Scott Sumner  

Bad policies lead to bad theory

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In the past, I've argued that bad economic policies led to the development of Keynesian economics. The two major culprits were tight money during 1929-32 and the NIRA (which both dramatically raised real wages.)

If Irving Fisher's "compensated dollar plan" had been adopted in the early 1930s, the US economy would have recovered quickly, and pundits would have seen that as confirmation of Fisher's theory that business cycles were primarily a "dance of the dollar", in other words, caused by monetary shocks. Because this policy was not adopted (until much later, in a watered down form by FDR), and because the NIRA delayed the recovery, the capitalist system became seen as inherently unstable and prone to long periods of depression. Keynesian economics was born.

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If Fisher's compensated dollar plan had been adopted, he would have been correct.

Now we are seeing something quite similar play out. In previous posts, I criticized the view that the recent sub-2% inflation shows that the Fed may not be able to hit a higher inflation target. The claim is silly, as the Fed is actually raising rates to hold down inflation, but seems to be widely held nonetheless. Here's The Economist:

Ben Bernanke, chairman of the Federal Reserve during the crisis, proposed a clever approach: when the economy next bumps into the ZLB, the central bank should quickly adopt a temporary price-level target. That is, it should promise to make up shortfalls in inflation resulting from a downturn. . . .

If credible, that promise should buck up animal spirits, encourage spending, and drag the economy back to health. Raising inflation targets would reduce the frequency and severity of ZLB episodes. . . . Less clear is whether a central bank could fulfil its promise. The Fed has failed to hit its 2% inflation target for the past five years, after all. Mr Bernanke's proposal would do little good if markets doubted a central bank's ability to fulfil its promise to deliver catch-up inflation.

The constraints facing central banks suggest better hopes for the second way forward--greater reliance on fiscal policy.


When we think of the cost of the Fed failing to hit its inflation target during recent years, the obvious place to look is employment. The job market recovered more slowly from the Great Recession that would have been the case with 2% inflation, on average, during 2008-2017.

But now I wonder if there isn't an even greater cost to monetary policy failure. It has created the incorrect perception that monetary policy is ineffective, even when not at the zero bound. This despite the fact that there are no serious Keynesian models where monetary policy is ineffective at positive interest rates. So strong is the profession's belief in central bank infallibility that they have distorted theory to match so-called stylized facts (of monetary impotence) that do not in fact exist.

BTW, the same issue of The Economist says:

The IMF reckons that the optimal tax rate on higher incomes, assuming the aim is revenue maximisation, is 44%. Britain's highest rate is already 45%. So the IMF study does not really provide much ammunition for Jeremy Corbyn, the leader of the Labour Party, the main opposition, who wants to raise it to 50%. It is a better argument, perhaps, for Bernie Sanders, the Democrat, since the top American tax rate, before any Trump cuts, is only 39.6%.
Where to begin. The phrase "assuming the aim is revenue maximization" certainly caught my attention. When governments maximize revenue from a tax, the marginal cost of the final dollar raised is infinite. It's a bit odd for the normally sober Economist magazine to be assuming that public policies with infinite marginal costs are sensible. And you can't fix the problem by assuming that the marginal benefit of additional consumption for the rich is quite low, as what is being discussed is an income tax, not a consumption tax. Rich people do not consume all of their income.

But the bigger problem is that the Economist is wrong in assuming that America's top income tax rate is 39.6%. The top federal rate is 43.4%, and with state and local income taxes included the figure is certainly well over 44%.

I eagerly anticipate the Economist's next issue, where they correct their mistake and point out that the IMF study actually calls for tax cuts for the rich in America.


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COMMENTS (11 to date)
Mark writes:

It seems many people just have a strong bias in favor of fiscal policy that makes them want monetary policy to be ineffective, very badly. In the podcasts I've listened to, it's a common theme for some Keynesian economists to tacitly concede the point (or not challenge it) that fiscal policy isn't strictly necessary to escape a putative liquidity trap , but then to springboard into a laundry list of things they'd like to use fiscal policy to justify funding: infrastructure, public education, health care, etc.

