Whither, Federal Reserve? (1) Before Our Crash
The Federal Reserve seems to be a big black box, containing magic. In fact, its high-wire acrobatics must not be allowed to fail. Nevertheless, it may be time to consider revising or replacing it.
One of the important provocations of the American Revolutionary War was shortage of cash caused by a primitive currency system. The British government would not permit colonies to print easily counterfeited paper money; while dependence on gold coins regularly caused temporary shortages during seasonal trade imbalances. Colonists became bitter about farm foreclosures when an otherwise prosperous farmer simply couldn't find enough coins to satisfy his mortgage payments. So, from earliest days the monetary system highlighted the important distinction between how much cash you had jingling in your pocket, and how rich you actually were. Electronic banking and funds transfers have now largely eased the cash flow issue; measuring the true wealth of the whole economy still contains much guesswork. When the economy seems to be undervalued (deflated) by the prices collectively set by the marketplace on each of its parts, two common fiscal remedies still provoke political controversy. To inflate the economy, the government can spend money, or it can reduce taxes. The empirical history of the past century seems to show that cutting taxes is quicker and more effective, particularly when taxes were too high, to begin with. It may not work when taxes are insignificant, so the political debate between the two parties who have adopted these programs as pets tends to center on whether taxes are too high or too low and who is paying them.
To a certain extent, this is a tempest in a teapot. Both reducing federal taxes and increasing federal spending lead to increasing federal deficits, which are then covered by issuing federal bonds. Not much difference, there. The important difference on a practical level is that cutting taxes increases money in circulation more quickly than wrangling about what programs might be best, and then painfully organizing them. The choices for spending opportunities are set by the private sector when taxes are reduced, are therefore more effective in stimulating the private economy, less likely to be politically filtered than legislative authorizations are. The fresh funds from cutting taxes go to those who were successful enough to be paying taxes. They personally need them less than poor people do, but they have a better track record in multiplying them. Unless taxes are already too low to make a difference, reducing taxes is clearly quicker and more efficient than authorizing government spending. Finally, the argument about "planning" introduces an unnecessary sour note. Although the Communist Party was famous for five-year plans and the like, the truth is their system of subordinating economic goals to political ones was the main source of their economic collapse. It was a German, Italian and Japanese systems of central planning which can fairly claim a measure of economic success, growing out of their admiration for an earlier era of success by huge industrial corporations, stimulating even in America a spirit of "win the war" top-down organization. We thus have the ironic situation where it is awkward to point out the technical reasons for the post-war failures of the centrally planned Axis nations since the people who now seem most attracted to central planning are the ones most likely to be offended by the comparison. Somehow, we must hope that the French and Chinese learn this lesson by themselves.
Originally published: Thursday, June 22, 2006; most-recently modified: Thursday, May 23, 2019