The Fall 2019 edition of the Cato Journal, the Cato Institute’s interdisciplinary journal of public policy, is now available online. Readers of Alt-M will find the articles on monetary and financial topics of special interest. Their topics range from financial inclusion, to macroprudential policy, to Modern Monetary Theory, to the politicization of the Federal Reserve, to European monetary policy. Here are links to the full-text articles—followed by a summary of each.
Drawn from remarks he delivered at the Cato Institute’s Financial Inclusion Summit this past June, Brian Johnson’s article, "Consumer Protection and Financial Inclusion," explores the relationship between financial inclusion, consumer protection, and free-market innovation. At the same time, Johnson—currently Deputy Director at the Consumer Financial Protection Bureau—draws a sharp contrast between promoting these ideals and "giving license to government actors to supplant consumer preferences with their own." Too often, he writes, regulators conflate the two: intervening in private markets, corrupting the principles of competition and choice, and jeopardizing consumers’ interests. While these sorts of regulations are "market-replacing," Johnson says, others can be market-enhancing. He identifies three approaches to consumer protection, the first two of which promote private choice and innovation, whereas the latter restricts them. The first, which Johnson calls the "disclosure-based" approach, favors regulations that prioritize transparency, facilitate the flow of information from businesses to consumers, promote trust between free-market participants, and grant individuals greater autonomy over their financial decisions. The second, which Johnson calls the "consumer welfare" approach, favors regulations that prevent businesses from obstructing consumer choice through unlawful exclusion, discrimination, or deception.
Yet businesses aren’t the only parties capable of consumer exclusion or obstruction: the government can also impede product access and financial innovation by taking a "product restriction" approach to regulation. This third and final approach, Johnson explains, blocks consumers’ abilities to access products and business’ abilities to design them. By "den[ying] consumers the choice to which they should be entitled," he writes, product restriction represents a "conscious policy of financial exclusion." Debates surrounding which of these approaches will promote a free and prosperous society are not new, he adds. They are merely new iterations of "the age-old debate about liberty and security." In identifying the optimal level and scope of financial regulation, agencies should choose those policies that promote consumer responsibility and provide individuals with the greatest opportunity "to make their own choices in free markets."
Allan M. Malz, Adjunct Associate Professor at Columbia University and former Vice President at the Federal Reserve Bank of New York, explores a new trend in monetary policy that emerged in response to the 2007–09 global financial crisis. Called "macroprudential policy," its advocates believe it can help prevent future crises by supplementing, and sometimes superseding, "microprudential" policies like inflation targeting and interest rate targeting. Malz begins by explaining the differences between the two. Microprudential policy, as its name suggests, applies to discrete measures of financial stability, like prices and economic growth. Macroprudential policy, on the other hand, attempts to measure and enhance overall financial stability. As a result, the range of macroprudential metrics and tools is broader, vaguer, and more likely "to vary over time, parametrically or at the discretion of regulators." In other words, the success of any macroprudential policy requires regulators to accurately "recognize threats to [financial] stability and react quickly and correctly." This concerns Malz, who considers regulatory discretion one of the chief causes of financial instability, rather than the cure. Too many regulatory policies shower undue favoritism on firms that are "too big to fail" and grant guaranteed bailouts to financial behemoths, he argues. Such policies only aid and abet the ongoing—and equally significant—problem of chronically undercapitalized banks. By increasing the scope of regulatory discretion—and the number of lopsided policies that often result—Malz argues that macroprudential policy "doesn’t fix this problem, but tries to ward off its consequences."
Malz would rather tackle that problem head-on. Calling for "higher ratios of better-quality capital," he discusses a series of proposed measures for enhancing banks’ capital requirements, removing guaranteed government bailouts, and improving the accuracy and transparency of bank asset risk assessments. Such measures can strengthen banks’ financial resilience without requiring regulators—or taxpayers—to foot the bill, although they also leave open the question of how (or whether) regulators should provide support to failed or failing banks. Malz warns that imposing any sort of immediate no-bailout policy could create market whiplash, and that as a result, "unwinding [bailout] guarantees cannot be done overnight, but only gradually."
