First: Wow, first post in 10 days… sorry, but my little trip to Japan caused all manners of different problems for me in the workload department, but now I’ve slept up enough that I’m at least beginning to get some use out of my head. I hope that this will somewhat make up for it, but I intend for this not to happen again, mostly for the sake of my own sanity.
This weekend special is an idea I’ve thought about for a while, and now finally it’s starting to flesh out into an argument. Into the major question:
Why do we let politicians set fiscal policy?
Premise – Aliens, dependence, and incentives for idiocy
First of all, we don’t let them set monetary policy, which is pretty natural, and if you don’t know the history of why this arrangement is done, there is quite a bit of economics catch-up that you have to do. The summary will nonetheless be provided below as it’s somewhat integral to the argument at hand.
In the beginning (and still today, in China) of central banking, our leaders had control of the central bank. One realization that dawned upon country after country going through the inevitabilities of a boom-bust cycle was that if these leaders were democratically elected and faced re-election pressures, the politicians had to create a sense of wealth and well-being for the population, and upon doing that successfully, re-election would be assured. Given the size and power of the government, one way of achieving this sense of wealth is of course by the process of tax-and-spend, out of which the latter part is the most important, and the former the necessary evil from the point of view of the electorate.
Enter fiat central banking. By issuing notes of claimed value, and printing said notes in new supply, the government is thus allowing itself to spend more, without directly taxing the people. Instead, they can print money, thereby transferring wealth indirectly and proportionately to the wealth of said citizens, as the government can lay claim to a larger proportion of the economy with no repercussions this way. Taxation by stealth was created, as the people didn’t immediately notice, but instead marveled at the ever-increasing “wealth” being created by the government and its spending.
As by now every student of Weimar, Zimbabwe and a whole host of different other countries surely know, printing money leads to the nominal increase in the value of goods – inflation, the process by which said fiat claims less and less value. The realization after a while was that this quickly becomes uncontrollable, goes chaotic and ensures the demotion of whatever economy there was before to the primordial soup of bartering and shadow markets. Members of the working population has all the incentives to consume as quickly as possible before prices rise further, and the rich (holders of actual capital) gain a smaller part of the economy, but relative to the rest of the people they’re still doing much much better by holding hard assets that can easily be bartered and thus perceive themselves as much richer and powerful.
In the western modern model of governance, this is thus offset by ensuring that government and central bank are separate, as politicians have incentives to override the long term benefit of the economy from their medium term desire to stay in power, and thus run the printing presses. It is further believed that the competence of politicians does not extend to the point of solving these problems, nor that the competence of voters includes seeking a solution, so an independent central bank with a clear set of mandates is instated, much like an independent judiciary, in every economy that lays a claim to being somewhat developed and hopes to stay in it for the long haul. This is the solution that was agreed upon after a long set of different other attempts, such as the gold standard, or fixed international exchange rates.
Politicians still face re-election. Their incentives to skew the system in the same way in the short term are still there! Now, do they have the power to do so? More importantly, can they do it by value transfer means that are more stealthy and insidious than printing money?
Enter debt. Debt needs to be repaid at the end of the term of the loan! Ever heard of a credit card trap? Show plastic trinket, get stuff, and “no money” needs to change hands. Of course, scale this up to the national level, run it for a few years, and interest rates come knocking on that door like a ton of bricks. Before this happens though, the politicians in charge for running up this debt gain enormously from the power to spend freely, and the rhetoric that “the world is lining up to lend our great country everything they can!” surely wins over the hardheaded spoilsports that think about the foreign concept of “the long term”. And, with today’s finance, who cares about what you need to repay in 30, 50 or 100 years? By then we’ll surely have fixed whatever problems could ever cloud the sky of our Great Nation!
You’re not even taxing by stealth anymore, you’re taxing a future that no one but your kids cares about! Sure, you can default, but then lending is shut off until confidence recovers and there are real transaction streams to tax, needs at the time or not. National equivalent of not having an unexpected hardships buffer.
Given that the means of wealth transfer to the government are still there, worse and more insidious than ever, the problem isn’t really solved until huge checks and balances are initiated. The EU went some ways with this, but they took the fiscal/monetary imbalances even further, and we can see the results all too clearly every day in the news.
To solve this, lets employ one of Paul Krugman’s possible solutions: find aliens. I am of a slightly more productive orientation than to wage wars on them and thus create the impetus to spend further in the short term. I’d instead employ them, and have them try to find the logical inconsistencies in our current governance structures. If they decide that we are at all intelligent to begin with, and that the field of economics survives an outsider’s logic scrutiny (pretty wild assumptions, I know), I am pretty confident that they would install an independent fiscal policy body as well to keep politicians in check and the economy ticking. Maybe from Krugman’s point of view, this would be a worse alternative than waging wars, but I am pretty certain that any intelligent civilization that would be intent to annihilate us and willing to shell out for it would just lend to us at low interest, turn it off just when the bubble is starting to peak, and let us do all the work ourselves.
Argument – The current path, heading for failure and how we could read history
I would argue that the current situation is, in essence, evenworse than a non-independent central bank. This takes a few leaps of thought, so stay with me.
