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December 21, 2006
How To Characterize Economic Policy In The 90's
A comment made by pgl in one of yesterday's posts at Angry Bear caught my attention:
And [why is chairman of Bush's Council of Economic Advisers Ed] Lazear opposed to my suggestion of easy money with tight fiscal policy, which was the 1993 approach?
What got me thinking was this: Was the policy in the period referenced by pgl really one of "easy money" and "tight fiscal policy"?
Answering that question requires answering the prior question of what, exactly, do those terms mean. That is not a straightforward task, but let me give it a shot. I'll start by suggesting -- as I have done before -- that a characterization of the stance of monetary policy -- as tight or easy, restrictive or stimulative, contractionary or expansionary -- can be found in the yield curve, or the spread between short-term interest rates and long-term interest rates.
What about fiscal policy? I suppose that what many people have in mind is the government surplus of revenue over expenditure relative to GDP or, alternatively, the "standardized" or "cyclically-adjusted" budget surplus relative to "potential" GDP. As explained by the Congressional Budget Office:
The size of the budget deficit is influenced by temporary factors, such as the effects of the business cycle or one-time shifts in the timing of federal tax receipts and spending, and the longer-lasting impact of such factors as tax and spending legislation, changes in the trend growth rate of the economy, and movements in the distribution and proportion of income subject to taxation. To help separate out those factors, this report presents estimates of two adjusted budget measures: the cyclically adjusted surplus or deficit (which attempts to filter out the effects of the business cycle) and the standardized-budget surplus or deficit (which removes other factors in addition to business-cycle effects).
With that background, here are pictures of the difference between the yield on 10-year (constant-maturity) Treasury securities and the effective federal funds rate...
...and various measures of the government surplus:
Is pgl right? Does it look like, let's say the Clinton years, were a period of tight fiscal policy and easy monetary policy?
You are not surprised, I presume, to see that there is a pretty good case on the fiscal policy characterization -- though it is interesting that the G.H.W Bush years look every bit as good as the Clinton years by the standardized surplus measure. (I haven't checked this carefully, but I suspect this may have something to do with smoothing out expenditures and receipts associated with the activities of the Resolution Trust Association created to manage the aftermath of the S&L crisis of the 80's, as well as adjustments for extraordinary capital gains taxes in the latter 90s.)
The case for easy money is a bit tougher. If you accept the 10-year/funds-rate spread as being related to the relative ease of monetary policy, then the period from 1993 to 1995 looks relatively stimulative. But the latter part of the decade is not so readily characterized in that manner -- and that is precisely the time when the budget deficits really shrink.
The story can get complicated if you throw in the proposition that the relationship between short-term and long-term interest rates changed in the past 10 years or so, an idea that is currently in favor as a rationale for not worrying about the inverted yield curve today. And, of course, you might reasonably object to my whole exercise by arguing that fiscal and monetary policy are really as much about what people expect to happen as they are about what is actually happening at any point in time.
I can readily agree to the proposition that fiscal policy ought to "tighten" up - though I would emphasize entitlement and tax reform in that definition, as opposed to any particular stand on how fast or how far deficits should recede. As for monetary policy, I'll appeal to higher authority:
Price stability plays a dual role in modern central banking: It is both an end and a means of monetary policy.
As one of the Fed's mandated objectives, price stability itself is an end, or goal, of policy...
Although price stability is an end of monetary policy, it is also a means by which policy can achieve its other objectives. In the jargon, price stability is both a goal and an intermediate target of policy. As I will discuss, when prices are stable, both economic growth and stability are likely to be enhanced, and long-term interest rates are likely to be moderate. Thus, even a policymaker who places relatively less weight on price stability as a goal in its own right should be careful to maintain price stability as a means of advancing other critical objectives.
If that ends up being "easy" money, well, so be it.
UPDATE: pgl responds in his usual intelligent fashion, noting (as he does in the comments below), that the high-growth late 1990s did indeed call for a tighter fiscal policy. What this suggests to me (as I also note in the comments below) is that it is not so clear that we ought to think of the stance of monetary policy in relation to fiscal circumstances. My inclination is to suggest that something like the Taylor rule -- with its emphasis on inflation goals and the level of economic activity relative to its potential - is a more robust approach to characterizing the appropriate course of monetary policy.
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