Olivier Blanchard asks an important question
|Joachim Klement||May 31, 2019|
Olivier Blanchard, former Chief Economist of the IMF and now with the Petersen Institute for International Economics, recently asked an interesting question on Twitter: “Central banks have large research departments. Ministries of finance typically do not even have a research department (with the result that research on monetary policy is much more developed than research on fiscal policy). Why?”
The question is particularly intriguing in the light of a recent op-ed in the Washington Post that described how the US legislature had been systematically starved of its research resources over the last 25 years. In 1995, after the Republicans took control of the House of Representatives, staff at the three major Congressional research units, the Government Accountability Office, the Congressional Research Service and the Congressional Budget Office were all cut by one third. Between 1994 and 2014 funding for Congressional staffers (the people who usually do the heavy lifting on matters of policy) declined by 35%.
These statistics already point to what many have proposed is the answer to Olivier Blanchard’s question. Monetary policy is typically set independently, while fiscal policy is the result of a political process. And in politics, we don’t want facts to get in the way of a good idea. The history of fiscal policy-making is ripe with misunderstandings and ideology that has led to economic decline. The most prominent examples in the 20th century are probably an overreliance on the Philips Curve to manage the trade-off between inflation and unemployment that was a major cause of the high inflation in the 1970s, and an overreliance on the Laffer Curve to promote trickle down economics, the notion that tax cuts would not increase the deficit because the additional growth would lead to higher tax revenues that would compensate for the lower tax rate.
The Laffer Curve has been completely debunked as a statistical artefact that existed in the US for a brief moment in time, but was contradicted by international evidence and the experience in the US since the 1980s, when these theories were put into practice. This, of course, does not prevent the Republican Party in the US from promoting tax cuts as a panacea to stimulate growth.
On the left, we now see the rise in prominence of Modern Monetary Theory (MMT). I gave a brief introduction to MMT last week, which is available here, but if you are interested to hear the the main arguments directly from one of the most prominent economists advocating MMT, Stephanie Kelton, you can watch her present the theory here . The main argument of MMT is that deficits and the size of the national debt do not matter because the government can always print money to pay for it. As you might expect, this makes this theory a really attractive theory for politicians who want to spend government funds on whatever their voters want. If you can do that without ever having to pay for it then this is really cool.
Of course, we know from history that financing deficits by printing money did go wrong in the past and advocates of MMT might want to brush up on the life and work of Thomas Gresham (1519-1579) . The moment investors lose trust in the government’s ability to pay back its debt with money that is a more or less stable medium of exchange is when money printing leads to massive currency devaluation and runaway inflation, if not hyperinflation. In the worst case, this debt-inflation spiral leads to default. In frontier markets and emerging markets, this loss of trust happens rather quickly, while in developed markets it often requires exceptional circumstances. But just because trust has never been lost in the US Dollar does not mean that the US will never have to face the consequences of larger and larger deficits. And proponents of MMT don’t argue that deficits don’t matter. They just argue that they can become much larger before they start to matter.
What the public and politicians will need is objective research that enables them to decide if the potential returns from higher deficits are worth the risk and to get a better understanding when deficits start to matter, because the honest answer is: nobody knows when deficits start to hurt. However, thanks to the budget cuts to the Congressional Budget Office and the Congressional Research Service, we are nowhere near a sufficient level of understanding of these issues. Instead, politicians in the US are operating at a somewhat “lower” level of knowledge, as became evident when the CEO of Google was asked by a lawmaker about the workings of an iPhone and another lawmaker was surprised to hear that Facebook was making money from advertising.