Also, I don't think the IMF should be regarded as a very credible source on tax policy. Its position seems to boil down to monotonically favoring higher taxes. I doubt the IMF actually wants even Britain to lower its taxes; the IMF has recently argued for higher taxes simply as a means to reducing 'inequality' even if they make most people worse off.

Thomas Boyle writes:

It's time for the Alternative Maximum Tax...

Robert Simmons writes:

"It's a bit odd for the normally sober Economist magazine to be assuming that public policies with infinite marginal costs are sensible."
That's quite an uncharitable interpretation. Seems like they're saying at best, even if we think this is a bad aim, if your aim is maximization, the highest to go is 44%, (but implicitly that) optimal policy that takes into account other factors points to having lower rates.

Scott Sumner writes:

Mark, You said:

"they'd like to use fiscal policy to justify funding: infrastructure, public education, health care, etc."

But here's the problem. Even if the Keynesian theory is 100% true, it does not in any way justify those specific things. It merely justifies budget deficits. You can have an expansionary fiscal policy with either high or low levels of government spending.

As far as the IMF, it doesn't matter what they "want" (and can a non-human entity like the IMF actually "want" anything?) Rather what matters is the implication of their their empirical studies. And their empirical work clearly calls for lower taxes on the rich.

Thomas . . . to be abolished?

Or to replace the other income tax?

Mark writes:

"As far as the IMF, it doesn't matter what they "want" (and can a non-human entity like the IMF actually "want" anything?)"

Sure it can. The conclusions reached in IMF reports and speeches seem to have some common themes. Here's a speech made by current IMF chief Christine Lagarde for example:

"Policies need to help lower income households – including through a higher federal minimum wage, more generous earned income tax credit, and upgraded social programs for the nonworking poor. …There is a need to deepen and improve the provision of reasonable benefits to households… This should include paid family leave to care for a child or a parent, childcare assistance, and a better disability insurance program. I would just note that the U.S. is the only country among advanced economies without paid maternity leave at the national level."
(http://www.imf.org/en/News/Articles/2017/06/07/sp060717-building-a-virtuous-cycle)

This chorus had been repeated often there, so I think it's fair to say that the IMF "wants" higher taxes, more generous welfare states, and even higher minimum wage.

Scott Sumner writes:

Robert, Maybe I did misinterpret it. But isn't the rest of the paragraph more consistent with my interpretation?

Mark, Certainly you are right about Lagarde. But again, their published research calls for lower taxes on the rich.

Kailer writes:

Do you really think Fisher would have gotten credit? I doubt it. The last few years just packed with evidence of the influence of monetary policy (ECB rate hikes precipitating a double dip, Swiss franc depreciation to avoid the double dip, QE3 offsetting the fiscal cliff, radical BoJ policy causing NGDP growth in Japan for the first time in 20 years), but nobody seems to give it any credit/blame, it's always some second order effect that gets credited.

Brian Donohue writes:

Excellent post, Scott.

I began reading the Economist in the early 1980s. At the time, the magazine was in the process of lurching toward more of a free market perspective in the wake of Thatcher and Reagan.

Over the past 20 years, it has slid considerably away from this view, along with the zeitgeist. I think they trail more than lead in their thinking.

Scott Sumner writes:

Kailer, Yes, I think the effect would have been so dramatic that it would have been unmistakable. But you make a good point.

Brian, That's unfortunate.

Robert Simmons writes:

The Bernie Sanders sentence arguably points your way, but I could see myself writing that sentence as well. The "perhaps" does a lot of work in my mind. I admit people often misunderstand me, so I may not be the best to judge.

Nick writes:

Agree with Brian about the Economist. In the 80s it understood markets and generally defended them. It has drifted leftward for the past 30 years and over the past 20 years or so has consistently endorsed leftist candidates in U.S. elections.

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