Many Americans believe government has a responsibility to fight recessions. They shouldn’t. Politicians and bureaucrats are bad at stabilizing markets. Usually, their patent remedies do more harm than good.
Economic textbooks will tell you that there are two ways government can smooth the business cycle. The first is fiscal policy. By increasing spending, Congress and the President can give the economy a boost. The second is monetary policy. The Federal Reserve, our country’s central bank, can meet exceptional liquidity needs by printing new money. What the textbooks seldom say – and this should be the forefront – is that the former rarely works and the latter only works under very specific conditions.
Let’s start with fiscal policy. For government spending to stimulate the economy, it must increase aggregate demand (total spending on goods and services). But often when Uncle Sam spends more, someone else has to spend less. Public spending crowds out private spending. When this happens, fiscal policy does not create jobs or increase incomes. It just shuffles around existing jobs and income.
But let’s be charitable and assume that fiscal policy can help. There is an even bigger problem: effective fiscal policy must be timely, targeted and temporary. Timely means the spending package needs to pass Congress and get the President’s signature before markets improve on their own. Targeted means that spending should focus on the sectors of the economy that are experiencing the greatest slack. And temporary means that once the economy recovers, spending must slow down or we ignite an unsustainable boom.
Given all you know about politics, how likely is it that emergency spending will meet these three criteria? Do you trust elected officials to make quick decisions, spend responsibly and voluntarily turn off the faucet once the economy stabilizes?
I’m waiting for you to stop laughing.
Now we turn to monetary policy. Unlike spending, printing money is pretty good at driving aggregate demand. When the Fed buys assets like government bonds, it credits newly created money to its counterparty’s bank account. In business jargon, the Fed counters rising money demand by expanding the money supply. This can prevent a downturn if done correctly. Because the Fed has a legal monopoly on the monetary base (the narrowest measure of the money supply consisting of bank deposits held with the Fed and physical currency), the only game in town when there is a flight from securities to dollars.
But don’t trust the central bankers too much. They screw up all the time. In order to stabilize the markets, the monetary expansion has to be dimensioned just right. Guess what happens if it’s too big? That’s right, inflation! We are currently experiencing the strongest price pressure in 40 years. Perhaps the Fed’s doubling of the monetary base from spring 2020 to fall 2021 has something to do with it. Finally, Milton Friedman was right: “Money supply rising faster than output” is a predictable recipe for inflation.
This isn’t the only type of money mishap. The expansion of the money supply sometimes lowers interest rates. Other things being equal, the more liquidity flows through the capital markets, the lower the capital price, i.e. the interest rate. If interest rates go down because of a real increase in savings, that’s all well and good. The lower price of capital signals to investors that borrowable funds are plentiful. But what if interest rates fall just because of the Fed’s funny money effect? Investors are fooled into thinking that capital is more plentiful than it really is. As a result, they take on a number of unsustainable projects. Boom inevitably becomes bust. If that sounds familiar, that’s because it happened in the 2008 subprime mortgage crisis. We’ve built too many homes and secured too many mortgages because the Fed kept interest rates too low for too long in 2003-05.
In truth, we don’t need a central bank at all. A free market for money and finance works just as well for pizza, laptops, and sports jackets. As long as we’re stuck with the Fed, we have to tie its hands with one strict rule. As in medicine, monetary policy is also about doing no damage initially. No inflationary expansions. No misleading interest rates. Congress can and should rein in the Fed by ordering the central bank to keep the value of the dollar stable.
In addition to the economic damage, there is another harmful effect of state intervention: we are becoming less free. Whenever the economic outlook worsens, the government plans to spend more, regulate more and print more money. As a result, markets are becoming increasingly dependent on government generosity. America’s financial markets, once the envy of the world, have become addicted to easy spending and easy credit. Political patronage supports entire industries. Private property and voluntary contracts are designed to ensure our independence and livelihood. But under the cloak of stabilization policy, Washington is turning these instruments of freedom into instruments of subservience.
Political planning and technocratic tinkering make markets less stable, not more. With each temporary crisis – likely caused by the government in the first place – the national debt and the Fed’s balance sheet continue to grow. Our nation would be freer and richer if Uncle Sam stopped micromanaging the economy.
Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics at Texas Tech University’s Rawls College of Business, a research fellow at TTU’s Free Market Institute, and a community member of the editorial board of the Lubbock Avalanche-Journal. The views in this column are solely his own.
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