This issue of the Cato Journal features two articles on Modern Monetary Theory (MMT), an increasingly popular monetary philosophy that, as Sebastian Edwards (Henry Ford II Distinguished Professor at the UCLA Anderson Graduate School of Management) explains, hinges on the belief that "it is possible to use expansive monetary policy—money creation by the central bank (i.e., the Federal Reserve)—to finance large fiscal deficits, and create a ‘jobs guarantee’ program that will ensure full employment." Although MMT has garnered plenty of disciples and detractors in recent years, there is little empirical literature on how well its policies would work in vivo.
Edwards’ article takes the first step toward changing that. He begins by illuminating the parallels between MMT and another approach to political economy, called "macroeconomic populism." Similar to MMT’s policy goals, macroeconomic populism’s "set of [expansive monetary] policies" are "aimed at redistributing income by running high fiscal deficits." Macroeconomic populism also parallels MMT’s rejection of free market principles, distrust of competition, fear of economic globalization, and support for "price and exchange controls, high minimum wages, high import tariffs, and large subsidies." Both approaches also favor "state-owned enterprises and… large multinationals (often associated to natural resources, such as oil and mining)."
Edwards then outlines what he and other economists call "the four phases of [macroeconomic] populism," which he uses as a framework for comparing three Latin American monetary regimes: Chile under Salvador Allende; Peru under Alan García; and Venezuela under Hugo Chavez and Nicolás Maduro. All three implemented policies and deployed rhetoric characteristic of MMT, and all experienced an eerily similar progression of events. In the very short term, the new regimes’ expansionist monetary policies produced a fleeting patina of economic prosperity. Inevitably, however, runaway inflation followed and grew higher with every effort made to conceal it. Both Modern Monetary Theorists and macroeconomic populists support financing fiscal deficits by printing more money, Edwards explains. But in the absence of true market growth, all that this means is that the velocity of money skyrockets, while its overall value plummets. The final inflation and unemployment data that Edwards presents from each of these countries show that "all these cases ended up in major macroeconomic disasters"—worse off, in fact, than they were under the depressed economic conditions that precipitated the populist uprising.
Warren Coats (currently a Fellow at the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins Krieger School of Arts and Sciences) takes aim at two of MMT’s core tenets: that countries with sovereign currencies can—and should—print unlimited amounts of that currency in order to fund unlimited government expenditures (partly as a means of employing jobless citizens); and that doing so will neither impede private investment nor spike inflation, since the government can always "drain" the markets of excess reserves through a combination of monetary and fiscal policy tools. As Coats points out, this last idea—that elected lawmakers should use fiscal policy measures, like taxation, to conduct monetary policy—would completely erode the principle of a politically independent central bank.
The article begins by juxtaposing the conventional, "money multiplier" narrative about the relationship between government-issued "base money" and market-generated "broad money" with the MMT narrative. According to the money multiplier theory, which informs the conventional approach to monetary policy, an increase in base money (i.e., currency held by the public plus bank reserves held at the Fed) will lead to a multiple increase in the money stock (i.e., currency plus demand deposits) as banks extend credit in a fractional-reserve system. According to MMT, however, market transactions are essentially closed systems. Quoting directly from three MMT-sympathetic economists, Coats explains that in the MMT worldview, "‘loans create deposits’ and ‘repayment of loans destroys deposits.’" He then reviews—and refutes—MMT’s claims that the U.S. government can "spend more without taxing more… because it can borrow in its own currency"; that after "borrowing" what it needs from either the public or the central bank, it can once again "spend more—by printing more money [or rather, by forcing the central bank to do so]—without crowding out private sector activity"; and that fiscal policy tools should also be used to manage the money supply.
Coats’ critique of MMT is both economic and normative. Before "shifting our limited resources from the private to the public sector," he writes, we must ask ourselves "whether society is made better off by such shifts." As his article shows, it is not. Any promise that MMT reveals an untapped source of extra "fiscal space"—one in which the government can spend more money without contributing to either deficits or inflation—rings hollow. What’s more, any proposal that would merge monetary with fiscal policy neglects a century’s worth of painful lessons about the perils of centralizing—and politicizing—both the means and the ends of production.
