Standard Keynesian theory claims that the government should stimulate the economy during a slump and cool it during a boom. Many objections exist to this interventionism, but there is apparently a new kind of interventionism concocted in the White House: stimulate the economy during a boom. Would this imply slowing it down during a recession?
In Keynesian theory, one way to stimulate the economy is to lower interest rates by increasing the money supply. John Maynard Keynes himself, however, did not trust monetary policy and preferred increasing government expenditures and the budget deficit. Later Keynesians reclaimed monetary policy and the idea of pushing down interest rates during a slump. The current administration apparently wants both higher budget deficits (which it has been achieving with enthusiasm) and lower interest rates. It’s the total Keynes, but at the wrong stage of the cycle: they want stimulus in a context of full employment and an economic boom, which is arguably where the American economy now stands.
Echoing his boss after a Labor Department’s announcement that employment has continued to expand last month, Vice-President Mike Pence declared yesterday (“Pence Doubles Down on Trump’s Call to Turbo-Charge the US Economy,” CNN, May 3, 2019):
The economy is roaring. This is exactly the time not only to not raise interest rates, but we ought to consider cutting them.
Assuming there is some validity in Keynesian remedies, the question is, what will the Fed do when a recession hits and interest rates are already low? Continue to stimulate with still more government deficits and quantitative easing? How long? Until the Fed owns the whole economy? This would be Marx’s revenge.
Note that it is questionable that the Fed can manipulate interest rates, especially long-term rates, at will; on this, see Jeffrey Hummel, “Central Bank Control over Interest Rates: The Myth and the Reality” (Mercatus Working Paper, 2017). Some epistemic and interventionist humility is required.
The White House wizards justify their stimulus desire with the argument that “potential output,” or the production possibility frontier (PPF), has expanded under the adroit economic management of the current president and that, therefore, pushing up interest rates is no longer necessary to cool down the boom. In other words, they claim that the American economy is not at full employment. The Wall Street Journal writes (“White House Escalates Feud With Fed,” March 3, 2019):
White House officials say the administration’s tax cuts and deregulatory moves have expanded the economy’s potential output, meaning there is room to cut rates to boost growth, wages and employment without risking a sharp increase in inflation.
If that were true, prices should be falling. A non-big increase in the price level (what we are now seeing, that is, between 1.5% and 2%) is not the same as a decrease. One could claim that the Fed’s policy has remained expansionary and barely contained deflation. But this looks like a very hypothetical claim.
In the CNN report, Pence says that Trump is “committed to the free market.” Let’s just say that it is not obvious. But if it is true and if it is also true that the PPF has shifted up, why doesn’t the administration simply propose a free-market solution: that the Fed stop trying to interfere with interest rates and instead let markets determine them? A period of expansion is the right time to start such a reform.
This reform would be consistent with the observation that the financial future is always clouded in fundamental uncertainty and that government intervention can only, as it has generally done, increase economic volatility and fuel economic crises. In his short book Finance and Philosophy (Paul Dry Books, 2018), Alex J. Pollock shows how dangerous is the Fed’s power to manage the economy. (I will review the book at Law & Liberty.) But the power taken out of the Fed’s hands should not be transferred to politicos or to other bureaucrats. “Managing the economy” is the problem.
There are many reasons to think that a laissez-faire solution is foreign or simply unknown to the sages in DC. It looks obvious that the only reason for the administration to want further stimulus is to temporarily boost the economy and the electoral prospects of Trump and the Republicans at the cost of future inflation and financial crash, just as Richard Nixon did in the early 1970s.
Nick Timiraos of the Wall Street Journal (“Trump Repeats Calls for Fed to Stimulate Growth,” April 30, 2019) reminded us of the evidence, which is available in many forms on the web:
Before he became president, Mr. Trump repeatedly criticized such bond buying [quantitative easing by the Fed] as a dangerous experiment, and he warned that low interest rates risked inflating financial bubbles. Since entering the White House, however, he has called on the Fed to stop raising rates and to resume its bond-buying program.
