Bryan Caplan  

Explaining the Pro-Market/Monetarist and Anti-Market/Fiscalist Correlation

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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?


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COMMENTS (19 to date)
A. writes:

I think it's as simple as not wanting to support increases in government spending, since many will argue that "tax cuts will just be saved"

Ashwin writes:

It's the notion that monetary policy is "neutral" which makes it so attractive to pro-market economists. Atleast in the context of the "Greenspan/Bernanke put" variant of monetary policy, this notion is misguided. If anything, current monetary policy is regressive and transfers wealth to a crony banking system.

Daniel Kuehn writes:

There's a very easy explanation, Bryan - they got there based on analytic, and not ideological reasons.

Could you clarify what you mean by "anit-market". Do you just mean "non-libertarian"? That doesn't seem like a very useful definition if you do.

Jacob Hedegaard writes:

Wouldn't fiscal policy - whether tax cuts or expansion - entail a belief in the 'misbehaving' of consumers? Consumers spend too little, so you should try to boost it, increase AD. An utterly paternalistic approach.

Monetary policy however is, more often, based on the assumption that it helps the adjustment of the economy, and that the need for adjustment is 'nobody's fault'.

That's the way I would explain it.

Daniel Kuehn writes:

Jacob - I don't think there's any assumption of misbehavior. Consumers (and investors) are acting perfectly reasonably. But "perfectly reasonably" and "socially maximizing" are not always the same thing. I'm not sure why libertarians have this tendancy to assume somebody is being blamed for the simple observation of a divergence of individual and social benefit.


I think monetary policy emerges from the exact same sort of divergence between individual and social benefits concerns, it just deals with it differently. So if you're going to tar fiscal policy with that (which I don't think holds up very well) you'll have to tar monetary policy with that too.

Skinner Layne writes:

Perhaps the explanation for this historical oddity is more practical and less theoretic. For most of the time that the two particular economists mentioned in Bryan's post were writing, Congress was controlled by relatively anti-market Democrats, and a resort to fiscal policy would have almost universally meant an increase in government spending, precisely the same reason that economists on the other side, like Samuelson, would support it.

There is also a common pattern of error I have noticed amongst professional economists in both the Monetarist/Supply-Sider and Keynesian/Neo-Keynesian camps, which is that they view the issues of economic growth in purely quantitative terms, and the selection of statistics like GDP and Unemployment are, on their own, poor indicators of the health of the economy.

Centre-right economists tend to talk most about GDP growth, which is artificially inflated by monetary policy manipulation, whereas centre-left economists tend to talk most about the rate of unemployment, which is most easily manipulated by increased government spending on the fiscal side of the equation. Because GDP includes transactions like debt refinancing, any reduction in interest rates will necessarily lead to increases in GDP (not necessarily net increases) simply by the number of transactions that will take place to alter debt maintenance costs to reflect the new rates. Furthermore, centre-right economists have historically been funded and held endowments or led foundations bankrolled by private sector groups who benefit greatly from low interest rates. Loose monetary policy benefits those with the earliest access to the newly minted cash, which are banks and industrial groups who are able to use massive amounts of leverage at the new, lower interest rates.

Alternatively, tax cuts, while beneficial to those same groups, are not only less helpful than infusions of new money into the economy, but they are politically contentious and fuel the rhetoric about the rich getting richer and such. From a pragmatic standpoint, at least until the last two years, monetary policy was a little understood, wonkish pursuit that the general public overlooked. This is why the Wall Street crowd was perfectly happy with the high tax rates and extremely loose money of the 1990s, and it is precisely why the gap between the rich and poor continues to increase.

The middle class and the poor have ready access to credit for primarily consumer-oriented pursuits. High levels of consumer debt represent a transfer of wealth from the poor & middle class to the banking & industrial interests. Where high taxes on business activity are not offset with loose monetary policy (the exact combination facing small business owners, since they do not have the same interest rates as say Goldman Sachs), we inevitably find the real causes of the middle class squeeze and the disincentive for new business starts in the United States.

The centre-left believes the only adequate remedy to the problem of unequal wealth distribution is higher marginal taxes. Unwittingly, they are advocating policies that only exacerbate the problem, since the real disparities emerge on the monetary side of the equation. Not wanting to do anything that upsets the combined central planning powers of both monetary and fiscal policy, they remain silent, hoping that they can increase their own spending powers and increase the size of the bureaucracy.

