Inflation targets and central bank independence

by John Quiggin on May 20, 2011

Linking to Bennett McCallum with some puzzlement a while back, Brad DeLong asked why a higher inflation target could be seen as undermining central bank independence. I’m with McCallum on the analysis, but not on the policy conclusion. A higher inflation target would reduce central bank independence, and a good thing too.

The problem is that ‘central bank independence’ like the famous efficient markets hypothesis, comes in weak and strong forms. The weak form of central bank independence is the principle that the executive government should not direct the decisions of the central bank.

In this sense, central bank independence has always been the norm in developed countries. In Australia, for example, the government retained the power to override the central bank through a declaration in Parliament. This nuclear option was never used, but it created a strong incentive for agreement among what was then called the ‘offical family’.

Central bank independence as it operated from the 1990s was much stronger. The extreme form, unsurprisingly, emerged in New Zealand, then the darling of free market reformers. The Governor of the Reserve Bank of New Zealand, Don Brash was appointed on a contract (the Policy Targets Agreement) that required him to maintain inflation rates between 0 and 2 per cent, and otherwise gave him complete independence (a nuclear option allowing the government to scrapt the PTA altogether was retained).

The NZ approach to monetary policy was a disaster. Whereas Australia’s more flexible Reserve Bank steered the country through the Asian financial crisis, New Zealand was pushed into an unnecessary recession.

But less extreme versions of this approach were adopted throughout the world, and appeared, during the Great Moderation, to be successful. The key elements were

  • Inflation targeting, typically with a range of 2 to 3 per cent
  • Comprehensive financial deregulation
  • The abandonment of active countercyclical fiscal policy
  • Interest rate adjustments as the sole instrument of monetary policy

Taken together, these measures gave central banks almost complete independence from government.

If the policy responses adopted in the immediate aftermath of the crisis, including active fiscal policy and regulation of the financial system to maintain systemic stability are continued, this strong form of central bank independence would be at an end. Unsurprisingly, central banks have fought hard to return to the status quo ante, doing their best to promote fiscal austerity and resist any radical change in financial regulation.

A higher inflation target would be an even more direct repudiation of central bank independence. Not only would it facilitate active fiscal policy but it would underscore the point that the greatest financial disaster in history occurred during the era of strong central bank independence and as a result of the combination of central bank independence and financial deregulation, previously cheered on as the cause of the Great Moderation.

To paraphrase Clemenceau, monetary policy is too important to be left to central bankers. Governments will inevitably held responsible for the outcomes of macroeconomic policy, so they need to take a substantial share in shaping it.

{ 24 comments }

1

Stephen Lathrop 05.20.11 at 10:13 am

One ancillary point about central bank independence and inflation. Not every price increase, or general run of price increases, is inflationary. Classically, inflation results from too much money chasing too few goods. But price increases can also result from rigged markets—as they routinely do in the case of oil, for instance. And those increases can spread throughout an economy, looking for all the world like inflation. Until you check on what is actually driving up the prices, and find out it isn’t too much money.

In such cases, central banks have a tendency to advance the interests of the rich, who always profit from cheap labor, by punishing the hapless citizenry with unemployment. The so-called stagflation of the Carter years was an example. There seems to be growing political pressure to do that again in the U.S. If that happens, the country will be skating toward crisis, because too much money is emphatically not the problem for most Americans now.

2

michael e sullivan 05.20.11 at 1:54 pm

I’m still not really following why it reduces central bank independence to give them a different target.

It seems to me that the firmness of target and lack of any other considerations is what gives more independence. Also, lack of restrictions on what they may do. If interest rate adjustments are the sole instrument, that seems to give less independence than if other instruments are allowed at the discretion of the central bank.

Whether independence is a good thing, is a whole other question, on which I am inclined to agree with you — central banks must be accountable to the political authority, since the political authorities are accountable to the public for macroeconomic performance.

3

Metatone 05.20.11 at 2:38 pm

In the spirit of the first two posters – I’m not sure how comprehensive financial deregulation can be described as increasing central bank freedom, as it basically just reduces their toolset for managing the financial sector.

It is part of the “package” but to reflect reality, the package needs a different name – otherwise we cede too much to the ideology at work.

