Andrew Smithers at American Affairs Journal, Summer 2023 / Volume VII, Number 2:
Monetary Policy, Tax Policy, and Investment
The economic performance of the United States and other major developed economies in the twenty-first century has been appalling, whether in comparison to the period of nearly eighty years since World War II or with the rest of the world over the past two decades. Having suffered the most severe postwar financial crisis in 2008, we now face a high risk of another one; real output and incomes have stagnated and inflation has shot up. This abject failure has dangerously damaged liberal democracy. Voters are angry and faith in experts has fallen.
Central bankers have been blown off course by Covid and the Ukraine war. But while the pandemic and Putin’s invasion have been damaging, they are only a small part of the problem. The stagnation of income goes back to the beginning of the new century and the upsurge in inflation was under way well before Russia launched its attack. So, even allowing for bad luck, policy errors have made a major contribution to our current malaise. This may not, however, indicate operational incompetence by governments and central bankers. Policy is necessarily based on theory, so mistakes can arise either from poor judgment in applying a sound theory or from the inevitable failures of implementing a bad one.
In the eighteenth century, doctors were probably more deadly than disease. This was not because doctors were incompetent; it was because they had been taught nonsense. Similarly, the disastrous start to the twenty-first century follows from the errors of economic theory rather than from mistakes in its application.
Like eighteenth-century medicine, the economics of today is basically unscientific: it is incompatible with the evidence. Until current theory is replaced, we will continue to suffer from stagnation and regular financial crises. Better theory is, however, available and, if used, would provide the tools we need for a well-managed economy, in which growth will replace stagnation amid low and broadly stable levels of unemployment and inflation.
Three Equilibria
Consensus macroeconomics rests on two assumptions. The first, which is termed profit maximization, is that companies invest with the aim of maximizing the value of their net worth. The second is that this is done by investing when returns compare favorably with the cost of capital, which varies with real short-term interest rates. From these assumptions it follows that we live in an economy whose stability can be maintained as long as demand matches the supply available. In the words of Ricardo Caballero, consensus theory holds that we have a one-deviation-at-a-time economy.1 But these assumptions are wrong and, as a result, so are the consequent conclusions. We live in a world where there are at least three equilibria which must be maintained for economic stability. In addition to balancing demand, we must avoid excessive levels of both asset prices and money supply.
Three problems require three solutions, and the solution to one must not create another disequilibrium. In other words, if demand is weak, we must have a way of boosting it without pushing up either asset prices or money supply. We must therefore understand the policies needed to keep each equilibrium independently in balance.
At any time, there is an equilibrium rate of unemployment consistent with a stable rate of inflation; this is the non-accelerating level of unemployment (nairu), which is constant unless there is a change in expectations about inflation. In the absence of such changes, inflation and unemployment will be stable if demand changes at the same rate as potential output, which is the trend growth rate. The twin tasks of demand management are thus to avoid demand growing either faster or slower than trend, and for this to take place at a low and stable level of inflation, so that inflationary expectations do not rise.
It used to be assumed that demand could be kept in balance by changes in short-term interest rates, but Keynes showed that demand did not always rise and fall to match rate changes. In these conditions, known as a liquidity trap, intentions to save exceed those to invest, and unemployment will rise unless there is a boost to demand. When monetary policy ceases to be effective, another source of demand is needed, and for this Keynes proposed changing the government’s budget deficit (fiscal policy). When government spending rises more than its income, the government’s savings fall, and this reduces the economy’s total savings. In neo-Keynesian terminology, changes in budget surpluses and deficits enable an ex ante surplus of savings over investment to be brought back to zero without the need for any rise in unemployment.
Keynes assumed that liquidity traps would be temporary affairs resulting from short-term falls in investment in response to the ebb and flow of business optimism. He therefore ascribed temporary weakness in business investment to a decline in “the animal spirits of entrepreneurs.” But our experience this century is not only for such temporary losses of confidence, as occurred after the financial crisis of 2008, but a longer-lasting tendency for investment to be insufficient to match the desired level of savings. We thus have an economy with positive net ex ante savings, which tends to be structural. It is difficult to combat such a situation with persistently high levels of budget deficits, which can lead to an ever-rising ratio of government debt relative to GDP. This becomes particularly threatening when, as so far this century, trend growth is near zero.
A liquidity trap which appears to be long-lasting rather than cyclical presents central banks with a major dilemma. Their attempted solution has been to try and boost demand by buying long-dated bonds through quantitative easing (QE), which has depressed their yield relative to short-term interest rates—flattening the yield curve. In terms of supporting demand, the policy has been successful. By preventing excess net ex ante savings, central banks have been able to maintain demand at the trend level of output. Had the consensus model been correct, this would have produced economic stability. But it isn’t, and therefore, it hasn’t. QE has destabilized the other equilibria needed for stability. It has produced excessive levels of both asset prices and money supply....
....MUCH MORE
