Sunday, July 28, 2013

A policy mistake, in retrospect

In his book "Economics and Liberty", Milton Friedman (probably the best-known monetarist, including Volcker and Greenspan) suggested that tax cuts could be used to stimulate the economy[1]. This was not a real dividing line between Monetarists and Keynesians at the time. In fact, President Kennedy's economic advisors (generally Keynesian) suggested using a broad-based tax cut in the early 1960s could keep the economy from sliding into a recession.

According to the old Keynesian model[2], both increases in government spending (financed through tax increases or deficits) and tax cuts (without spending reductions) can stimulate additional consumption in an economy. 

To any reasonable Monetarist or Keynesian, new or old, any fiscal stimulus would be better placed during a slump than during a boom. The reason is quite clear: why provide support in the form of tax cuts to an economy that is already doing well? This was the situation in 1990, when a tax rebate was issued to each income taxpayer. Given that the unemployment rate around that time was  in the 3-4% range, additional spending was not needed to support the economy at that time. It may be that there was a degree of consumption-smoothing occurring and anecdotal evidence from shortly thereafter seems to indicate an increase in purchases of durable goods, which could certainly enhance peoples' standards of living. Nevertheless, one might question the advisability to use revenues on a tax rebate when debt reduction or building up a rainy day fund were possibilities.

Unfortunately, there seems to be an all too common tendency of political leaders to think almost solely about finances in the here and now, instead of weighing present and future revenues and obligations. In those days, that meant that the policy-makers were more inclined to programming excess revenue for some purpose (the rebate), rather than using it to retire debt, fund future obligations, invest in financial instruments (debt or equity), etc.

Now, naturally, matters are very different. Rather than having a wad of cash burning the hole in GovGuam's pocket, there is a rather large load of future obligations, the recognized debt being maybe a third of it. At the same time, some would argue, as I do, that there is excessive unemployment because there is not enough spending in the economy.

I would take the lesson of the early 1990s as a precautionary tale to take appropriate action at the appropriate time[3]. In those days, the proper stance of fiscal policy should have been more conservative. At this point, we have a comparatively more challenging situation.

[1] Professor Friedman used this as an alternative policy to the prevailing tendency to rely upon federal spending increases to drive additional consumption.
[2] The model I have in mind is the IS/LM developed by John Hicks and Paul Samuelson.
[3] LOL.

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