James A. Dorn, Vice President for Monetary Studies and a Senior Fellow at the Cato Institute, makes an especially timely case for a rules-based monetary policy in his new article. From President Trump’s recent insistence that the Fed buoy up his reelection prospects by lowering interest rates, to former New York Federal Reserve president William Dudley’s demand that the Fed tighten policy in order to thwart Trump’s shot at a second term, both maneuvers are stark reminders that, as Dorn puts it, "in the absence of a monetary rule, a central bank is vulnerable to politicization."
The Fed’s "political independence," Dorn explains, is meant to insulate it from partisan interference and help it fulfill its "triple mandate" of promoting stable prices, maintaining moderate interest rates, and achieving maximum employment. But that mandate is far too vague a substitute for a rule—especially since, in our fiat currency regime, the Fed already has considerable discretion in setting and adjusting monetary policy. And policy discretion is hardly political independence: Dorn reviews over half a century’s worth of partisan attempts to interfere in central bank policy in order to show that the Fed’s discretion is frequently the plaything of political whims—making it neither politically independent nor politically accountable. Notwithstanding a few exceptions, he writes, Fed policy tends to be politically "accommodative," promoting an economy immediately favorable to the party in power.
Yet the short-term benefits of accommodative policies—high growth, easy money, and low interest rates—often give way to extreme long-term costs: high rates of inflation, skyrocketing national debt, and greater vulnerability to financial crises that, when they do occur, help justify further increases to the Fed’s discretionary powers. That cycle will likely worsen unless the Fed adopts and adheres to a monetary policy rule—or a series of them—about how to measure the health of our economy and when to intervene if that health begins to fail. Before that, Dorn urges Congress to establish a monetary commission to evaluate the Fed’s performance and "consider alternatives to the present discretionary government fiat money regime." Until then, monetary policy tools will continue to double as tools for partisan meddling—and that, of course, will jeopardize the independence of more than just the Fed.
A few of the Fed’s new policy tools, however, might pose a threat to the Fed’s political "independence" in and of themselves. That’s the case that Robert Heller, a former member of the Federal Reserve Board of Governors and former President and CEO of VISA, makes in his article. Heller begins with a brief history of the Fed’s policy of paying interest on excess reserves, or IOER. As the "bank’s bank," the Fed lends to and stores deposits from other U.S. financial institutions. In 2008, it began paying interest on those deposits, not only for banks’ required reserves (the amount banks need to meet the minimum legal threshold for solvency) but for their "excess" reserves as well. This radically altered the Fed’s relationship with the private market: whereas the Fed could once only "target" the rate at which banks borrow and lend among one another, its IOER policy now allows it to influence those rates directly. The Fed’s IOER rate, which it sets and adjusts at its discretion, creates an interest rate "floor" that private banks have little reason to borrow above or lend below. Taken alongside a second Fed policy tool, called Quantitative Easing (or QE), Heller explains that IOER also significantly blurs the lines between monetary and fiscal policy. Initially a strategy for injecting further reserves into the economy (not to mention adding to the Fed’s own capital surplus), QE involves the Fed purchasing large, high-risk (and therefore high-return) assets from large, private sector “dealer” banks, directly crediting those dealers’ Fed accounts as payment. As those dealers’ Fed accounts increase, so do their IOER returns. The Fed, in turn, profits from the interest paid on its new assets. Both QE and IOER simultaneously complement, and supplement, one another.
In some ways, this strategy worked too well: the Fed’s large-scale asset returns proved so profitable that lawmakers began leeching from its newfound surplus to finance their own pet projects—everything from government programs to entirely new bureaucratic agencies. (Ironically, Heller notes, this now makes the Fed "one of the least well-capitalized banks in the country"). Things soured, however, once the Fed decided to combat inflation by tightening monetary policy in 2015. This meant raising market interest rates—which the Fed could only do if it, too, increased its own interest payments to its members’ accounts. The more money it shunted to depositors, the less it had to delegate to lavish spending programs. As a result, every time the Fed raises interest rates, it also raises the level of tension between itself and our elected officials. This explains why we now see politicians across the aisle "blam[ing] the Fed for making excessive payments to the banks and for growing Treasury deficits."
