breaking a window is good for the economy.

Better for government to provide targeted tax breaks that encourage private individuals or corporations to spend in ways that stimulate demand, perhaps to encourage buying a vehicle from a domestic auto maker or to install solar or wind energy, etc. A substantial increase in these sorts of tax credits for a limited period would generate demand.

2008 Dec 14 08:14 AM

[Elwood Blues:]

prudentinvestor, I agree with your analogy and would take it a step further... for years the gov's watched kids running around breaking windows and then papa Greenspan wakes up from a long nap and says he can't believe his beautiful children would throw all those precious brics.

So now we're left trying to figure out what to do about all the broken windows. If I'm worried I may not have a job tomorrow, I may not opt to repair a broken window in my house, even with a government incentive. So short term demand could be limited. The gov, unlike me, has less concern about losing a job tomorrow, could opt to invest now for new windows in their buildings... with the hope that 4 yrs from now, those new windows will be saving on heating bills and creating some big demands at the glass factory where I work. Maybe even result in development of a new glass that people in Bric-land like and buy. And now that orders are looking good at the glass factory, it's about time I got some new windows, and we all live happily ever after. The moral of the story probably involves people in glass houses..

2008 Dec 14 10:42 AM

[Errol:]

Couldn't agree with Prudentialnvestor and Elwood Blues anymore. Repairing a road is great, but once the road has been repaired, those employed to repair it, go straight back into unemployment. This "counting on government for work" nonsense that began in the early 1900's has always been and will always be less efficient that the market place. Tax cuts across the board and calling for lower pay for dare I say government officials (why not, ceos and workers are doing it) will benefit the economy the most.

2008 Dec 14 05:33 PM

[tinman:]

I take several exceptions to the zealots of private sector spending. First, the point of the article is that the private sector WON'T spend if they're pessimistic, at least not until the tax incentive becomes the equivalent of government spending.

Gov spending can be like kids breaking windows (loading the cannons with money and firing in the general direction of Wall St.) or can be far more efficient (building the interstate highways) than the private sector could ever hope to be. I hope that the incoming crowd is smart enough to discern which of the two a particular proposal most resembles.

That said, some tax cuts and incentives in the right places are also helpful but they are probably not sufficient by themselves to arrest the still-accelerating vicious spiral toward the drain of Depression.

2008 Dec 15 11:25 AM

[honestscop:]

Errol's comment stops far too short of the big picture. Following the logic: Recessions occur when people stop spending, people stop spending when they feel it more beneficial to hold onto cash rather than spend it -- a typical emotion in an uncertain job market.

But Errol seems to view recession as simply job loss -- what must be realized is that job loss is merely the symptom, not the disease. Therefore, simply stating that infrastructure spending is useless because workers will just go back into unemployment upon project completion -- conceptualizes labor as the only cost driver.

There are entire supply networks standing to benefit from infrastructure investment . For example, there are capital equipment purchases and raw material purchases -- each of which buy into their own supply chains. Also, these projects won't happen just one at a time -- they happen in several places at once.

If one accepts the definition of recession as economic contraction (of which job-loss is merely a result), than any econ. policy advocating further spend reductions (whether in private or public sectors) fails prima facie.

2008 Dec 15 01:35 PM

[Errol:]

Honestscop -
I wholeheartedly agree that a recession is a contraction of the economy and that job loss is a symptom of recession, not the cause. However, and I have worked in the supply chain for four years, so I can speak with some experience, that government expenditure in infrastructure, is great if it promotes increased economic activity outside of the initial goal of the project - i.e. that spending leads to further growth. In this case, how can repairing roads that are already there lead to further growth? Moreover, you state that supply networks would benefit from this spending, again I disagree. Supply networks are running very low on product as companies have slashed prices in order to promote sales and increase cash. Any spending on copper, lead, etc will only lead to a supply chain inefficiency and a spike in prices - hence stagflation. I think you assume to much in capital purchases - I am not confident that businesses in this climate would invest in expensive capital if the future aside from government sponsored purchases may not be there. I think you'll agree that a better source of spending would be in energy independence - both alternative sources of energy and drilling for more oil, since our entire infrastructure does depend on oil and because as the price of oil drops, so do oil producing projects which could lead to a harsh bottleneck in the future.
Cheers

2008 Dec 15 08:34 PM