A Central Bank that Fights Bubbles Needs Control Over Fiscal Policy

In 2003 and 2004, a debate emerged in academic and financial circles over the appropriateness of the Fed’s “easy money” response to the crash of the tech bubble and the ensuing recession.  Hawks argued that the Fed’s low rate policy was inevitably going to create another asset bubble, and ensure a repeat recession in the future when it bursts. Doves argued that if the Fed imposed tight money on the economy in the lingering aftermath of a recession, simply to eliminate the risk of a future bubble, the recession would turn into a depression. Both were right.

Unsurprisingly, a similar debate is taking place now, in the aftermath of the crash of the housing bubble. The difference, of course, is that the dovish case for monetary stimulus is stronger now than it was then.  The US economy is organically weaker and more inclined towards recession than in 2003 and 2004, and it faces stronger non-monetary headwinds. In terms of bubble risks, conditions in the US economy are not conducive to the formation of another asset bubble.  The two primary candidates for asset bubbles–stocks and homes–are tarnished by their recent track records.  Investors have vivid memories of what happens when you buy stocks and homes at extreme prices.  The reflex they experience in the face of rising prices is more on the side of caution now, rather than excitement.  The situation is further stabilized by the society’s aging demographics.  Older people are more risk-averse than younger people.  It’s harder to get them to play in bubbles.

But let’s go back to 2003-2004 for a moment. What would the correct Fed response have been? Dean Baker says that if he had been the Fed, he would have publically threatened to raise interest rates until homes prices returned to orbit.  But this would have caused a recession–then what?

The truth is that the Fed in 2003-2004 was in a genuine bind. The choice was depression or bubble. Pick your poison. The 2003-2004 Fed chose a bubble; the 1930 Fed chose a depression.  The only reason that the 2013 Fed can escape from both is that it’s been bailed out by weak demographics and the scars of ugly memories. It probably couldn’t create a bubble in stocks or homes if it tried.

The Fed was right to choose a bubble over a depression (or, more generously, to choose the risk of one over the risk of the other).  A depression surely would have caused more suffering. But this is not to say that bubbles don’t matter.  They matter a ton.  In the U.S., they’ve had a significant negative effect on the well-being of millions of low and middle-income citizens.  If there are stimulatory policies that can avoid provoking them, those should be a goal.

What are the costs of a bubble?  The costs are the damaging effects of the unwind–on balance sheets, on the banking system, and on confidence, the foundation of economic growth.  If a housing bubble emerges in response to overly easy money, then when inflation picks up in the cycle, and tighter money becomes necessary, a lot of people are going to lose a lot of money–not money they own, but money they’ve borrowed, money that ultimately belongs to other people. The negative effects on their behavior and on the behaviors of those who lend to them will spread throughout the system, culminating in a recession.  If the Fed can prevent, or at least avoid contributing to, such an outcome, shouldn’t it want to? Shouldn’t it want to help foster an economic environment in which asset prices, like consumer prices, are stable and predictable over time, rather than violently ballooning and then crashing?

Now, it would be a terrible mistake to try to pursue asset price stability at the cost of perpetually-induced recessions. And so using the blunt instrument of monetary policy alone to fight the excesses of financial markets, without consideration for the negative effect on the economy, is obviously the wrong approach. But what if we gave the Fed more tools? Specific to the purpose of this essay, what if we put the Fed in control of a certain amount of fiscal policy, so that it could prudently mix the two types of stimuli in ways that create the optimal economic outcome–a healthily growing economy, without an asset bubble?

The current recession–especially the last 12 months of it–has taught us an important lesson. Fiscal policy matters–a lot. Here we have a Fed that is engaged in arguably the most aggressive balance sheet expansion in the history of the post-war developed world. But even a relatively small amount of fiscal tightening has been enough to entirely neutralize the economic boost–and leave us with nominal growth rates that are the lowest they’ve been at any time in the last 50 years, outside of recession.