Lets start with having an independent central bank that follows a price stability target. Further posit that this stability target favors annual inflation of 1-2%. Then, assume the government will face elections down the line. We can now have an active or a passive central bank. Lets assume we have a fairly passive one and that no printing occurs to maintain the economy for a while, at least 20 years. This is mostly to isolate the political factors first before we delve into where things can go really wrong.
Putting the priorities straight, the politicians have incentives to do things quickly as they get into office that they fundamentally believe in, and no matter if that helps the economy or not, they should then be able to lavish in pork-barrel spending closer to the end of their terms. Debt be damned: either it works and they get re-elected, or it doesn’t and the next political party/bloc has to clean up the mess.
Most people tend to feel rather miserable during these periods, so winning the next election is actually not too difficult!Just remind people of the great times under your government, and take another few rounds on the power carousel. One example of this would be the aftermath of the Swedish early 90’s housing bubble, where there was a quick party change, people were experiencing economic hardship, and the original party in power easily won the next election. I won’t pass judgement on the quality or contribution from getting the country out of the quagmire on either party, but the win was easy and recovering for the other bloc was difficult.
Worst economic case? Default, but that sets the slate clean and gets you cred if it works, so not too bad.
Does this sound like a game of “heads I win, tails you lose” to you? Turn on the taps and lets spend!
Now, lets use the central bank. The initial spending and borrowing spree is obviously not good for inflation since there’s a lot more money in the economy chasing fewer goods, and we want to keep inflation below 2%. Solution: Hike interest rates to remove excess cash from the economy and lock it into investments. The government will still be in debt, but this situation does make it a little bit better on companies which gain access to investment capital, grow and create employment. Everyone thrives, we pop the champagne, and call it a day, right?
That was the narrative five years ago. The economic differential equation had been solved. Nothing more to see than McMansions, financial safety for all and models and bottles for the i-bankers we tasked with overseeing this wealth creation. Then we got the fundamental problem: what happens if there is, despite this, a steady price rise in investment assets (housing) turning out to become a bubble and we’ve gotten too complacent to spot it since it’s not in consumption goods?
Tax revenue falls, so the prospect of paying back looks ever weaker: the current school of thought goes that the government must spend since it’s the only economic participant that has any significant confidence, and thus the cycle hits the interest payment on the government loans. Household equivalent: you lost your job, but still have that top of the line credit card policy which requires you to spend just to maintain your benefits and VIP status, but the card fee will skyrocket unless you get a job again. So far, the political policy response seems to be to do the household equivalent of using your credit card to pay for services in your own company, and hope that if you spend enough you will get economies of scale to start selling something to someone else as well!
Again, now we have a central bank which is independent, but have their jobs subject to an ability to maintain price stability. Inflation is now coming down below 1%. Lower interest rates! When we hit the zero bound, if the government is needed for spending because of lack of other economic drivers and everyone acknowledges this, the effect is essentially the collapse of the independence of the central bank. We are back to money printing more or less controlled by the government.
Now, retracing a little bit: we have a huge government debt with relatively high interest rates, and the available pathways out are technically to either see through policies that makes the economy grow on its own from there, or default on debt ensuring quick and intense austerity which will almost invariably throw you out of office. Of course, the collapse of central bank independence allows you to subjugate it, spend, which will make your financial position even worse and thus force printing, and go forth to prosperity and new elections. The major question is of course… is the central bank competent enough to reign in inflation once it goes hyperbolic and employment, standards of living, etc. aren’t yet catching up and are now more than ever threatening to throw the politicians out of their seats unless said politicians spend a tide of money to lift all boat( price)s?
Government debt + inflation. This is better than inflation alone how exactly? Granted, if employment and living standards lead corporate profits and price rises, everything is fine, and the central bank can go back to using interest rate hikes to moderate the ever-increasing government spending sustained by increasing tax receipts. The logical fallacy is that this would put your economic hopes of recovery on the cart pulling the horse, since printing money does seem to work more directly on the prices of goods rather than living standards!
Comments on examples and the western model
Japan is perhaps the best example of this type of model, when coupled with strong economic growth, causing an extended boom and then leading to a sharp and long contraction. Was the world not willing to look at that example of the western model applied to a growing economy and learn? Were we too busy patting each others’ backs in cheering our success at first, and then to disown it as a failed application of said success by outsiders the moment things turned south?
Japan provides us with a not particularly aggressive central bank case that I started out with, and and has thus led to this type of political carousel (one new prime minister for every time you actually bother learning his name) coupled with spending and government debt increases as outlined before. Predicting Japan’s future path is perhaps ill conceived at the moment given a few domestic economic factors, but is there anywhere in the world where the central bank has been more resilient to continued political onslaughts and waved away ever mounting government debt increases so vigorously?
