Salter: National economy policy and liberty

Many Americans believe the government has a responsibility to fight recessions. They shouldn’t. Politicians and bureaucrats are lousy at stabilizing markets. Usually their nostrums do more harm than good.

Economics textbooks will tell you there are two ways the government can smooth out the business cycle. The first is fiscal policy. By ratcheting up spending, Congress and the president can give the economy a shot in the arm. The second is monetary policy. The Federal Reserve, our nation’s central bank, can meet extraordinary liquidity demand by printing new money. What the textbooks rarely say—and this should be front and center—is that the former rarely works, and the latter only works under very specific conditions.

Let’s start with fiscal policy. For government spending to jolt the economy, it must increase aggregate demand (total spending on goods and services). But oftentimes, if Uncle Sam spends more, someone else has to spend less. Public spending crowds out private spending. When this happens, fiscal policy doesn’t create jobs or boost incomes. It just shuffles around existing jobs and incomes.

But let’s be charitable and assume fiscal policy can help. There’s an even bigger problem: Effective fiscal policy must be timely, targeted, and temporary. Timely means the spending package has to pass Congress and get the president’s signature before markets improve on their own. Targeted means spending should focus on those sectors of the economy with the most slack. And temporary means spending must fall once the economy recovers, or else we’re setting up an unsustainable boom.

Given everything you know about politics, how likely is it that emergency spending will satisfy these three criteria? Do you trust elected officials to decide quickly, spend responsibly, and voluntarily turn off the spigot once the economy steadies?

I’ll wait for you to finish laughing.

Now we turn to monetary policy. Unlike spending, printing money is pretty good at expanding aggregate demand. When the Fed purchases assets, such as government bonds, it credits its counterparty’s bank account with newly created money. In economics jargon, the Fed meets an increase in money demand by expanding the money supply. This can prevent a downturn if it’s done right. Since the Fed has a legal monopoly on the monetary base (the most narrow measure of the money supply, consisting of bank deposits held at the Fed and physical currency), it’s the only game in town when there’s a flight from securities to dollars.

But don’t put too much trust in central bankers. They mess up all the time. To stabilize markets, the monetary expansion must be sized just right. Guess what happens if it’s too big? That’s right, inflation! Currently, we’re experiencing the strongest price pressures in 40 years. Perhaps the Fed’s doubling of the monetary base from Spring 2020 to Fall 2021 has something to do with that. Milton Friedman was right after all: “A more rapid increase in the quantity of money than in output” is a predictable recipe for inflation.

This isn’t the only kind of money mischief. Expanding the money supply sometimes lowers interest rates. All else being equal, the more liquidity flowing through capital markets, the lower the price of capital, which is interest. When interest rates fall due to a genuine increase in savings, all well and good. The lower price of capital signals to investors that loanable funds are more abundant. But what happens when interest rates fall only because of the Fed’s “funny money” effect? Investors are fooled into thinking capital is more abundant than it really is. As a result, they take on a bunch of unsustainable projects. Boom inevitably turns to bust. If this sounds familiar, it’s because this happened with the 2008 subprime mortgage crisis. We built too many houses, and securitized too many mortgages, because the Fed kept interest rates too low for too long from 2003-5.

In truth, we don’t need a central bank at all. A free market for money and finance works just as well as for pizza, laptops, and sportcoats. As long as we’re stuck with the Fed, we must bind its hands with a strict rule. Like medicine, monetary policy is about first doing no harm. No inflationary expansions. No misleading interest rates. Congress can and should rein in the Fed by ordering the central bank to keep the dollar’s value steady.

Besides economic harm, there’s another pernicious effect of government intervention: We become less free. Whenever the economic outlook sours, the government plots to spend more, regulate more, and print more money. As a result, markets become increasingly dependent on government largesse. American financial markets, once the envy of the world, have become addicted to loose spending and easy credit. Political patronage props up entire industries. Private property and voluntary contract are supposed to safeguard our independence and livelihoods. Yet under the guise of stabilization policy, Washington turns these instruments of liberty into tools of servility.

Political planning and technocratic tinkering make markets less stable, not more. With each passing crisis—probably created by government in the first place—the national debt and the Fed’s balance sheet grow ever-larger. Our nation would be freer and richer if Uncle Sam stopped trying to micromanage the economy.

Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics in the Rawls College of Business at Texas Tech University, a research fellow at TTU’s Free Market Institute, and a community member of the Lubbock Avalanche-Journal’s editorial board. The views in this column are solely his own.

This article originally appeared on Lubbock Avalanche-Journal: Alexander Salter on national economy policy and liberty