I view this as the "cynical alternative" to the answers provided to Bryan's question. I think there is a widespread confusion between cynical views and conspiratorial views. It is my contention that the larger a system is, the more unlikely it is that an actual conspiracy can exist, but that the larger a system is, assuming a unified source of capital for its continued operation, then the more likely it is that individuals acting in their own self interest will create the appearance of a conspiracy. But that is perhaps a topic for another day.

Roger Sweeny writes:

When I learned economics from Samuelson's classic text, he told me that an increase in government spending would by definition be completely spent and stimulate the economy. A tax cut, on the other hand, would be partly saved, and those savings would have no stimulative effect, so spending increases got you more "bang for the buck."

Belief in a fairly fixed "marginal rate of consumption" led to this result. Belief in a relatively fixed "velocity of circulation" didn't. Since "Keynesians" believed in the former and monetarists believed the latter, Keynesians could advocate increased spending secure in the belief that they were not just making excuses for a for bigger government. Monetarists could do the opposite.

stu writes:

There are also plenty of economists who believe in both monetary and fiscal - e.g. Paul Krugman. A major unappreciated fact is that Keynes himself was in this category.

Anyway, my theory about why the pro-market/monetarist combination occurs is that it is correct, and will naturally tend be the conclusion reached by the conscientious observer who seeks the truth. Of course, that implies a more complex explanation is needed for the anti-market/fiscalist combination of views.

Chris writes:

Fiscal policy always causes the deficit to get larger, which is why I would guess that pro-market people dislike it. It is certainly a reason that I dislike it.

I seldom (if ever) see anti-market forces advocate fiscal policy in the form of tax cuts. It's always in terms of increases in government spending, usually on the left's fantasy projects (such as clean energy, high speed rail, etc. etc.). That is why I would guess anti-market forces like fiscal policy so much.

Charles R. Williams writes:

Monetary policy is perceived as neutral vis-a-vis the market economy whereas fiscal policy - even temporary tax cuts - are not neutral. There is both intertemporal and intratemporal redistribution. If you favor an activist government, fiscal policy generates plenty of opportunity to do good.

I don't think your analysis includes the supply side approach which favors the lowest possible marginal tax rates and minimal regulation - but of course supply siders are not really interested in fine-tuning the business cycle. There are also people like Cochrane who view monetary policy as impotent under current circumstances.

My own opinion is that the economy cannot be fine tuned - that fiscal policy has always been ineffective and that monetary policy has become permanently ineffective over the last 30 years. Government can none the less do great damage both by behaving erratically and through microeconomic policy.

I see a slightly different divide: long-run/pro-market vs. short-run/pro-govt-intervention. Even Friedman, if I'm not mistaken, believed in long lags and monetary targets. His monetarism was not a theory of quick fixes. I would be careful in comparing modern monetarism with Great Depression monetarism, since they seem like very different regimes (what with all that gold-hoarding talk etc...).

Steve Roth writes:

Stu: "There are also plenty of economists who believe in both monetary and fiscal - e.g. Paul Krugman. A major unappreciated fact is that Keynes himself was in this category."

I think this is an understatement.

I don't think you could find a left/Keynesian/fiscalist-believing economist who would not stipulate to the spectacular, even miraculous powers of monetary policy -- when inflation is up. Everybody saw what happened when Volcker eased in '83: an economic turnaround *within months* -- including unemployment. (This last observation lifted *directly* from Krugman's recent book-tour speech.)

On the other hand, you will find no shortage of right/monetary-believing economists who believe (or pretend to believe) that fiscal policy is powerless, "always and everywhere." (Well, except when it consists of tax cuts...)

You have to ask: which group has its eyes closed, hands over its ears, and is humming loudly. "La la la la la la la..."

Jacob Oost writes:

I am just an amateur, but from my reading of Milton Friedman I think that there is this massive misconception about what Friedman really wanted out of monetary policy. What he mainly wanted was stability in the fiat money system, because of the havoc that instability can reach. His views were entirely pragmatic, that since we are stuck with fiat money then we ought to do it in the least harmful way--by maintaining monetary stability and let the employment/demand chips fall where they may. He admitted that in a theoretical country where government spending was less then ten percent of GDP and regulations and restrictions were minimized, a gold standard of the type dreamed of by Austrians might be feasible and desirable, but since the "gold standard" we are far more likely to get under a real-world government is so far from the pure hypothetical one, and so likely to be blamed for the inevitable economic downturns brought about by monetary mismanagement, we might as well accept fiat money but with solid rules to keep it stable.

