Suspend the payroll tax. The Federal Reserve might still have to cut interest rates to zero.
Brian Riedl has a nice piece in this publication articulating the case against fiscal stimulus. It provides a solid rundown of what I think are the strongest contemporary arguments that tax cuts or spending benefits don’t serve to boost economic growth. That provides me with the ideal foil to explain why those arguments ultimately fail in our current environment, and conversely why conservatives and libertarians should reconsider their opposition to recent economic-stimulus proposals.
Riedl starts out with a simple but crucial premise:
Every dollar that Congress injects into the economy must first be taxed or borrowed out of the economy. So in a typical, full-employment economy, government spending merely redistributes purchasing power from one part of the economy to another. It is the equivalent of trying to raise a swimming pool’s water level by taking water from one end and dumping it into the other end. (Yes, government could fund new spending through the printing press, but that would be monetary stimulus, rather than fiscal stimulus.)
That’s essentially correct. Fiscal stimulus can work only if it somehow generates monetary effects. Though this insight was lost among Keynesians in the mid 20th century, when consequently the term “Keynesian” earned its current poor reputation among conservatives, it’s at the heart of the story that Keynes himself was trying to tell. His opus is titled “The General Theory of Money, Employment, and Interest.”
Indeed, if the Federal Reserve is exacting precise control over monetary policy, it’s impossible for fiscal stimulus to have any effect on the macroeconomy. Whatever short-term increases in growth Congress generated through cutting taxes or increasing spending would be completely offset by the Federal Reserve in the form of interest-rate increases.
In our current environment, however, the Fed is not exacting complete control. On a basic level, the problem the Fed faces is that its primary tool for stimulating the economy is the lowering of interest rates. Interest rates, however, are already near zero. That gives the Fed little room to respond to a major economic downturn.
If an economic stimulus-package were able to generate monetary effects, the Fed, now facing the prospect of a global recession in the wake of the COVID-19, would not offset it. Fed members have, in fact, repeatedly signaled that they would welcome stimulus.
Can fiscal stimulus even generate monetary effects? Riedl argues that it cannot, at least not to any significant degree. That’s because, he suggests, to do so Congress would finance its stimulus by borrowing otherwise idle money and there isn’t much of that lying around:
And where there are idle savings — in safes, mattresses, excess bank reserves — it is not clear that most of Washington’s deficits will be funded by these sources. In fact, despite common assumptions that banks fund most stimulus spending out of their excess reserves, less than 5 percent of all Treasury securities are held by banking institutions. Households and investors hold much more of the national debt. The Federal Reserve buying securities would inject new spending into the economy, although that becomes monetary stimulus and can be done without stimulus legislation
That misunderstands how excess reserves work. They are used not just to finance the bank purchases but to settle the purchases of anyone who has an account at the bank. That includes a household or investor purchasing Treasury securities.
Riedl notes that, “in fairness to John Maynard Keynes, he was writing in the 1930s when the financial system was in chaos and there were significant idle savings for the government to borrow and spend. That is not the situation in the modern economy.”
In fact, that is almost precisely the situation we are in today. During the financial crisis, the Fed flooded the system with reserves through quantitative easing. It now operates what it calls an abundant reserve system. That means that although the Fed has suspended QE and even began selling off some of its Treasury holdings, it intentionally ensures that there are always idle reserves in the system. If for whatever reason banks come even close to not having enough reserves, the Fed loans out more — as it did on Thursday, in the amount of $1.5 trillion.
The new system also mitigates Riedl’s worries about empirical studies purporting to show that economic stimulus is effective. He correctly points out that many of the empirical studies on stimulus look at whether states that received more aid grew faster.
Yet this could simply mean that spending, and hence growth, was transferred from donor states to receiver states. In the current system there are no “donor states,” and so increases in growth from spending in one state are not offset by decreases elsewhere.
In closing, Riedl leaves open the possibility that stimulus could have an effect:
This does not mean that fiscal stimulus is completely worthless. Surely some idle resources get transferred to the government, creating a multiplier slightly above zero. . . . On the other hand, the new debt adds permanent annual interest costs to the federal budget. If the goal is to fight a recession, monetary policy is a much more effective tool.
The recession we now face is one in which traditional monetary policy will quickly become ineffective. The current abundant reserve system, however, allows fiscal stimulus to act as a de facto monetary stimulus, because it ensures that excess reserves are always available to fund loans to public or private borrowers. The more the government borrows, the more reserves the Fed creates.
It may seem that this is all too good to be true. That’s not the right way of looking at it. Instead, it’s that that global instability combined with an aging population has created a persistent shortage of safe saving opportunities.
That shortage drove down interest rates around the world, and have in turn made it more difficult for central banks to fight recessions. That in turn creates more fundamental instability, driving down interest rates further. Rather than a blessing, the current ability of fiscal stimulus to produce monetary effects is the side effect of a curse.
Furthermore, instead of fearing fiscal stimulus as an opportunity for government to increase spending, conservatives and libertarians should ask why the government is still levying taxes on capital. Decreasing capital taxation would increase investment opportunities, leading to a rising interest rate and a greater ability of the Federal Reserve to stabilize the economy on it own. To prevent crises over the long term, that’s the direction that we should be headed in.
In the short run, the U.S. faces a potential recession as COVID-19 and our much-needed social-distancing efforts produce a massive cash-flow crunch for businesses. The way to alleviate that and to mitigate the waves of layoffs it’s likely to produce is to suspend the payroll tax. The Fed will still likely have to cut rates to zero and restart quantitative easing. And, to be clear, even that might not be enough.
Stimulus is not a cure-all, but a way to reduce the damage from a recession when the Fed has lost its primary tools to fight it.