By contrast, the Fed looks much more malleable, and with continued QE and rate pledges etc. looks to be doing its part in surrendering independence and allowing the government to print ever more money. The US government, despite all the ruckus on the debt ceiling debate, is pretty good at running up debt no matter who is in office. ECB LTRO looks very similar, but there it added the problems of a one size fits all solution. Initially, it worked pretty well with adding the impetus that there was a supranational organization that slammed you hard for budget deficits and increasing debt, but politicians proved to be politicians and unsurprisingly, when the biggest backers of the idea of policy adherence stepped out of bounds, playing by the rules was not as fun anymore.
We decided that politicians, if given the tools to find ways to game the economy to please voters in the short term at their long term expense, would wreck the economy by means of stealth taxation thanks to inflation. We thus removed the central bank from their hold, and said that they could only be trusted with monetary policy. They then responded by debt-driven policies, which was powered by stealth future taxation due to debt which appeared sustainable because of the slower pace of appreciation in consumption goods thanks to the independent central bank, allowing ever increasing tax receipts. When the investment goods that this additional debt in extension was plowed into reached bubble territory and aptly burst, the prolonged way that this debt had traveled from government issuance pretty much brought all aspects of the global financial system to its knees. Thus the central banks given their price stability targets were forced into the arms of the government bidding waiting eagerly just above the zero interest rate bound, and we’re back to exactly what we looked to avoid but now have a huge government debt burden on top, and a habit of employing logic that in this case puts the cart of inflation before the real economic muscle of increasing living standards and employment. It is indeed a system where the central banks end up being wagged by the governments tail whichever way it swings, but the system as such cannot endure stresses.
Reattempting to solve the economic equation – a sadly serious proposal:
I am not saying that all of this is a failure of the western model. I am saying that this is a failure in taking the model far enough. Politicians did that they do best, and fought tooth and nail to find a way to turn on the spigot, keep the money flowing and keep that cushion under their buts, because debt allowed them to.
The European experiment of enforcing constraints on budgets and debt worked fine until it was broken beyond its initial intent. People saying it was doomed to fail from the start when they see today’s headlines are beating their own chest a bit too hard: these debt dynamics currently playing out are mainly the fruits of disregarding the stability and growth pact in the name of ever growing union to fuel roundabout modern day equivalents of imperial ambitions (control the largest economic bloc in the world and you’re the new superpower, after all). Naturally, these fruits ripened quicker than expected thanks to the financial crisis. One could present the reverse argument that hadn’t it been for Chimerica’s empowering of this continued growth and easing of the job of the Fed by the low-cost goods selling from China, the European experiment would never have appeared to have at first succeeded. Given that this project was one pretty much born on even footing with the US when the world was leaving the shadow of the IT crash just after the turn of the millennium, and strong continued de-levering and economic reorganization in Asia following the bubble burst there some two or three year earlier, I think that it’s not a particularly appealing counterargument.
One could also wonder, if non-national politician fiscal control really doesn’t work, why does the IMF even exist? After their own crisis and IMF-led rescues, Asian countries seem to have been doing just fine. It might be because of China, but one can’t say with their great government and corporate finances that they look like the canary in the world economic coal mine any longer. Even now, the big rage in Europe is a variety of technocrat governments hopefully stepping in and controlling the economy of whatever country, trying to steer it onto a sustainable path and do everything to avoid default, which represents an extension to the policy targets set out before, although this is born out of crisis.
My proposal is thus to take this one step further. Instead of pestering trade surplus countries everywhere and try to bring them into currency agreements that skirts responsibility on the end of the deficit countries (good one on Japan though, their central bank seems to finally have given the US the currency slap that the government couldn’t) or discussing bank stability covenants worldwide (I’m still having trouble keeping myself from doubling over in laughter at this idea), why not create a grand new world order grouping where both monetary and fiscal policy is taken away from politicians? We could call these central budget offices, or whatever.
My idea is that the governments simply have no control of the broad strokes of the budgets and instead have to ask the central budget office for permission to enact their financial policies. Total revenue, spending, etc., is all controlled by the central budget office. The government will of course be able to dabble in the details of how those totals are distributed, who is taxed, what taxes are being spent on, and so forth, but they have no control of the total numbers. If not enough tax receipts come in, or it’s a prohibitively large part of the GDP, or more debt is being proposed, or whatever, the central budget office simply cuts the spending part of the budget until the government yields and balances the budget. Of course, there should be a provision for different economic times, and the details of this central budget office governing requires a bit of thought and adaptation to each individual country, but we went through the problem for our monetary policy, why not for our fiscal policies as well? Ideally, the central budget offices should also estimate independently the validity of different politically proposed uses of budgets, but that’s a pretty big can of worms and requires brighter minds than mine to make sense of.
I sure hope this proposal it beats the alternatives of endless bickering á la US debt ceiling debate, return to the gold standard, or other failed economic policies. Enemies of central banking and its effects surely will disagree with me (“why replace two economically incompetent interacting systems with three?”) but while the politicians figure out some way to game an economic system where they have no control of the totals of neither fiscal nor monetary policy, we can do the same and figure out ways to shut down those loopholes as well. The system as it is now is simply incomplete, where central bank independence looks like its going down the drain thanks to them having to adapt to politicians whose moves are only dependent on what gets them back in office.