Monetary Alchemy, Fiscal Science

The year 2013 marks the 100th anniversaries of two separate major institutional innovations in American economic policy: the Constitutional Amendment enacting the federal income tax, ratified on February 3, 1913, and the law establishing the Federal Reserve, passed in December 1913.&

It took some time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy, respectively. It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macro-economy. John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression. Milton Friedman blamed the Depression on the Fed for allowing the money supply to fall. [Tools of fiscal policy used by governments, in addition to tax rates and tax deductions, are spending and transfers. Tools of monetary policy used by central banks include interest rates, quantities of money and credit, and instruments such as reserve requirements and foreign exchange intervention used in various (non-US) countries.]

In subsequent debate, Keynes was associated with support for activist or discretionary policy. The aim was counter-cyclical response to economic fluctuations: expansion in recessions, discipline in booms. (It is a myth that he favored big government generally. He said “the boom is the time for austerity.”) Friedman opposed activist or discretionary policy, believing that government institutions, whether monetary or fiscal, lacked the ability to get the timing right. But both great economists were opposed to pro-cyclical policy moves, such as the misguided US tightening of 1937 at a time when the economy had not yet fully recovered.&

After World War II, the lessons of the 1930s were incorporated into all the macroeconomic textbooks and, to some extent, into the beliefs and actions of policy-makers. But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by experiences such as the high-inflation 1970s. As a result, many politicians in advanced countries are repeating the mistakes of 1937 today. This despite conditions that are qualitatively similar to those that determined Keynes’ policy recommendations in the 1930s: high unemployment, low inflation, and rock-bottom interest rates.