READER COMMENTS
Warren Platts
May 4 2019 at 4:22pm
According to the MMT folks, if I understand them correctly, if inflation–too many dollars chasing too few goods–is a problem, the money supply can be reduced through raising taxes rather than raising interest rates.
Pierre Lemieux
May 6 2019 at 8:40pm
Warren: I don’t know what MMT says exactly. My co-blogger Scott Sumner had a recent post on this theory: https://stageeconlib.wpengine.com/sebastian-edwards-on-mmt-and-latin-american-populism/. However, standard Keynesian macroeconomic theory, I think, would forecast that raising taxes, which would push the IS curve to the left, would increase interest rates by raising the QUANTITY DEMANDED OF MONEY along the LM curve, not by reducing the MONEY SUPPLY (which would come from a shift in the LM curve). I am interested to know if anybody Keynesian would disagree with that.
Thaomas
May 4 2019 at 7:33pm
Trump is probably right that the Fed ought to nudge rates down a bit as a clear signal that it is serious about price level targeting( as the “stable prices portion of its dual mandate to seek stable prices and full employment). When it achieve (or overachieves) that, it can raise rats again.
Benjamin Cole
May 4 2019 at 8:37pm
I just hope Pierre Lemieux calls for a silver standard and not a gold standard. Silver was a monetary metal long before gold; in fact today banks in China are still called Silver Houses. In various epochs, gold has been considered a gaudy metal, useful for women’s jewelry, fop’s finery and brothel-gilding.
Pierre Lemieux essentially calls for an end to central banking. He should tell us what substitute he has in mind.
And is a gold standard better than a silver standard? Why?
Thomas Sewell
May 5 2019 at 12:04am
I don’t want to speak for Pierre, but it seems clear in context that he is calling for an end to central banking, not for substituting some other central banking solution.
So I suppose the “substitute” would be freedom to make your own banking arrangements, rather than having them determined by others. It’s not like there have never been competing banks/competing currencies, etc… which would all be even simpler with today’s technology level.
Pierre Lemieux
May 5 2019 at 12:21am
I agree with Thomas. I am in favor of free banking. On the fraud of the Fed and the real problems of the banking system in America, I have an EconLog post (including many links) at https://stageeconlib.wpengine.com/archives/2018/01/a_bad_solution_to_very_real_problems.html. This topic is often a surprise for those who discover it. It was for me when I discovered it.
Benjamin Cole
May 5 2019 at 4:52am
The intelligent and persuasive George Selgin is an advocate of free banking too—including private banks setting their own level of reserves.
In theory, I like it.
In practice? Well, remember that AIG was the private-sector’s idea of financial insurance, underwritten, purchased and relied upon by sophisticated institutional investors. AIG failed in the first financial strong breeze that came along.
The dang thing is, as long as someone can find a way to leverage up, they will. If there is daylight (or a spread arbitraging) a transaction after borrowing costs, then it makes sense to borrow a few trillion dollars. In our polite world, if the transaction goes belly-up (think Long Term Capital Management), the managers run away, and that is that. No selling of families into slavery, or torture at the rack.
In a sense, all of us are dunces for not getting into a position to leverage 100-to-one and letting it rip. If you hit the jackpot, great. If not, declare bankruptcy and move on.
Pierre, if you have good credit, get all the credit cards you can, borrow to the limit, then play some sort of futures or options.
Thomas Sewell
May 10 2019 at 8:54pm
The problem with your view of AIG is that it was a scandal because of the government regulator’s actions, not despite their best attempts.
In the world you describe, the reason AIG can continue to exist is because government regulators at the time made the decision to expend taxpayer money in bailing out the people who had made risky decisions and the shareholders of the company which enabled them.
So yeah, market discipline doesn’t work to correct things when government regulators first setup the conditions to make taking excessive risks profitable (by writing their regulations that way), then continue on and refuse to allow the market to work by allowing those risks to not pay off.
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