The reason that we leave monetary policy to a group of “enlightened dictators” is precisely because it’s too economically important to be subjected to the chaos and corruption of the political process. Noisy politicians who do not understand it are not in position to intelligently vote on it. And if they were allowed to vote on it, they would vote purely on the basis of their own competitive electoral interests, rather than the interests of the general public. It would devolve into a mess of lies and brinksmanship–similar to what congressional discussions on fiscal policy have presently devolved into.

It’s quite ironic then, that we would be comfortable with an approach that relegates fiscal policy–the most powerful type of economic policy there is, at least in the current environment–to the whims of uninformed democracy.  Like monetary policy, fiscal policy belongs in the hands of those who understand it and who can be trusted to employ it prudently for the general benefit of all, not in the hands of those who know nothing about it and who are bound to try to exploit it for personal political gain.

The solution I propose, then, is this. We formally desegregate retirement programs from their trust funds, and fund them instead from general revenues. We then give the Fed full control over the rate on the payroll tax. We allow the Fed to set that rate anywhere from 0% to 10% (or higher). Because the payroll tax is a tax that primarily hits low and middle income paychecks, it has a significant effect on aggregate demand, and can therefore be used to both stimulate employment and fight inflation–the two responsibilities that we entrust to the Fed.

This proposal is filled with hidden benefits:

First, the proposal gives the Fed the ability to safely stave off asset bubbles in early-stage economic recoveries. If the Fed finds itself in a 2003-2004 type situation where the economy still needs stimulus, but where bubble risk is growing quickly, it can proceed with the Dean Baker approach–raise rates punitively to send a message to speculators–while lowering the payroll tax to bolster aggregate demand. The fiscal offset would concentrate the destimulatory effect of the rate increases precisely where the Fed wants it to hit–in speculative asset markets–and not everywhere else.

Second, the proposal allows the Fed to effectively deal with the opposite scenario–a stagflation similar to the late 1970s, where it needs to put downward pressure on incomes without disincentivizing needed capacity-expansive investment.  In such a scenario, the Fed could maintain lower interest rates to avoid excessively discouraging corporate investment in new capacity, while maintaining a higher payroll tax to reduce disposable income and keep inflation in check.

Third, the proposal makes it possible for the Fed to move quickly and apolitically on the fiscal front in response to recessions and crises. Under the current paradigm, a significant part of the policy equation–fiscal policy–is entangled in the congressional morass, and can therefore only move at a snails pace. In late 2008, when the economy needed every bit of fiscal stimulus it could get, it had to wait six long months, as congress dithered.  On the monetary side, in contrast, the Fed was able to cut interest rates and expand its balance sheet immediately after Lehman.  Had it been in control of the payroll tax, it could have done the same on the fiscal side–cut the tax to zero, putting money directly into the pockets of income-starved households.

Fourth, the proposal would dramatically increase the Fed’s policy credibility, particularly at the zero lower bound. Right now, in a zero interest rate environment, it’s very difficult for the Fed to credibly stimulate investment. Sure, the Fed can buy treasuries and mortgages, and make stock and bond markets rise on the excitement, but this is very different from causing corporate managers to invest.  To invest, they need to believe that they are about to see more customers with more money coming through their doors.  The experience of the last 4 years confirms that simply “swapping” assets with the private sector–treasuries and mortgages for cash–does very little to stimulate that belief.

But what if the Fed had the ability to boost everyone’s income 10% in one fell swoop? Then, the game would change. Empty jawboning would turn into talk that you better listen to. The Fed would be able to target a nominal income with significant reflexive suasion, because it would have direct, unmediated control over nominal income (unlike now, where all it can really control is the rate paid by low-risk borrowers, if they want to borrow–a huge if).

Fifth, the proposal would allow the Fed to influence the private-public mix of debt so as to optimize the long-term stability of growth. All growth involves the expansion of debt in some form. Private sector debt tends to be unstable–each individual must carry it on his own back, and stomach its associated psychological pressures, pressures that, when they get heavy, tend to cause everyone to want to deleverage at the same time, to catastrophic effect.  Public sector debt, in contrast, is stable–it is collectively borne, something that no individual person ever has to lose sleep over, or carry on her own back.  For this reason, it doesn’t tend to provoke the dangerous waves of deleveraging that private debt tends to provoke (though it sometimes provokes lawmaker stupidity).  In the worst case scenario, the society as a whole defaults on it through inflation–or, in the case of debt denominated in a foreign currency, through explicit default.  Importantly, in explicit default, no individual citizen’s life is ever destroyed, as would be the case of a private default.    

