If you're so skeptical of the ability of Congress to time fiscal stimulus, why aren't you skeptical of the Fed's ability to time monetary stimulus?
First, the Fed is a much smaller institution than the federal government. Since it is (supposed to be) independent of Congress, it is not subject to intense political pressure from lobbyists and constituents. Since it's smaller and has fewer forces pushing and pulling on it, the decision-making process is shorter and the Fed has greater discretion.
|Weekly average federal funds rate (blue) and federal funds target (red)|
Second, the Fed has actually demonstrated the ability to conduct discretionary operations on a daily basis. The Fed's open market operations keep the fed funds rate in line with its target. (Whether the Fed's operations in the loanable funds market are justified is a matter of discussion - but there's no question it can manipulate the market.) When has Congress ever legislated anything on a daily basis? Let alone consistently and cleanly produced the results it wants?
Nonetheless, I do agree that this point has some merit. The Fed is not omniscient; while it can react on the order of days or weeks, conditions can deteriorate so rapidly the Fed can't respond in time - consider that it raised the fed funds target rate the day after Lehman Brothers collapsed (that little spike in the middle of the recession).
The Fed is also subject to some political pressure. Its mandate requires it to balance full employment and price stability. On the right, Ron Paul and other extreme Republicans insist that it should cease to exist and the economy should return to a gold standard (what a disaster that would be, I will discuss in later posts).
And evidence suggests that it often considers the American public's visceral fear of inflation as it balances employment and inflation. Even though monetary indicators suggested a full-blown recession was underway during the summer of 2008, one read of the September price hike is that the commodities price spike spooked the Fed into making its rates decision based on headline inflation, rather than core inflation.
So using discretionary monetary policy against the business cycle is a better bet than using discretionary fiscal policy, but it's still not a money shot. The institution of the Fed is subject to some political pressure and may not respond quickly enough to changing conditions to counter at its discretion. Moreover, the "counter" here is discretionary, and we've seen what damage discretion can do.
So perhaps the key here is to remove discretion from countercyclical policy, whether monetary or fiscal, which brings me to counterpoint number two ...
What about automatic stabilizers?
Automatic stabilizers are programs like unemployment insurance and welfare which by their nature increase expenditure during a recession and decrease expenditure during a boom. The easy response to this counterpoint is: If they're automatic, they're not discretionary! So they don't count as "discretionary fiscal policy" - technically, this is a red herring.
But it's an interesting and useful subject to discuss. As I said in my previous post about fiscal stimulus, good policies are good regardless of whether the economy is booming or busting; bad policies are bad regardless of whether the economy is booming or busting. When we make policy, we should regard the policy as in place for the long run, not as a momentary response to the business cycle.
One implication is that the government should operate by rules, not discretion. The larger the institution or its impact, the less discretion it should have (at least in response to the business cycle). Moreover, rules whose impact correlates strongly and negatively to the business cycle stand a much better chance of providing countercyclical amelioration than discretionary policy.
Automatic stabilizers, in the form of tax cuts or welfare assistance to the needy, are one form of rule-based policy that acts countercyclically. (Mind, this also implies that we don't discretionarily tinker with automatic stabilizers during the business cycle, such as extending unemployment benefits to be more generous than in some socialist countries.)
Since the safety net functions as an automatic stabilizer (and that's usually what people mean when they talk about automatic stabilizers), I do have concerns about the impact of the post-tax, post-benefit (PTPB) income curve on long-run incentives for behavior. The withdrawal of means-tested programs, such as food stamps, can create very high effective marginal tax rates, punishing poor people for harder work instead of helping them out of poverty.
More broadly, in the US the PTPB curve is very flat at low incomes and does not begin to increase until one has reached the middle class. This implies that poor people face approximately effective 100% marginal tax rates. I don't need to mention how perverse this is, but I will anyway. This outrage will be the subject of a different series of blog posts. Nonetheless, it's a reasonable concern about automatic fiscal stabilizers.
There is similar scope for making a case for automatic policy on the part of the Fed. Scott Sumner points out that there are no small recessions. I'll have more to say on this at a later date, but for now let's take it for granted that the Fed's discretion can turn small recessions into big recessions. In fact, the Fed's discretion is directly responsible for the five largest recessions in American history:
- The great decline of 1929-1933 (as the Fed at its own discretion chose not to stop the annihilation of a third of the monetary base),
- The crash of 1937 (when the Fed at its own discretion raised reserve requirements prematurely),
- The two recessions of 1980 and 1981 (when the Fed at its own discretion sharply contracted monetary policy to kill inflation expectations and shift price growth to a lower trajectory), and
- The great recession of 2008 (when the Fed at its discretion stopped growth of the monetary base, contracted monetary policy, and then refused to engage in unconventional monetary policy in the face of the sharpest decline of nominal income since 1929-33).
Removing the Fed's discretion is not a new idea. Milton Friedman proposed simply increasing the monetary base by some fixed percentage each year, regardless of the business cycle. A different rule --- one I favor --- is to require the Fed to target nominal income growth at some fixed long-run percentage. The Fed would do this by either setting up a prediction market in which to conduct open-market operations, or by targeting its own internal forecasts.
The key here is to cut down the scope of the Fed's discretion, because abuse - passive or negligent - of that discretion leads to great harm.
Two criticisms of my skepticism of discretionary stimulus are, "If Congress can't do countercyclical stimulus, why would the Fed be able to?" and "Wouldn't automatic stabilizers play the role of countercyclical stimulus?"
The Fed is smaller, not subject to the same political and special-interest pressures, and has a demonstrated track record of successful economic manipulation. It can make decisions in a matter of days or weeks, while Congress often takes months to make decisions --- it didn't pass its fiscal stimulus until the recession was two-thirds over, and that fiscal stimulus took effect just as the recession ended.
Meanwhile, yes, automatic stabilizers should play the role of countercyclical stimulus, precisely because they're not discretionary. Since they require no decision-making time, an automatic stabilizer can be tightly and negatively correlated with the business cycle, whereas discretionary fiscal stimulus has significant built-in lag time.
Even the Fed's discretion is questionable; it's directly responsible for the five greatest recessions in living memory. We should therefore be looking at replacing the Fed's discretion with an automatically stabilizing rule, such as monetary growth or a nominal income target.