My reading is that he never advocated monetary "stimulus," as the Keynesians mean it. Many people providing their interpretation of Friedman's economics say he was advocating monetary stimuli during recessions, but nothing I've read in his writings (that I've gotten to so far) actually backs this viewpoint up. Rather he meant that during a recession, when the velocity of the money supply went down, it was important for the money supply to grow to counter-balance it, for the sake of stability. So we don't have any deflationary spirals or inflationary surges. He was not advocating cheap money during recessions to bolster demand, I never read that.

In the case of the Great Depression, the Fed "doing more" would actually count as *less* government intrusion into the economy. Allowing a fiat money deflationary spiral to occur is more interventionist than trying to balance out a deflationary spiral by growing the money supply. Friedman wasn't necessarily advocating discretionary action OR macroeconomic tinkering. Rather, had the Fed been following one of his policy prescriptions all along (such as a fixed money rule or that indexing thing he later endorsed) the bubble wouldn't have happened in the first place and if it had the contraction wouldn't have been nearly so severe. Monetary stability is all about *neutralizing* the government's effect on the economy due to the existence of fiat money.

david (not henderson) writes:

I would suggest that the inconsistency, at least in respect of the Right, is more apparent than substantive.

The mistake is to think of monetary policy in terms of “stimulus” or as “expansionary” or contractionary". The better way to think of monetary policy is the maintenance of some sort of desired relationship between money demand and money supply. In a free banking world, the adjustment of supply to demand would happen automatically through the market mechanism. If you don’t have free banking, then it falls to the central bank to manage the demand/supply relationship. There are arguments about what the desired money demand/supply relationship should be, how to manage it and how best to do determine whether there is monetary disequilibrium, but one cannot avoid doing monetary "policy" as long as one is stuck with a central bank, regardless of one's political leanings.

Doc Merlin writes:

One thing wrong: monetarists are against using monetary policy? This is why Friedman was always arguing for replacing the fed with a computer? They thought that monetary policy was powerful, but also that it was dangerous.

Hyena writes:

A combination of both factors. Past systems shaped their perceptions of policy and reasoning guided what they then formed from those perceptions.

The major monetarist thinkers lived, at least in part, when the gold standard still existed. Under that standard, the closest analog to our current system is the Fed magically increasing the amount of gold in the universe.

To someone shaped in part by the economics of commodity money, this looks very good from a free market perspective. You're increasing the supply of some resource, out of thin air, and not so much reallocating any resources directly. That this impacts the economy isn't so bad; after all, so too does the discovery of more productive wheat germ and in much the same way.

Whether that makes sense after taking two steps back is questionable, but our views in the thick of things are more like an exquisite corpse than we want to admit.

John Fast writes:

You can count me as a hard-core libertarian who believes that both monetary *and* fiscal policy would be equally effective if they were done properly.

I'm also as a public choice economist who believes that government will almost never (i.e. no better than random chance) do either one (or anything else) properly.

Some of the problem is voter irrationality, as you describe in your book; some is (per standard public choice theory) concentrated benefits vs diffuse costs; and by far the most important part is institutions, i.e. agency problems due to flawed (nonexistent or counterproductive) incentives.

Find me a government agency where people are actually rewarded or punished based on performance and I'll show you one which works as well as a private firm.

Tom Grey writes:

The fiscal stimulus folk all want something else as well as stimulus--some kind of centrally planned Industrial Policy.

Small gov't folk should be clamoring for Tax Cuts, tax cuts, and more tax cuts.
A $1 tril tax cut in 2009 and the unemployment would have been less than 9%, probably less than 8%.
Guaranteed!

Along with tax cuts should be tax holidays, and even tax loans -- letting taxpayers take out a loan based on the amount of tax owed, so send the IRS an IOU instead of cash.

The monetarists are generally against gov't discretion, which becomes crony-capitalism, and is a key reason gov't spending has negative rates of return.

Mike Valotta writes:

Government deficits = non gov. sector savings to the penny.

It's an interesting question that you raise. If taxes don't necessarily fund anything at the Federal level, we should be cutting taxes dramatically. How about a payroll tax holiday?

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