The government versus the central bank: monetary policy as the only game in town

The working economic model in North America and Europe is one in which the central bank and the fiscal agents are working at cross-purposes, with the central bank doing the heavy lifting if stimulus is desired.

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I’ve pointed this out before, but it bears repeating: despite the large buildup in US government debt under Obama, the Obama administration ran a pretty restrictive monetary policy. In fact, compared to the other large, developed economies, Obama actually had the most restrictive post-crisis fiscal stance.

I think this makes sense if you listen to comments by Obama’s last Treasury Secretary Jack Lew about the Republican tax cuts. He says, “It’s a ticking time bomb in terms of the debt.” 

On its face, this comment is laughable since the US government creates dollars — especially given my view that, if you actually wanted to win an election like the upcoming US mid-terms, you don’t do it by opposing tax cuts on the grounds that, “It’s a ticking time bomb in terms of the debt”. That’s actually a losing strategy. What you’re supposed to say is this: “we will be responsible by looking at spending line by line and eliminating every wasteful program. On taxes, we want to lower taxes too. But these are the wrong tax cuts to make.”

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But of course, Lew didn’t say that. And a lot of other Democrats aren’t saying that. They are banging their fists on the table, screaming about the deficit.

Meanwhile the Republicans just passed a tax cut that will give cuts in the first few years to just about everybody that matters in states important to their electoral chances. The potential electoral benefits are so large that, despite the Trump millstone, Democrats are worried and threatening to sue based on the tax bill ‘illegally harming blue states’. Moreover, on average, every income quintile gets a cut. It’s only later when some of those tax cuts get unwound and and taxes start to go up for the middle class on average. Corporations and and the wealthy get to keep their tax benefits. Pretty crafty, huh?

As far as the mid-terms go, the Republicans have a pretty good strategy. Democrats talking about deficits don’t.

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But this whole affair got me to thinking about how the federal government interacts with the central bank.

We know the Fed has a dual mandate to keep inflation low and stable and to keep unemployment down. In the Fed’s most recent policy statement it told us it thinks 2.0% inflation and 4.6% unemployment is a good target level. And the implication is that, since we are below that level on the unemployment side, the Fed will have to move rates up a tad to make sure inflation stays manageable.

Why doesn’t the federal government think this way? I’m not talking about inflation as a trade-off with unemployment. I mean, why is Jack Lew talking about deficits at all? And why was the Obama Administration running a restrictive fiscal policy when the country was still in deleveraging mode? Shouldn’t they be trying to get to full employment and low inflation, just like the Fed? The way I see it, if the Obama Administration is running a restrictive policy — i.e. an almost 6% fiscal tightening relative to the structural government balance — the Fed has to offset that. In fact, because the Fed is mandated by a 1977 law to pursue low unemployment and inflation, the Fed is guaranteed to offset tight fiscal policy.

Basically, you have monetary and fiscal policy working at cross purposes. And given the Fed’s mandate, tight fiscal policy can only mean one thing: loose monetary policy. And we all know that loose monetary policy drives up asset prices, favouring the rich.

In Europe, it’s the same thing, by the way. Right now, Europe is actually growing faster than North America. EU GDP growth is higher than US GDP growth. And yet, while the Fed is raising rates, the ECB is running negative interest rate policy and engaged in quantitative easing.

The bottom line: The economic model running in the US and the EU right now is pretty much the same as it was before the Great Financial Crisis. That’s a model in which it’s the government versus the central bank. The government is supposed to run as tight a ship as it can and the central bank is called on to offset this and deliver growth. The British economist Wynne Godley recognized this 25 years ago as the flaw in the setup of the euro. 

So, both in Europe and in North America, the central bank is the only game in town. And it looks like it will remain that way for the foreseeable future. That’s great for asset prices, by the way. It’s not great for growth or for working and middle class wages and employment.

P.S. – If you didn’t have a model with the government versus the central bank, you would not only see more balanced growth, you would hit the long-term potential economic growth levels more quickly. And that would mean higher interest rates too.  

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