The payroll tax cut side of the Fed’s stimulus option would be a way of fueling growth through increased government debt. The interest rate side of the Fed’s stimulus would be a way of fueling growth through increased private debt. The Fed could alter the mix of the two types so as to maximize long-run economic stability. It could also tweek policy to address any shortages that emerge in the supply of “safe assets” used by financial intermediaries as collateral for funding, a shortage of which can create squeezes in entangled financial markets where each lender is rehypothecating the collateral it receives.

But what of the national debt?  It’s certainly true that the policy would give the Fed a certain amount of indirect control over the national debt.  But that’s a good thing, not a bad thing.  The people that are best equipped to focus on long-term issues of debt sustainability are leaders at the Fed who manage and understand the economic system, not uninformed politicians and voters. Conveniently, because those people are appointed to their positions, they are also the most likely to be capable of stepping back from the political process and doing the right thing.

An important question that few bother to ask: why is high government debt a problem? For one reason and one reason alone: because it constrains monetary policy.  When the stock of government debt gets really large, the Fed is put in a situation where it can’t raise short-term interest rates without destabilizing the economy. If the Fed can’t raise short-term interest rates, then it can’t control inflation in accordance with its mandate.

To make the point clear, suppose that a country has a debt to GDP of a 1000%. Inflation, which had otherwise been tame for demographic reasons, starts to pick up, as the age distribution of the population shifts.  The central bank is supposed to be able to respond by raising short-term interest rates. Suppose that it needs to raise the short rate from 0% to 5% to keep inflation subdued. If the debt is financed short-term (as most government debt tends to be) the rate increase will increase the government’s interest expense from 0% of GDP to 50%. Absent a dramatic change in fiscal policy, the government will have to borrow 50% of GDP.  But borrowing 50% of GDP and using it to pay interest (lender’s income) to a stock of money and debt that is three times the size of the economy is going to be wildly stimulative–at a time when inflation is already a problem.  Thus, the 5% short rate that the Fed needs to control inflation is going to turn into 25%, then 50%, then 100%, and so on–with each hike, a ballooning deficit, more borrowing, more interest paid, more interest income to households, and therefore more inflation.

Absent fiscal austerity, the only way such a spiral can resolve itself is if rates are held low, despite the rising inflation.  Over time, the real value of the debt will then burn off, which will allow for a more stable equilibrium to be reached.  But this is unfair to the savers who end up holding the bag–enduring large inflation in an environment where their money earns no interest.  The beauty of putting the payroll tax under Fed control is that it gives the Fed the ability to protect their interests by preventing the sovereign from choosing this option.  The Fed would be able to impose the needed medicine –fiscal austerity, the only option that can tame the inflation without ballooning the sovereign’s interest expense.

Some might object that the proposal would be unconstitutional, because, constitutionally, only congress has the power to levy an income tax.  But congress is free to pass laws that delegate that power to other branches of government–in this case, it would be delegating the power to the Fed.  This is exactly what it does with with monetary policy–it delegates its constitutional monopoly on creating currency to the Fed.

Let me close by explicitly outlining the proposal.  We fund retirement programs from the general fund, and turn the payroll tax into a fiscal mechanism.  We let the FOMC adjust the rate on the payroll tax in accordance with its primary mandates: to maximize employment, and maintain low inflation.  But we add a secondary mandate, explicitly stated to be less important than the primary mandates: to employ where possible, a fiscal-monetary policy mix that prevents asset prices from reaching levels that are dangerous to the health of the economy.

If we really wanted to empower the Fed, we could give them the ability to adjust the capital gains tax rate on specific types of assets, so as to discourage excesses from growing.  But that might be taking things too far.

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