Public Choice Watch: Fiscal vs. Monetary Stimulus

Scott Sumner may be good at macroeconomics, but he needs to brush up on his public choice theory.  In the latest Cato Unbound, he has a long essay The Real Problem was Nominal, which argues:

The sub-prime crisis that began in late 2007 was probably just a fluke, and has few important implications for either financial economics or macroeconomics.[1] The much more severe crisis that swept the entire world in late 2008 was a qualitatively different problem, which has been misdiagnosed by those on both the left and the right.

I know very little about macro, and so I have nothing to say about this claim, or the economic arguments Sumner makes.  But he does, unfortunately, stray into our area when he attempts to diagnose the reason for the US policy response (emphasis added):

Much of recent macro theory has focused on showing how and why monetary policy can be highly effective in a liquidity trap. Thus I was quite surprised to observe the general sense of powerlessness that seemed to grip the world’s central bankers as the crisis intensified last fall. In early October 2008, the world economy was in free fall, with forecasts of falling prices and output going well into 2009. And yet there was a general sense that monetary policy could do nothing to arrest this collapse, despite the fact that the Fed’s target rate was still 200 basis points above zero, and the ECB’s target rate was 425 basis points above zero. By the time the Fed cut rates close to zero in December 2008, almost all of the attention was focused on fiscal stimulus. How did this happen? Why did policymakers ignore what we teach our students in best-selling money and banking textbooks?

In The Economics of Money, Banking and Financial Markets, Frederic Mishkin says: “Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.” [3]

In the next two sections I will trace out the series of errors that led to this policy failure.

Um…maybe because policymakers are playing the game of “Accumulate wealth and power”, not the game of “Correctly understand economics and fix the economy”?

Sure, inasmuch as Sumner is talking about the views held by macroeconomists, he may be right about the importance of macroeconomic theory and history.  But when it comes to explaining why the US Government might choose fiscal rather than monetary stimulus, his eyes are missing the elephant in the room.  Policymakers are not selfless maximizers of the utility of the American people.  They are humans, much like the rest of us, maybe a bit smarter, taller, and hungrier for power, maybe even a bit more public spirited, but angels they are not.

And it seems pretty clear to me that fiscal stimulus offers dramatically greater scope than monetary stimulus for politicians to personally benefit.  In a stimulus or bailout bill, hundreds of billions of dollars are redistributed via thousands of pages of legislation, offering enormous scope for catering to special interests, rewarding key voting blocs, directing money to swing districts, rewarding supporters, and everything else that is the bread and butter of life as a politician.  Whereas simple changes to the money supply, whether by QE, price of money, or changes to interest rates, have much broader effects.  They may reward some groups at the expense of others, but the groups are far larger (“debtors”, “creditors”, “Treasury bondholders”), and there is far less flexibility in allocating the rewards.

I can certainly understand how the assumption of honest striving for truth and justice is more pleasant a framework to operate in than the messy selfishness of the real world.  This is presumably one reason why Professor Sumner is a professor and not a businessman or (God forbid) a politician.  But an economist should know better than to assume away rational self-interest, and it distresses me how often in this post-public choice age people still make this basic error.  Frederic Mishkin operates under a dramatically different incentive structure than a policymaker – why would anyone be surprised that he reaches different conclusions and advocates different policies?

There may be other reasons besides individual selfishness why policymakers chose fiscal over monetary stimulus, but surely the self-interest of the policymakers should be where we start the analysis.