A Truce Between Monetarists and Fiscalists?

Matthew C. Klein writes for Bloomberg View about the economy and financial markets. He previously wrote for the Economist magazine and its economics blog, Free Exchange.
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Ever since the economic crisis began in 2007, there have been vigorous debates on the best ways for governments and policy makers to respond. (Obviously, some people argued that the best response was to do nothing.) The most interesting has probably been what CNBC's John Carney calls "fiscalists versus monetarists." Last week, Cardiff Garcia of the Financial Times did a great service for everyone confused by these distinctions by creating a guide to economics commentators.

Appropriately, I was placed at the extreme end of the fiscalists, as I think the best way out of our current predicament is for the government to make direct cash payments to individuals financed by the issuance of sovereign bonds. The monetarist extreme consists of those who believe in the nearly unlimited power of central banks to affect the level of nominal income through a combination of jawboning and asset purchases, which would mean that fiscal operations are either useless or downright counterproductive.

Fortunately, David Beckworth, an economist and blogger, has come up with a compromise to help us overcome our differences. In a nod to the monetarists, he wants the Federal Reserve to start by publicly committing to a target path for nominal income. To make this commitment credible, Beckworth would have the Treasury pledge to make direct cash payments to households in the event of an economic slowdown. These payments would be financed directly by the central bank, so no bonds would be issued.

I like this idea because it gets around the big concern that many people, including me, have with monetary stimulus: It just doesn't work that well given the current structure of our financial system. There are also a lot of perverse distributional outcomes relative to a system of simple cash transfers, as Steve Randy Waldman has noted.

However, some people objected to Beckworth's proposal because they believe that an activist central bank can literally increase the amount of spending power of households and firms all by itself. (This isn't actually true, however, since it ignores the role played by banks and other financial firms in creating money and credit.)

Some of the confusion may come from Paul Krugman's 15-year-old Slate column about the Capitol Hill babysitting co-op. His point was that heightened demand for liquid savings can depress spending and potentially make everyone worse off. This is an important insight, but it doesn't really have much to do with monetary policy as it is normally understood (setting interest rates, declaring public targets for inflation or nominal income, buying and selling assets, etc.) In fact, the original story makes it clear that there was nothing resembling a modern financial system or central bank.

The co-op started out with a fixed number of vouchers that members traded with each other for babysitting time. Couples that wanted to go out gave vouchers to others who stayed in and babysat. The co-op also had a "civil service" that matched bids for babysitters with offers of babysitting time. These government employees were paid extra vouchers from "taxes" levied on the other members of the co-op.

Problems first arose because the number of vouchers collected in taxes was systematically greater than the number being paid out in salaries. The shortage was ended when the "government" literally gave every member new vouchers -- something effectively equivalent to Beckworth's proposal. (They also changed the rules about what happens when people leave and join the co-op in an attempt to eliminate the budget surplus, which worked out less well.) Far from being a lesson in central banking as normally understood, the Capitol Hill babysitting co-op is a lesson in the importance of using fiscal policies to get money where it is needed.

The original monetarists agreed that the structure of the financial system determined the ease with which the central bank could accomplish its objectives. When Milton Friedman proposed that the central bank should stabilize the growth in the quantity of money, he also expected that the financial system would be split between depositary institutions that owned only government-issued reserves and investment trusts that made loans but did not sell anything that could be mistaken for "money." Similarly, one of the big selling points of the International Monetary Fund's revised version of the 1930s "Chicago Plan" to reform the financial system is that it would make it easier to implement monetary policy. (I wrote about that plan here.)

While these sorts of reforms are unlikely to happen any time soon, Beckworth's proposal could bring us much closer to where we would need to be.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.