4

Watson Ladd 05.20.11 at 7:05 pm

No, it is precisely because governments will be held responsible for macroeconomic policy they do not want to touch it. Inflating ones way out of a depression brought on the Carter years: it was always easier to avoid raising rates and restraining inflation then to do the right thing. Because governments are seen as wanting loose money for short term gain against long term macroeconomic stability mechanisms to insure the credibility of inflation targeting are required. While it is clear that New Zeeland took central bank rigidity to far, I don’t think that Philips Curve targeting by political fiat is a good thing, because the Philips Curve just doesn’t work.

5

James Kroeger 05.20.11 at 7:49 pm

JQ: “…the greatest financial disaster in history occurred during the era of strong central bank independence and as a result of the combination of central bank independence and financial deregulation…monetary policy is too important to be left to central bankers…

Indeed.

It needs to be constantly emphasized that “the greatest financial disaster in history” occurred for one very simple reason: the ‘independence’ of America’s central bank is independence only from the influence of government, and not from the influence of the elites that dominate the financial services sector of the economy. Defenders of the status quo like to suggest that The Fed’s independence is of the purest form, not unlike the idealistic dedication many academicians feel re: their [purely objective] search for The Truth; but they are, quite frankly, either delusional or disingenuous.

This Noble Purpose conceptualization of The Fed’s independence has never been anything other than very clever ‘spin’, created to disguise the true agenda of the Fed, which is simply to protect the perceived interests of the [financial] Investment Class. They created the myth of true independence for the same reasons they chose to name the [for-profit commercial banking industry's] Central Bank the Federal Reserve.

The problem with this arrangement is the coterie of economist-apologists who serve the banking industry, a collective that appears incapable of understanding the crucially important distinctions that must be made between financial investments and economic investments. For those who need to be reminded, economic investments—the kind that actually end up improving the economic welfare of a population—involve purchases of capital goods or other economic resources that are used to either produce more capital goods or more final goods that consumers find desirable. In other words, economic investments either increase output or expand the supply-side’s productive capacity.

In contrast, financial investments are purchases, or commitments of money, that provide the “investor” with an income stream. Saving money is a financial investment because it provides interest income; purchases of assets can be financial investments if they eventually provide a capital gain. Economic investments made by firms are usually also financial investments because they generate income that exceeds their cost. However, the economic investments made by governments that improve infrastructure or human capital are typically not financial investments because they do not provide the government with an income stream.

Some financial investments are also economic investments, but many of them are not. The purchase of a piece of land is a financial investment if it appreciates in value over time, but it is not an economic investment if it just sits there, undeveloped. Purchases of stocks in secondary markets (e.g., NYSE, NASDAQ) are clearly financial investments if the stocks appreciate in value, but they are not economic investments because they involve nothing more than exchanges of titles of ownership of already existing assets. One wealthy financial investor hands money over to another wealthy financial investor for a piece of paper. These transactions do not typically put any money into the hands of firm managers that could be used for economic investments.

This habit of conflating the two kinds of investment is ultimately the key reason why economists/apologists for the Investment Class have always supported policy initiatives that do little more that generate high levels of price inflation isolated within the Investor Class, at the expense of many true economic investments that could otherwise have been made through the government. But there is yet another conceptual error that blinds them to the efficacy of truly beneficial policy initiatives (that would actually increase the amount of real wealth consumed/enjoyed by the wealthy).

This crisis has also revealed the utter foolishness of claiming that the economy is desperately dependent upon the investment monies of the Investor Class, and therefore upon their confidence. Any time the Supply-Side of the economy is in need of loanable funds (like during a recession?) through the banking industry, the Central Bank can simply—through Quantitative Easing—inject newly-created money into the excess reserves of banks that was not saved by any saver. There is simply no reason why we need to continue kissing the asses of the Investor Class (to maintain their confidence).

6

James Kroeger 05.20.11 at 8:07 pm

Steven Lathrop, 1:

…Not every price increase, or general run of price increases, is inflationary.

Quite true.

It is also important to note that America’s central bank doesn’t have any problem with high rates of inflation when they are experienced by only the upper class. The Bush/Republican tax cuts created double-digit inflation within a particular segment of income earners, the Top 5%, at the same time that members of the working class were experiencing disinflation (due to unemployment, outsourcing, illegal immigration, etc.).

