Jeffery Sachs on Fiscal Policy
Is the current approach to fiscal policy misguided, if well intentioned? That is the case Jeffery Sachs is making.
The U.S. political-economic system gives evidence of a phenomenon known as “instrument instability.” Policy makers at the Federal Reserve and the White House are attempting to use highly imperfect monetary and fiscal policies to stabilize the national economy. The result, however, has been ever-more desperate swings in economic policies in the attempt to prevent recessions that cannot be fully eliminated.
President Barack Obama’s economic team is now calling for an unprecedented stimulus of large budget deficits and zero interest rates to counteract the recession. These policies may work in the short term but they threaten to produce still greater crises within a few years. Our recovery will be faster if short-term policies are put within a medium-term framework in which the budget credibly comes back to balance and interest rates come back to moderate sustainable levels.
Looking back to the late 1990s, there is little doubt that unduly large swings in macroeconomic policies have been a major contributor to our current crisis. The lessons of the high inflation of the 1970s had supposedly chastened policy makers against trying to fine-tune the economy. The quest for never-ending full employment had contributed to high inflation in that decade, which required years of economic pain to wring out of the system. Monetary policies thereafter were supposed to be “steady as she goes,” not trying to smooth out every fluctuation and business cycle in the economy.
That was indeed the prevailing attitude. The problem is that the financial crisis at home has changed the attitudes in favor of those who think the economy is like a car engine and the government is at the whell controlling not only the direction, but also the gas and break pedals (hence metaphors like “jump starting the economy”).
During the decade from 1995 to 2005, then-Federal Reserve chairman Alan Greenspan over-reacted to several shocks to the economy. When financial turbulence hit in 1997 and 1998—the Asian crisis, the Russian ruble collapse and the failure of Long-Term Capital Management—the Fed increased liquidity and accidentally helped to set off the dot-com bubble. The Fed eased further in 1999 in anticipation of the Y2K computer threat, which of course proved to be a false alarm. When the Fed subsequently tightened credit in 2000 and the dot-com bubble burst, the Fed quickly turned around and lowered interest rates again. The liquidity expansion was greatly amplified following 9/11, when the Fed put interest rates down to 1 percent and thereby helped to set off the housing bubble, which has now collapsed.
To be sure the low interest rates weren’t the only cause of our current problem, but their historically low levels were likely what got the balling rolling. Alan Greenspan apparently became enchanted with the notion that the Fed could pursuse counter-cycle policy despite evidence that this has not produced very good outcomes.
Sachs then points out why parallels to the Great Depression are out of line, obviously Matthew Yglesias will be writing a post shortly telling us how Jeffery Sachs is nucking futs.
There is little reason to fear a decade of stagnation, much less a depression. The U.S. economy is technologically dynamic and highly flexible. The world economy has tremendous growth potential if we don’t end up in financial and trade conflict, and if the central banks ensure adequate liquidity to avoid panicky runs on banks, businesses and sovereign borrowers. We should understand that the Great Depression itself resulted from a horrendous run on the U.S. banking system in an era without deposit insurance, and when the Fed and Congress did not understand the critical role of a lender of last resort. Moreover, the Gold Standard of the 1930s, which we long ago abandoned, acted like a kind of straightjacket on monetary policies.
This is exactly right. Furhter government expenditures prior to the Great Depression were much smaller and there was no such thing as unemployment benefits. Both of these act to some degree as automatic stabilizers. The spending by the government would have likely changed very little even absent any fiscal spending stimulus. The resulting deficits would have been the result of a fall in tax revenues. And provided Team Obama themselves don’t go nucking futs and go down that idiotic “Buy American First” road again we wont have the Smoot-Hawley style tariffs that added to the Great Depression.
However, I think that the large amounts of spending that is currently being proposed, voted on and passed could cause problems in the medium to long term. Since everyone is focused almost solely on the immediate/short run nobody is keeping in mind our already large fiscal commitments to Medicare and Social Security. Combined these pose significant budgetary problems for the U.S. The higher taxes and/or interest rates they would require would act as a drag on the economy and thus ensure sub-optimal growth for years, maybe even a full decade.
Via Greg Mankiw.