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I’ve often argued that the fiscal multiplier would be zero if the central bank was doing it’s job. Of course the central bank doesn’t always do its job, and hence I wouldn’t argue the multiplier is always precisely zero. Spending on WWII probably raised both NGDP and RGDP (although it’s doubtful it raised consumption, which is arguably what matters.) And it’s possible that a big tax increase (such as the highly anticipated taxaggeddon) could slow the economy; certainly via supply-side effects, and perhaps because the Fed would fail to offset the tax increases.

Here’s what I do strongly believe:

1. If the modest spending increases that have been touted over the past few years were enacted they would have been unlikely to have had much effect, as long as the Fed was targeting inflation at 2% or slightly below.

2. The Fed could offset even a big fiscal shock, such as taxaggeddon—which is the expiration of a host of previous tax cuts, due to occur in January 2013.

3. The Fed should offset a big fiscal shock like taxaggeddon.

4. Most importantly, the economics profession needs to change the way it talks about the role of monetary policy. No more soft bigotry of low expectations. We should insist that Fed try to produce an appropriate level of AD. We should talk as if the fiscal multiplier is zero. And I’d even go farther than I’ve gone in the past. If we are so far down in a liquidity trap that there is any question as to whether monetary policy could offset needed fiscal retrenchment, then ipso facto money is already far too tight.

Let me be more specific. Bernanke has recently argued that current monetary policy is appropriate, and that no further stimulus is needed. But he’s also argued that the Fed wouldn’t be able to offset taxaggeddon. Those two answers are simply not acceptable. It’s the Fed’s job to steer the nominal economy. Period, end of story. If they feel that they may not be able to do so because of near zero rates, then they need either a different policy instrument, or a higher inflation target.

I believe the economics profession has been far too kind to the world’s major central banks. Most economists (not all) think the world has an AD problem. And most economists are not demanding the Fed do more. That’s what I’m trying to change.

Matt Yglesias did a recent post that made some similar points. Interestingly, I think we ended up in the same place coming from different directions. Although I believe the fiscal multiplier is normally zero, I also understand that my hypothesis is “just a theory.” Commenters like Andy Harless have pointed out that the multiplier might be slightly positive if the Fed is more reluctant to do unconventional stimulus than if all they have to do is cut the fed funds target. It seems to me that this argument is more likely to apply to very large fiscal shocks, as compared to smaller changes. So I’m a tiny bit worried about taxaggeddon despite my zero multiplier argument. And I’m also a small government guy, who’d prefer spending cuts to tax increases. But even with my theoretical doubts, and my small government bias, I was so outraged by the soft bigotry of low expectations that I did a scathing post a few days back, arguing that it was absurd for Bernanke to claim the Fed couldn’t offset the demand-side effects of tax increases.

Yglesias is more comfortable with bigger government. But on the other hand he also tends to favor fiscal stimulus. So he probably feels an ambivalence to tax increases for very different reasons. He thinks we need fiscal stimulus, but also knows that in the long run Obama’s social spending agenda will require more revenues, and it would be nice if the Fed could provide enough stimulus so that Obama could begin moving in that direction in his second term.

But despite these differences, what strikes me about the Yglesias post is that Matt and I seem to share the same outrage about how little we expect from our central banks. I suppose it’s dangerous to do mind reading, so read it for yourself and see what you think:

Conventional wisdom in DC is that not only would the full expiration of the Bush tax cuts make people grumpy as they find themselves needing to pay more taxes, it would also provide the macroeconomy a job-killing dose of fiscal drag. . . . I don’t buy it. The problem is that this chart ignores what I think we’re now going to call the Sumner Critique. In other words, it assumes that the Federal Reserve is somehow going to fail to react to any of this. You can probably construct a scenario in which the Fed is indeed caught unawares, or is paralyzed by conflicting signals, or is confused by errors in the data, or any number of other things. But Ben Bernanke knows all about the scheduled expiration of these tax cuts. . . . Maybe he and his colleagues won’t do anything to offset this drag on demand, but if they don’t as best I can tell that’s on them. This is the very essence of a predictable demand shock, and the policymakers ultimately responsible for stabilizing demand are the ones who work at the Fed.

If I was a progressive I think I’d feel exactly the way he does. Whether you are on the left or right, it’s very aggravating to see our monetary policy producing massive dead-weight losses, and also pushing fiscal policy away from what it does best.

PS. Business reporters could learn from sports reporters. The press tends to mock Lebron James (perhaps unfairly), for failing to take the big shots. Why don’t reporters do the same with Bernanke? He’s got a long track record as an academic making fun of the argument that central banks can run out of ammo. Ask him “Why are you so afraid of taxaggeddon? Don’t think the big bad Fed has what it takes to get NGDP up to appropriate levels? You guys have your own printing press, for God’s sake!”

Of course I’m being silly. But you have to wonder about a press corps that asks tougher questions of 26 year old basketball players, then of the men and women who are most responsible for the health of the global economy. Maybe it’s the reporters who are afraid to ask the big questions.

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This entry was posted on May 20th, 2012 and is filed under Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



