Here is the full text of my 18th Quartz column, “The Stanford economists are so wrong: A tighter budget won’t be accompanied by tighter monetary policy.”I honestly couldn’t think of a good working title of my own before my editor Mitra Kalita gave it the title it has on Quartz. But it finally came to me what I wanted my version of the title to be: the main theme is short-run monetary policy dominance, so my title is “Show Me the Money!”
The heart of this column is a discussion of the paper I wrote with Susanto Basu and John Fernald:“Are Technology Improvements Contractionary?” It was first published on March 19, 2013. Links to all my other columns can be found here.
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© March 19, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.
Until the election last year, Stanford economics professor John Taylor was one of Mitt Romney’s chief campaign economists. This morning, he joins his Stanford colleague John Cogan in a Wall Street Journal opinion piece, “How the House Budget Would Boost the Economy.” Cogan and Taylor write:
According to our research, the spending restraint and balanced-budget parts of the House Budget Committee plan would boost the economy immediately.
Leaving aside the long-run merits of the House Budget, let’s evaluate Cogan and Taylor’s argument about what its short-run effects would be. The key to any hope that cutting spending would stimulate the economy is that the spending cuts are all in the future—hopefully after the economy has already fully recovered:
The House budget plan keeps total federal outlays at their current level for two years. Thereafter, spending would rise each year, but more slowly than if present policies continue.
If government spending doesn’t change for the next two years, why might the budget being put forward by the US House of Representatives boost the economy now? Put plainly, their argument is that companies sitting on big piles of cash will invest more and individuals who have money to spend because they have funds in stocks, bonds and bank accounts will spend more now because of reduced concerns about higher future business and personal taxes.
The thing that Cogan and Taylor leave obscure in their argument is that the short-run effect of the House Budget would depend critically on the Federal Reserve’s reaction to it. Let me illustrate the importance of what the Fed does by pointing to the short-run effects of technology shocks. All economists agree that, in the long run, technological progress raises GDP—more than anything else. Yet, in our paper “Are Technology Improvements Contractionary?” which appeared in the scholarly journal American Economic Review, Susanto Basu, John Fernald and I showed that, historically, technology improvements have led to short-run reductions in investment and employment that were enough to prevent any short-run boost to GDP, despite improved productivity. (Independently, using very different methods, many other economists, starting with Jordi Gali, had found the negative short-run effect of technology improvements on how much people work.)
How can something that stimulates the economy in the long run lead people to work and invest less? It is all about the monetary policy reaction. Historically, in the wake of technology improvements, the Fed has cut interest rates somewhat, but has failed to do enough to keep the price level on track and accommodate in the short run the higher level of GDP that eventually follows from a technological improvement in the long run.
So what monetary policy do Cogan and Taylor envision to go along with the House Budget’s proposed cuts in future government spending? Arguing that the results of the House Budget would be even better than predicted by the model they are relying on, Cogan and Taylor write:
Nor does the model account for beneficial changes in monetary policy that could accompany enactment of the budget plan. Lower deficits and national debt would reduce pressure on the Federal Reserve to continue buying long-term Treasury bonds.
To translate, Cogan and Taylor are envisioning tighter monetary policy to go along with the House Budget. But, to the extent that their arguments about the stimulative effects of cutting future government spending have any merit, it would be in conjunction with continued—and likely accelerated–Fed purchases of long-term government bonds and mortgage bonds. As I discussed in an earlier column and at much greater length on my blog, John Taylor is so strongly opposed to even what the Fed is currently doing to support the economy that he is willing to resort to specious arguments to argue for Fed tightening. There is no hope that the House Budget will stimulate the economy as Cogan and Taylor claim unless John Taylor gives up his misguided wish for tighter monetary policy.