Why it is that economists do not acknowledge the fact that different income groups can [and do] experience different rates of inflation is a mystery to me. Instead of producing a single ‘average’ inflation rate, a spectrum of inflation rates should be produced, based on ‘market baskets’ that are relevant to each income-earning group.

7

Watson Ladd 05.20.11 at 9:18 pm

The problem with this arrangement is the coterie of economist-apologists who serve the banking industry, a collective that appears incapable of understanding the crucially important distinctions that must be made between financial investments and economic investments. For those who need to be reminded, economic investments—-the kind that actually end up improving the economic welfare of a population—-involve purchases of capital goods or other economic resources that are used to either produce more capital goods or more final goods that consumers find desirable. In other words, economic investments either increase output or expand the supply-side’s productive capacity.

In contrast, financial investments are purchases, or commitments of money, that provide the “investor” with an income stream. Saving money is a financial investment because it provides interest income; purchases of assets can be financial investments if they eventually provide a capital gain. Economic investments made by firms are usually also financial investments because they generate income that exceeds their cost. However, the economic investments made by governments that improve infrastructure or human capital are typically not financial investments because they do not provide the government with an income stream.

I have several reservations with this clean division. Following Marx the essence of capital is that it is money that pursues its own increase through conversion into commodities and back. Financial capital is simply skipping or obscuring the conversion into commodities.

Suppose a group of investors purchase a spinning jenny for $100. This purchase is an economic investment. But now suppose the leverage at 1:5 and purchase 5 at $100 each for their $100 down. The total $500 economic investment to use your terminology is only possible because of $500 in finance capital that is also put forward in the form of a loan.

“Fine” you argue, “that is economic. But the arbitrage that makes up so much financial capital is not”
One of the classic examples of arbitrage is the carry trade. Capital seeking a productive outlet in one country is directed to a country needing capital for productive opportunities. This purely financial operation enables economic ones to take place.
The critique of political economy views capital as a single category for a reason, namely the difficulty of making a clean separation.

8

Anders 05.20.11 at 11:51 pm

I like the idea of restoring demand mgt to fiscal policy. What’s wrong with a model where an independent body (called perhaps the “Office for Budgetary Responsibility”) estimates both inflation and the level of automatic stabilisers, and dictates movements in the ‘structural’ budget deficit (up to the Government whether it complied by adjusting tax or spending) in order to target a given inflation band?

9

Tom T. 05.21.11 at 12:47 am

Classically, inflation results from too much money chasing too few goods. But price increases can also result from rigged markets—as they routinely do in the case of oil, for instance.

A “rigged market” is just a method for achieving “too few goods,” isn’t it?

10

James Kroeger 05.21.11 at 9:25 am

Watson Ladd, 7:

The total $500 economic investment to use your terminology is only possible because of $500 in finance capital that is also put forward in the form of a loan.

If facts carry any weight in this discussion, please note that approximately 85% of all investment by corporations in America is financed by retained earnings or other internally generated funds (Brealey & Myers, Principles of Corporate Finance, 2000, pp. 383-384) and not by savers. Society is simply not as dependent upon savers for the economic investments it needs, as financial sector apologists would have us believe.

“…the carry trade. Capital seeking a productive outlet in one country is directed to a country needing capital for productive opportunities.”

A lot of people don’t seem to understand that when capital “flows” from one country to another, nothing is actually travelling from one country to another. A buyer of foreign currency is simply purchasing ownership rights of funds that don’t really leave the ‘country of origin.’ If, for example, a British financial investor wanted to buy some U.S. treasuries, he would have to purchase dollars that would be available from a U.S. bank. If he had not made this ‘investment’, the dollars that he didn’t buy would still have been available to lenders in the U.S., as a fraction of the total of loanable reserves available in the U.S.

Generally speaking, ‘inflows’ of foreign capital do not actually occur, or rather, nothing occurs that would actually increase the total amount of money available for lending in the country; it simply puts control of a portion of a nation’s loanable funds in the hands of foreign nationals. Foreign investors may be more willing to lend to certain customers than domestic lenders would be, but the total amount of money available for lending changes very little, if it changes at all. The money was available for lending before it was traded for foreign currency, and it remains available for lending in the U.S. after it is purchased by the foreign buyer.

“The critique of political economy views capital as a single category for a reason, namely the difficulty of making a clean separation.”

