Monday, November 22, 2010

Policy Instrument Preferences of Pro- and Anti-Market Economists

Bryan Caplan is puzzled by the polarization of policy instrument preferences both of pro- and of anti-market economists. Excerpt:

“Austrians and hard-core libertarians usually jointly dismiss monetary and fiscal policy. But among more moderate economists, there's a long-standing tendency for pro-market views to correlate with a preference for monetary over fiscal policy. Friedman and Samuelson are the classic examples: Friedman combined highly pro-market views with a strong belief in the macroeconomic power of monetary policy and impotence of fiscal policy, while Samuelson combined rather anti-market views with a strong belief in the macroeconomic power of fiscal policy and far less confidence in the power of monetary policy. The generations of economists that Friedman and Samuelson taught usually bought the same intellectual bundles.

On reflection, these intellectual bundles are puzzling. Fiscal policy encompasses not just spending, but taxing as well. So when anti-market economists see a downturn and demand more government spending, pro-market economists could insist that tax cuts are just as good a solution, if not better. Indeed, in turns of libertarian purity, belief in the power of fiscal policy allows pro-market economists to claim that all government has to do in a downturn is "get out of the way." Belief in the power of monetary policy, in contrast, requires pro-market economists to advocate additional government action in the face of a downturn. Remember: Friedman's critique of the Great Depression is that the Fed didn't do enough.

Question: Is there any good explanation for the pro-market/monetarist and anti-market/fiscalist correlation? Or is the right story mere happenstance and path dependence?” (Econolog, November 21, 2010).

My comment.

First, a remark: the position of Milton Friedman towards the efficiency of monetary policy was rather ambiguous. Of course, he held the Federal Reserve responsible for the depth and intensity of the Great Depression, due to its excessively restrictive stance when confronted to banking failures. But otherwise he claimed that active monetary policy had mostly negative (inflationary) consequences, and anyway was much too imprecise, due to its lags in impact on real activity, to be useful for compensating shocks on the macroeconomy. He thus advocated an “automatic monetary growth” policy. Things got even more complicated with the later “rational expectations” school of monetarism that held monetary policy to be powerless. Hence the current criticism of the Fed’s quantitative easing.

Second, regarding the question raised by Caplan: Pro-market economists probably prefer monetary policy because its channels of influence are diffused through the banking system, and thus it is, as a first approximation, non discriminatory with respect to different sectors of the economy. Obviously monetary policy exerts some differential effects on small and big firms, individual and corporate borrowers, but these differences are relatively small.

On the contrary, fiscal policy is inevitably discriminatory and selective. An across-the-board spending policy his highly unlikely, and organized pressure groups are going to see that it is oriented towards their favorite beneficiaries.

In other terms a monetary policy is naturally more neutral than fiscal policy, and thus creates less distortions and welfare losses in the economy.

That being said, I completely agree that “when anti-market economists see a downturn and demand more government spending, pro-market economists could insist that tax cuts are just as good a solution, if not better”. That is indeed what I advocated earlier in this blog as the best policy in the current great recession: cut taxes and simultaneously cut some spending in order not to increase deficits too much, but do not give priority to cutting deficits (and especially not by increasing taxes in a recession). And at the same time adopt an expansive monetary policy in order to avoid over valuation of the currency and in order to stimulate exports in our typically quite open economies. It is a pro-market-neo-keynesian-old-monetarist policy.

The instrumental preferences of pro-market and anti-market economists are thus likely to be separated by more complex fault lines than that of the old monetarist/fiscal policy debate.

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