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October 27, 2005

Somebody Needs to Be the Institutional Advocate for Sound Fiscal Policy

We are live in the Financial Times:

FT.com / Comment & analysis / Comment - Fiscal stability should be Fed's new mantra : Many -- including myself -- will spend the next three months praising the monetary stewardship of the Greenspan Fed.... Mr Greenspan... and his team managed the extraordinary feat of monetary policy fine-tuning: their policies proved superb at preserving macroeconomic stability and at nurturing rapid long-run economic growth.... [T]here is no doubt the Greenspan Fed hit a grand slam.... But...

[T]he Greenspan Fed has fallen down on part of its job. It did warn that effective budget balance is necessary to controlling inflation in the long run, but its warnings were too soft. Mr Bernanke thus faces a difficult problem. In the absence of other institutions that will do so, the Fed itself needs to preach the gospel that monetary stability ultimately rests on fiscal balance. This is not how the Fed usually perceives its role, but it is difficult to see how it can avoid taking on this burden while ensuring effective price stability.

FT.com / Comment & analysis / Comment - Fiscal stability should be Fed's new mantra : By Brad DeLong Published: October 27 2005 20:15 | Last updated: October 27 2005 20:15: On January 31, Alan Greenspan will preside over his last federal open market committee meeting and retire soon after as chairman of the US Federal Reserve. Many -- including myself -- will spend the next three months praising the monetary stewardship of the Greenspan Fed. The preceding Volcker Fed felt it had no choice but to inflict on the US economy the very painful Volcker disinflation of 1979-83. In so doing, it re-established the Fed's credibility as the guardian of effective price stability.

Mr Greenspan watered and tended this credibility so that it grew tall and strong. He and his team managed the extraordinary feat of monetary policy fine-tuning: their policies proved superb at preserving macroeconomic stability and at nurturing rapid long-run economic growth. You can say that the Volcker Fed loaded the bases -- creating the right preconditions. But there is no doubt the Greenspan Fed hit a grand slam. All of this is true. But...

Looking ahead, I cannot avoid concluding that Ben Bernanke, Mr Greenspan's designated successor, and Mr Bernanke's successor thereafter, are being dealt bad cards. Perhaps it is Mr Bernanke whose hand will be called. Perhaps it is his successor. Either way, it seems clear the Fed is not going to find it easy to maintain relative price stability. And Mr Greenspan has to shoulder part of the responsibility.

Why? Because rising government nominal debt puts irresistible upward pressure on price levels. The government needs to balance its budget in the sense of keeping the growth of nominal government debt in line with real gross domestic product growth. If the government does not achieve effective balance, the market will balance the budget for it. And when the market balances the budget, it does so by levying the inflation tax on the economy. That is the unpleasant monetarist arithmetic.

The inflation tax is a bad tax. It haphazardly redistributes income and wealth. It degrades the ability of the price system to convey accurate signals on social scarcities. It redirects business attention from making more and better products that consumers want to focusing on any change in the value of the monetary standard.Through the 1970s, America had a strong institutional mechanism that kept the government budget from getting too far out of balance. Bracket creep -- the fact that with a progressive but unindexed tax system, inflation raised taxes as a share of GDP -- gave an automatic yearly boost to revenues whenever inflation increased. In the 1980s, this institutional mechanism was erased. In the 1990s, thanks to the leadership of George Mitchell, Tom Foley and George H.W. Bush who negotiated the 1990 deficit-reduction budget deal, America found a replacement: the Budget Enforcement Act's procedural Paygo requirements.

Now this institutional mechanism has also been erased. The president's public response to Paygo and the Budget Enforcement Act is to make fun of them.

Without strong core support in both political parties for effective budget balance America will not have the institutions needed. Without institutions, America will not have effective budget balance. Without effective budget balance, America cannot have effective price stability in the long run.

Thus it is uncertain how long the post-Greenspan Fed can succeed in its mission of maintaining effective price stability. President George W. Bush and his Republican majority have taken three steps to unbalance America's federal budget: the smallest is the military move into the Middle East (a big spending increase with no additional taxes to fund it); a larger one is the tax cuts the administration wants to extend (revenue reductions without any spending-reduction offset); and the largest is Medicare, Part D: the drug benefit plan for pharmaceutical companies and the elderly (a staggering expansion of spending with no additional taxes to fund it). These have been loaded on to a federal budget that an ageing population has already unbalanced for the long run.

Hence the Greenspan Fed has fallen down on part of its job. It did warn that effective budget balance is necessary to controlling inflation in the long run, but its warnings were too soft. Mr Bernanke thus faces a difficult problem. In the absence of other institutions that will do so, the Fed itself needs to preach the gospel that monetary stability ultimately rests on fiscal balance. This is not how the Fed usually perceives its role, but it is difficult to see how it can avoid taking on this burden while ensuring effective price stability.

Posted by DeLong at October 27, 2005 07:09 PM