Friday, May 29, 2009

I found this early essay much more helpful than his better-known later proposal for a constant growth of the money supply

TO BE FILED: From the FT:

‘A framework for economic stability’

By Samuel Brittan

Published: December 4 2008 20:21 | Last updated: December 4 2008 20:21

The reduction to 2 per cent and 2.5 per cent of the Bank of England’s and European Central Bank’s respective official interest rates may be historically unprecedented, but it is the least the two central banks could have got away with. Their measured step-by-step approach falls below the level of events and makes me wish that the US Federal Reserve were in charge of policy on the European side of the Atlantic as well.

The Bank’s continued reluctance to resort to extreme measures makes it all the more unfortunate that the November 24 pre-Budget report turned out, at best, a damp squib and, at worst, counterproductive. Little of the discussion was on the fiscal stimulus but rather on the subsequent tax increases required “to pay for it”. If an old-school economist had deliberately tried to arrange a demonstration against fiscal policy, he could hardly have done better.

It did not help that vetoed proposals to announce an 18.5 per cent or even 20 per cent value added tax at some future date leaked out. Nor was the smallness of the immediate VAT cut – from 17.5 per cent to 15 per cent – a brilliant idea. Having decided to risk being hanged, why not for a sheep instead of for a lamb? If VAT had been cut to, say, 12.5 per cent, it would have been far more difficult for populists to dismiss it as a small factor among the many other influences affecting prices in the shops. Can Gordon Brown really have feared the European Commission?

The most important error, however, was to take too seriously the voices clamouring for a re-entry path to sound finance once the recession is over. Hence the projections showing a return to current budget balance by 2015-16. Hence, too, the assumption of a sharp but short-lived V-shaped recession. Thinking about alternatives led me to re-read a 1948 paper by Milton Friedman entitled A Monetary and Fiscal Framework for Economic Stability, reprinted in Essays in Positive Economics (1953).

I found this early essay much more helpful than his better-known later proposal for a constant growth of the money supply. The 1948 paper contained four proposals:

First, a long-term policy of determining government expenditure on goods and services, either in money or real terms, entirely on the basis of the community’s desire and willingness to pay for such services.

Second, a predetermined programme of transfer payments for items such as pensions and unemployment pay. “Such payments will be high when unemployment is high and low when unemployment is low.”

Third, a progressive tax system primarily based on the personal income tax. The rates set should be sufficient to balance government spending at a hypothetical level of national income corresponding to “reasonably full employment at a predetermined price level”.

Fourth, budget deficits would be financed entirely by the creation of money by the Fed and surpluses used to retire money. This would best be accomplished by adopting the 100 per cent reserve proposal for banks, “thereby separating the depositary from the lending functions of the banking system”.

The first three proposals look at first sight like the “automatic stabilisers” that governments came to rely on as the main fiscal contribution to economic stability before the present emergency. But there is a crucial difference. In a recession, governments would not have to forecast the path of recovery, as the British government has done, or the timing of the return to budget balance. In a normal cycle, the return would be automatic. But, if forebodings of secular stagnation, with the desire to save at high employment levels exceeding investment opportunities, were fulfilled, then budgetary stimulants would continue as long as necessary.

The banking and monetary side might appear novel. Friedman regards them as desirable in their own right. In this context, they have the advantage of making the monetary response to the business cycle automatic. But he concedes that the same results could be achieved under the present fractional reserve system by appropriate monetary policy rules.

Clearly much work would be required to adapt the Friedman framework to today’s institutional structures. In any case, it would not make sense to stake out a public expenditure path and corresponding tax rates until we have a better idea of the sustainable employment level (or output gap) likely to emerge from the present turmoil and also the new trend growth rate. But it is not too early to start preparing.

Postscript. Those alarmed by UK official projections showing public sector net debt climbing from 36 per cent of gross domestic product last year to 57 per cent in 2012 should bone up on their history. There are long passages in Macaulay showing how the nation prospered despite increases in the national debt – regarded by sages as catastrophic. In his one and only Budget speech, Harold Macmillan noted how the national debt had risen from £600m in 1914 to £8.4bn in 1939 and £27bn in 1956 – representing 27, 133 and 146 per cent of GDP. As Macmillan put it: “Whatever the temporary difficulties from trying to run too fast, if we stand still, we are lost.”

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