Economic fluctuations can result from swings on the demand side (total nominal expenditures) or the supply side (general productive conditions). Countercyclical policy can stabilize the former but not the latter. The best we can do is keep aggregate demand on a steady path. Given stable demand, fluctuations in output, employment, and inflation must be due to changes in technology, resource availability, and laws.
This doesn’t mean aggregate demand management is easy. Far from it. Keeping total spending level (or growing at a constant rate; both can work) is tricky for policymakers. Monetary policy works better than fiscal policy. But even monetary policy, so long as it is administered by discretionary technocrats, is fraught with problems.
Fiscal policy is a poor way to stabilize aggregate demand. Government spending can change the composition of economic activity, but rarely boosts it. A well-known macroeconomic aphorism says that fiscal policy must be “timely, targeted, and temporary.” These prerequisites rarely hold.
Suppose the economy is in a slump and that fiscal policy might help. How likely is it that politicians (Congress and the President) will design an appropriately sized package, get it passed before the recession turns to expansion, and will voluntarily reduce spending after the recovery? Doubtful, to say the least.
Monetary policy works better in theory. Central bankers can make decisions much more quickly than elected officials. The link between the Fed’s chief instrument, the monetary base (physical currency plus deposits at the Fed), and total spending is relatively straightforward (though far from constant). And broad-based monetary stimulus can give production a jolt while minimizing the distortions to relative prices.
Despite these advantages, monetary policy in practice is often a mess. Look at all the mischief the Fed has failed to prevent, if not outright caused: the Great Depression, the inflation of the 1970s, the Great Recession of 2007-9, our current inflationary episode. These are hardly encouraging! Each generation of economists seems fated to (re)learn that solving models and making good policy decisions are very different problems.
Monetary policy could be improved by putting it on autopilot. The Fed should have a single, well-specified mandate that forces it to hit an outcome variable, such as a price level target or a nominal spending target. Give it some leeway on the tools it uses, but no leeway on its basic goal. Mere verbal admonishments by legislators are clearly not enough to keep central bankers’ eyes on the ball. When inflation hits 9.1 percent, something has clearly gone wrong and must change. It’s not enough to reshuffle FOMC members. “Getting the right central bankers” is just as silly as “getting the right politicians.” The point is to make the process work well even when we’ve got bad policymakers. If we must have a central bank, let’s at least keep it on a tight leash.
Once we’ve built good institutions for aggregate demand management, aggregate supply is all that’s left. Supply-driven economic fluctuations aren’t cyclical, strictly speaking. Things like pandemics, wars, and tax hikes aren’t reliably periodical. When they happen, we need a very different policy response than spending money or printing money.
Hampered supply lowers the maximum sustainable levels (or growth rates) of output and employment. There’s usually nothing we can do about that. What happens to inflation depends on the demand-side response. If the central bank is stabilizing inflation, it will have to double down on output and employment contractions. If it’s stabilizing nominal spending, it can allow inflation to absorb some of the blow to output and employment. I prefer the latter. But there’s no way to have our cake and eat it, too. Supply-side difficulties make production harder in general. That’s the source of our hardship, not the secondary policy response.
On the demand side, we should keep nominal expenditure as steady as we can. On the supply side, we should keep taxes low and regulation light. These simple policies might make sophisticates scoff. Ignore them; they are far too confident in their fine-tuning abilities. In truth, we’ve advanced little beyond the classical-liberal prescriptions of free markets, sound money, and peace. “Keep it simple, stupid,” is good enough for government work.
