The Captain and the Firefighter: How Fiscal Stimulus Screwed Up Monetary Policy

In the basic New Keynesian model the Fed is seen as something like a ship’s captain, which steers the economy between the twin dangers of recession and high inflation.  They do so by controlling aggregate demand.

It’s not  surprising that many people don’t see the Fed that way; after all, few people bother to follow monetary policy very closely, and indeed few even understand it very well.  But I’d like to argue that the problem is getting worse, that people who should understand have become confused.  And I’d like to suggest that fiscal stimulus played a role.

In my view the key mistake occurred in early 2008, when the Bush administration called for fiscal stimulus in the form of tax rebates.  Recall that lump sum tax rebates have no supply-side effect, so this was pure demand stimulus.

The Bush policy made no sense, and yet very few people pointed that out.  Some conservatives argued against it on “permanent income hypothesis” grounds.  That may or may not be correct (it’s probably partly correct) but in fact it was an extremely damaging argument.  The problem with the conservative argument against fiscal stimulus is that it created the impression that more demand was desirable, and that tax rebates were a bad idea for the reason that they’d fail to boost demand, not because no extra demand was needed.

Here’s the argument the conservatives should have made:

The Fed is responsible for controlling aggregate demand under our system.  They’ve been given to duty to set demand at a level most likely to hit the dual mandate.  If there’s a problem, we need to reform the Fed, or change the mandate.  Fiscal stimulus makes no sense, as the Fed will simply offset the policy with whatever monetary policy is most likely to hit their demand target.  Congress should never, ever, vote for fiscal stimulus, rather they should vote to change the Fed’s mandate.

However almost no one made this argument, and thus the damage was done.  Both sides of the debate implicitly acknowledged that if growth was needed; that “it sure would be nice if the fiscal authorities could provide some.”  Yes, they disagreed over the factual issue of whether fiscal stimulus worked, but that’s a side issue.

The effect of the debate over Bush’s fiscal stimulus was to marginalize the Fed in the minds of the People Who Matter.  Who are the People Who Matter?  They are a collection of academics, reporters, think tank people, politicians, Fed officials, big bankers, and various other groups that participate in the debate over monetary policy.  After the Bush tax rebate the Fed stopped being thought of as the institution that steers the economy, or at least that steers AD.  But the Fed must have some important role, so if they aren’t a ship’s captain, what are they?

Several years later progressives discovered to their dismay that the Fed had become a sort of firefighter.  If it’s not the Fed’s job to insure adequate AD, and they clearly have a major role to play, the most obvious alternative is firefighter—the agency that puts out inflationary fires.  Notice I don’t say “target inflation,” as that would imply they want to raise inflation 50% of the time and lower inflation 50% of the time.  No, they became an anti-inflation institution.

I think this occurred for two reasons.  First, in the Keynesian model inflation is caused by growth.  If it’s the fiscal authority’s job to spur growth through tax rebates, then the Fed would seem to have no role in raising the rate of inflation.  They sit back and wait for “inflation to become a problem” and then leap into action like firefighters.  Don’t believe me?  OK, do this test:  Count the number of times “inflation becoming a problem” is used in the press over the past few years, or even the past few decades.  Then count the number of times the reporter was referring to excessively high inflation and the number of times the reporter was referring to excessively low inflation.  I’d guess the numbers would be roughly 100 to 1.

Conservatives may pay lip service to “stable prices” but in practice they never want higher inflation, even when there is deflation.  Why is that?  Because when there is deflation (1930-33, and 2009) interest rates tend to fall to zero and people hoard lots of money.  To most conservatives that looks like easy money.  And that’s an “inflationary time bomb” waiting to explode (or course it isn’t really, as we see in Japan.)  So even though in principle some conservatives might favor easy money to prevent deflation, in practice they don’t.  The Fed is a firefighter, nothing more.  Hence if I propose 5% NGDP targeting, a policy roughly followed for several decades, they become apoplectic about “inflation.”

Why did I pick on the Bush stimulus; why not the bigger Obama stimulus?  I wanted to pick a time period when the economy was clearly not in any sort of liquidity trap, in order to show that the zero bound isn’t the real problem.  Everyone knows that if fiat money regimes really want to inflate, they can find a way (well perhaps everyone except MMTers.)  The zero bound isn’t the issue.  The real problem is that we stopped thinking about the Fed as a ship’s captain, and started thinking of it as a firefighter.  And now we are asking the Fed to stop being a firefighter.  And that a terrifying prospect for many people, even many of the People Who Matter.

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