So because it can get a little messy, you simply conflate the two? How can it make any sense to do such a thing when (1) as I mentioned previously, 85% of corporate investment is NOT funded by loans, and (2) during years that enjoyed cyclically high levels of business investment, the combined borrowing of all non-financial corporations and all non-corporate businesses only accounted for 20-34% of total borrowing nationwide (Federal Reserve BOG, Flow of Funds)?

11

Stephen Lathrop 05.21.11 at 9:48 am

A “rigged market” is just a method for achieving “too few goods,” isn’t it?

Sometimes. But even in those cases, the correct remedy can hardly be throwing people out of work to constrict demand to match rigged supply.

But where you have relatively inelastic demand, as in the case of oil, a rigged market allows the sale of the same quantity of goods at higher prices—the point of a monopoly, after all.

I’m also inclined to believe that because of inelastic demand, energy price increases tend to propagate more readily than their share in the actual cost of goods would suggest. I hear all the time from people like grocers that some, for instance, 25% increase in the cost of an item is because of a 30% increased oil price. But of course that kind of equivalence vastly overstates the oil price factor in all but the heaviest and least expensive goods—where the cost of transportation is nearly the whole cost of the product—like dump truck loads of sand.

Instead, what seems really to be happening is that retailers and wholesalers know that because of inelastic demand, increased oil prices create consumer expectations for higher prices everywhere. My guess is that provides a synchronizing signal that market price setters use to evade competition in pricing policy, without actually colluding illegally. It would be interesting to see that studied. Maybe it already has been; I’m not an economist.

And once again, if price-increase synchronizing is going on in response to rigged markets, the right remedy can hardly be forcing demand reduction by throwing people out of work.

12

Robert Waldmann 05.21.11 at 11:54 am

In this post, I see an argument against strong central bank independence, but I don’t see an explanation of how a higher inflation target reduces central bank independence. How would things have been different if Don Brash had been appointed on a contract that required him to maintain inflation rates between 1 and 4 per cent, and otherwise gave him complete independence ?

When you finally get to inflation targets, you simply assert that “A higher inflation target would be an even more direct repudiation of central bank independence. ” That is the point on which you disagree with DeLong, but this assertion just appears out of nowhere with no supporting argument whatsoever. The form of the post is “I think that Brad is wrong, it would be good for the following reasons if that which he said wouldn’t happen were to happen, Brad is wrong.”

Neither you nor McCallum (as excerpted by DeLong … I didn’t read the original) give any hint as to why you believe that a higher target would reduce or repudiate or re-anything central bank independence.

My guess is that this is tribalism — the advocates of central bank independence are also inflation hawks. The only question is to which group are you loyal. It’s all about us and them.

I suppose it is also possible that arguments for central bank independence were based on arguments for low inflation and that, therefore, arguing against low inflation undermines the case for central bank independence. But then the logic is that the truth value of a claim (a 2% target is better than a 4% target) follows from its policy implications. Very odd. Also I remember no arguments for low inflation, no case ever being made (ever). I know of Lucas calculating it is no big deal. Period.

Clearly the right rhetorical strategy for defenders of independent central banks to deal with a strong case for a higher inflation target is to redefine low inflation as 4% inflation and say that we need low inflation and central bank independence (to gracefully surrender that which they could no longer withhold).

Of course the political realities are that advocates of a higher inflation target have no hope of success so it all academic.

13

Anders 05.21.11 at 12:01 pm

Re: inflation – surely we should move on from “too much money chasing…” and “rigged markets” to a model with two ingredients:
(A) exogenous shocks injected into the economy: FX devaluation, VAT rises or commodity price increases (themselves pulled by high foreign demand or else supply shock eg poor harvests)
(B) the level of market power in the economy: (i) an inadequate output gap (ie aggregate demand getting too high relative to aggregate supply), or else (ii) automatic inflators in wage contracts or (iii) entrenched union bargaining power (both of which latter two conditions were factors in 1970s stagflation)

The level of market power will determine the extent to which rising prices will intensify/accelerate as inflation, as opposed to dissipating. Market power determines how far workers’ compensation and capitalists’ profit are able to pass on the shocks in their own output prices as opposed to absorbing such shocks by reducing their share of national income. Market power is required to validate price rises as inflation.

14

Kevin Donoghue 05.21.11 at 12:37 pm

Robert Waldmann: Also I remember no arguments for low inflation, no case ever being made (ever).

I don’t claim to know any convincing arguments for low inflation, but didn’t Friedman argue that the optimal setup is one in which the price level is falling at a modest rate so that the short-term nominal interest rate is zero? Why do you not regard that as an argument (however unconvincing) for low inflation?

15

NotThatChris 05.21.11 at 12:53 pm

What abandonment of active countercyclical fiscal policy? Budget deficits have become more countercyclical over the past several decades, at least in the United States, with a fairly large contribution coming from things like the Reagan and Bush tax cuts.

If anything, fiscal policy may have become more ‘active’ (in a ‘not stabilizing the debt’ sense), which would take away central bank independence in a big way.

Otherwise, my hunch is that Robert has it dead on; it’s tribalism; though I’ll note that I think that the Fed should be independent from Ron Paul’s deflation target or the naive Phillips-curve type thinking in other circles. But that’s purely because I think that 2% or 3% or whatever is the right target.

16

Watson Ladd 05.21.11 at 3:43 pm

So where do the other savings go? There are three categories of loan: business loan, consumer loan, and government loan. Two of these finance productivity directly as I am sure you will agree. The other is consumption schedule trading, as in I have needs now and money later. While it is true that a financial transaction may not actually move anything, it does determine the possibility of later transactions. All capital is employed to generate profits through the conversion into commodities and back into money. Finance capital is no different from industrial capital in that respect, and indeed capitalists value both kinds in the same way via NPV calculations.

As for arguments about inflation, it is worth noting that inflation is a form of liquidation. Inflation cuts prices without seeming to. It makes markets where people are reluctant to change prices change prices. In the process it inflicts pain upon people on low fixed incomes for the benefit of no one: higher inflation eventually disrupts markets as we learned in the 1970′s, 1920′s etc. But keeping inflation under control requires increasing interest rates which is politically unpopular.

17

James Kroeger 05.21.11 at 7:40 pm

Bennett McCallum:

“In that regard, an increase in the target inflation rate would tend to undermine the rationale for central bank independence.”

What McCallum is implicitly stating here is that the whole point of making your central bank ‘independent’ [in his opinion] is so it be able to resist calls from national legislators to inflate the economy.

He is hyperbolically claiming that if the CB were to increase the target rate to 4% against its will, its compliance would be equivalent to the CB complying with an extraordinary dictate from the Legislature that it violate its [purported] raison d’etre.

18

James Kroeger 05.21.11 at 8:30 pm

Robert Waldmann, 12:

“Also I remember no arguments for low inflation, no case ever being made (ever).”

I suspect there is only one way to construct an argument for low inflation [that is not circular] and that is to invoke its impact on the real economy. The real economy is the only thing that matters. If certain types of money flows can be expected to cause an optimal arrangement of economic activity to occur (one that maximizes the production/consumption of real wealth), then that type of money flow is justified.

The problem for inflation hawks is that no such justification is possible. Economic history reveals the empirical fact that low inflation regimes occur during periods of economic contraction. In contrast, periods of ‘moderate’ inflation (not hyperinflation) are associated with economic booms. It is during periods of ‘moderate’ inflation that productive output, employment, and investment are all at cyclical highs.

Gerald Epstein of UMASS has done research in this area which showed that “…moderate rates of inflation, inflation up to 20% or more, has no predictable negative consequences on the real economy: it is not associated with slower growth, reduced investment, less foreign direct investment, or any other important real variable that one can find.

The positive economic correlates that have been observed in the real economy during periods of ‘moderate’ inflation constitute a strong argument for ‘moderately high’ inflation rates. It is only when CB’s use extraordinary measures to stamp out inflationary expectations (shutting down all lending) that the real economy begins to suffer.

It should be noted that as recently as the mid-1990′s, Chinese monetary authorities were able to successfully ‘slow down’ their economy’s 24% inflation rate until it again reached single-digit levels without bringing their economy’s annual growth rate down below 7.2%.

It has never been necessary to throw economies into recessions as the only means of taming inflation. Intelligently-designed credit controls, that reduce only particular categories of lending, can be very effective in moderating inflation levels. And then there is the proven use of ‘sterilization bonds’ to remove excess liquidity from an overheated economy.

The Fed’s current statutory mandate [essentially] requires that it seek to maximize employment, but only up to the point when such efforts begin to threaten price stability.

A Central Bank that serves the needs of the vast majority of people (and not just the interests of the Investor Class) would seek, instead, to pursue the goal of price stability, but only up to the point when those efforts begin to threaten maximized employment.

First get everyone working, and then do what you can to keep inflation as moderate as possible.

19

Martin Bento 05.22.11 at 8:58 am

Watson, just to make one specific point for now, you do realize that it was Carter who appointed Volcker to the Fed, at the cost of his re-election prospects (Well, that and Iran, but Volcker was a deliberate move, not a crisis that emerged). Carter had so much recession along with his inflation because he was doing what the inflation hawks claim he should and letting Volcker kneecap the economy. Since this didn’t work as quickly as its advocates claimed it would, the recession lasted into early Reagan, but if you think having the Fed jack rates through the roof to bring down inflation at whatever cost to employment was a wise policy, Carter is your man.

20

James Kroeger 05.22.11 at 1:14 pm

Watson Ladd, 16:

“it is worth noting that inflation…inflicts pain upon people on low fixed incomes for the benefit of no one…”

This particular concern re: inflation would be one to take very seriously if it weren’t a ‘problem’ that is so incredibly easy to fix.

In a political-economy that isn’t stricken with a rabid fear of inflation, individuals/households of modest means that must get by on fixed-incomes could keep up with rising prices if the managers of the money supply were to simply print up enough money for them to keep up with the general rise in prices affecting members of their income bracket. Yes, doing so would add an additional fraction of a percentage to the overall inflation rate, but it would also eliminate the only concern re: inflation that actually merits any serious discussion.

Other often-repeated ‘costs’ of inflation (e.g., ‘menu-costs’, and ‘shoe-leather costs’) are utterly ludicrous; the additional cost (to society) of more-frequent price changes is only a tiny fraction of the enormous cost imposed on society by almost any level of unemployment. Achieving a full-employment economy would increase costs in a particular category, but it would only increase society’s total costs a tiny fraction.

Embracing the comparatively minor cost-increases that higher rates of inflation would bring would enable society to reap enormous cost-savings (poorer folks would be able to provide for themselves, crime rates would drop to negligible levels, etc.). Levels of economic investment would be optimized, thereby optimizing economic growth rates over the long run. All of these desirable economic outcomes would be possible if society were willing to embrace the ‘nuisance’ costs of higher rates of inflation.

If economists were to simply subtract the tiny additional costs of higher inflation from the enormous cost-savings of zero-unemployment, they would have no choice but to conclude that, contrary to widespread public perceptions, higher rates of inflation would not force ‘unnecessary’ costs on society for no gain, but would actually be the key to reducing the overall costs that society must otherwise continually bear.

Overall attitudes re: inflation would be less hysterical if money supply managers were to reassure the public that higher rates of inflation do not actually do any harm to the purchasing power of household incomes (that are able to ‘keep up’ with price increases). Prices may keep going up, but household incomes are also increasing enough to where those higher prices are still affordable. If nominal incomes were not increasing sufficiently, then the higher prices would not hold, and prices would drop to levels that households could then afford.

21

Watson Ladd 05.22.11 at 3:48 pm

There seems to be a continuing assumption that inflation actually increases employment ala the Philips curve. This isn’t actually true. I’ve checked using the Federal Reserve data and plotting employment against interest rate doesn’t give anything parabolic. Furthermore, the theoretical justifications for the Philips curve seem to only hold in the short term. So I’m not sure that the Philips targeting makes sense.

Now, as for targeting and independence, it seems as though once the target is set politically the Fed is best placed to achieve it. Certainly TARP, as political a mess as it was, would have been worse if the Fed was under the thumb of Congress at the time.

22

James Kroeger 05.22.11 at 5:04 pm

Watson Ladd:

“There seems to be a continuing assumption that inflation actually increases employment ala the Philips curve.”

I’m actually not arguing that kind of causal relationship. I’m simply saying that if the government increases its spending on real economic investments enough to create an actual labor shortage, then there’s a good likelihood that higher levels of inflation will occur, and that all of it will be quite acceptable.

Compare that to a plan by the CB to inflate the economy solely through the banking sector, viz. by ‘giving’ banks huge quantities of excess reserves (created out of thin air) to lend as they see fit. A certain amount of such lending would create jobs, but a good deal of it would probably just end up inflating asset prices to ridiculous levels.

One of these types of inflation is beneficial; the other is largely wasteful.

Not the same thing.

23

chris 05.23.11 at 4:28 pm

I find James Kroeger’s distinction between economic investment and financial investment interesting and potentially useful, and I wish it were more widely employed (or at least discussed). Obviously there is overlap, as he points out in comment 5, but not every FI is an EI or vice versa so the conceptual distinction can still be useful for discussing and analyzing cases that fit one criterion but not the other.

In particular, an EI with positive return is highly likely to be socially useful (unless its return comes solely from creating a market failure, rent-seeking, etc.), but an FI with positive return need not be. The valorization of “productive” investment (in the EI sense) ought not be extended to allow FIs to be self-justified by their rate of return.

Also, in response to NotThatChris: Budget deficits have become more countercyclical over the past several decades, at least in the United States, with a fairly large contribution coming from things like the Reagan and Bush tax cuts.

I’m not sure about the timing of the Reagan tax cuts, but the Bush tax cuts were procyclical; they occurred before the crisis, during the “Bush boom” (or bubble, if you prefer). It’s partly because Bush squandered the Clinton surplus in addition to destabilizing the financial system that the US govt is in such dire straits now. (Which would be only modestly dire if not for its internal politics.)

24

James Kroeger 05.24.11 at 1:47 am

chris, 23:

“…I wish [the distinction between AI and EI] were more widely employed (or at least discussed).

I am frankly baffled by the failure of ‘left-leaning’ economists to recognize the political value of emphasizing this distinction in public policy debates. It is really the only argument that needs to be uttered whenever Wall Street economists start calling for capital gains tax rate cuts.

Also, in response to NotThatChris: Budget deficits have become more countercyclical over the past several decades, at least in the United States, with a fairly large contribution coming from things like the Reagan and Bush tax cuts.

I’m not sure about the timing of the Reagan tax cuts, but the Bush tax cuts were procyclical; they occurred before the crisis, during the “Bush boom” (or bubble, if you prefer).

This brings up another important distinction that left-leaning economists really need to start emphasizing. In almost every introductory economics textbook around the world, tax cuts are referred to as a stimulative fiscal policy initiative, when precisely the opposite is true.

Yes, it’s true that if government spending is maintained through borrowing at the same time that tax cuts are put into effect, a net stimulus occurs, but it is not the tax cut that provides any kind of stimulus; it is the spending of borrowed money that accounts for all of the stimulating effect.

Tax cuts—by themselves—are almost always contractionary, and never stimulative. This is because unless something else is done a tax cut deprives the government of revenue that it needs for its spending projects. Unless something else is done (like borrowing the money needed), a tax cut forces the government to cut its spending by the amount of the tax cut.

If (when nothing else is done) any of the money that the government gives to the recipients of a tax cut is saved, instead of spent, then the tax cut is contractionary, for the reduction in government spending will be greater than the increase in consumption that will occur as a result of the tax cut. The only time a tax cut—by itself—is not contractionary is when every single bit of it is spent by the recipients, and then there is still no net stimulus, for the increase in consumption will be exactly equal to the drop in government spending.

The question is why have left-leaning economists allowed their conservative rivals to get away with this obfuscation, portraying tax cuts as stimulative, when they are anything but? If fiscal stimulus is needed, then why combine the stimulus of spending borrowed money with a contractionary initiative (tax cuts) and then call the combined package a stimulus?

If left-leaning economists were to start making this important distinction, it would then become obvious that tax increases are far more stimulative to the economy than tax cuts. Tax increases always provide a net stimulus to the economy if any amount of the taxes collected by the government would have been saved.

If/when the taxes of the economy’s wealthiest households are increased, a significant percentage of the money they end up giving to the government would have been saved. Since the government only raises taxes in order to spend the money, the increase in government spending that would occur would be greater than the decrease in consumption that would also occur…a net economic stimulus.

It certainly does explain why the American economy struggled to recover following George Bush’s two tax cuts (it became known as the “jobless recovery”) in spite of the fact that the economy was also experiencing historically low interest rates at the same time. The Republicans dramatically increased the government’s spending of borrowed money—a true stimulus—but it was only barely enough to counter the negative effect of cutting the taxes of the nation’s biggest savers.

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