Heller concludes by urging the Fed to change course on both policies. Whatever costs may come from doing so, he argues, are benign compared to the potentially irreversible damage that will befall to our economy—not to mention our political institutions—if the Fed stays on its current path. Unless the Fed winds down its balance sheet expansion and reduces its market footprint, he writes, "increased political pressures may well… threaten the position of the Fed as a separate and independent government agency."
Gunther Schnabl, Professor for Economic Policy and Director of the Institute for Economic Policy at Leipzig University, lends some historical perspective to present-day debates about what the European Monetary Union (EMU) should do to mend an increasingly fragile and uncertain European economy. Schnabl suggests that the EMU revisit the monetary policies and economic philosophy of ordoliberalism, which many scholars today credit for Germany’s remarkable post-World War II socioeconomic recovery. Ordoliberalism, Schnabl explains, is a "concept for a market economy" in which the state does little more than provide the regulatory foundation most conducive to private competition and innovation. Its core principles are monetary and currency stability; free prices; open markets; individual ownership of the outcomes of their financial decisions; and a "constant and forward-looking" economic policy that defends "market principles against interest groups."
Schnabl presents data supporting his claim that ordoliberalism fueled Germany’s postwar growth and facilitated the rapid increase in prosperity and economic integration that spread throughout Europe at the same time. He then chronicles the dramatic shift in European monetary policy that followed the creation of the European Central Bank (ECB). Particularly in the aftermath of the 90’s dotcom boom, the ECB concentrated its economic stabilization efforts on lowering interest rates, raising inflation, expanding government asset purchases, and increasing government spending. These policies had detrimental and far-reaching consequences the German economy and for Europe as a whole. Schnabl even traces Europe’s current climate of political unrest and factional extremism to the ECB’s post-2000 policy stance. The first step toward mitigating that political and economic unrest, he says, is for the ECB to wind back its dangerously loose monetary policy. Beyond that, however, the EMU should undertake further reforms to restore the legacy of ordoliberalism. "Just as the stable German mark was the backbone of the German economic miracle," he writes, "a stability-oriented European monetary policy is today the prerequisite for economic and political stability in Europe."
With the 2020 elections heating up, so are debates about what an "optimal" tax rate for the wealthiest Americans would be. But as Cato Institute Senior Fellow Alan Reynolds explains, the terms of that question are themselves open to debate. Before we settle on what an "optimal" top tax rate is, we have first to determine what the word "optimal" even means. Is an "optimal top tax rate" one that maximizes economic efficiency, innovation, and productivity? Or is it one that maximizes tax revenue itself? As Reynolds notes: "what is optimal from the point of economic efficiency… is not necessarily optimal if the government’s priority… is to maximize tax revenue collected from high incomes, ostensibly for the purpose of redistributing that extra revenue to the poor." Nor is it clear, even if the goal is to increase the amount of tax revenue the government collects, that raising taxes on the very wealthy will do the trick. This is because the sheer act of raising or lowering income tax rates changes the way in which individuals report that income. The metric that most economists use to measure that change—the Elasticity of Taxable Income (ETI)—calculates the difference in individuals’ income tax returns before and after major tax adjustments. This is why Reynolds calls it "treacherous" to "derive optimal tax rates from tax return data," since "when marginal tax rates go up, reported top incomes go down."
Even within the economic literature, the specific rate of ETI is fungible, and Edwards’ article refutes several of the most extreme claims that ETI is, or can become, virtually nonexistent. One reason for this is called "tax avoidance," which has less to do with outright fraud and more to do with the fact that high earners can shift portions their income to things like stock options, capital gains, and employer benefits. Indeed, Reynolds shows that after top tax rates increased in 1993, so did stock-based executive compensation—although he also provides plenty of data to disprove what proponents of higher tax rates call the "CEO rent-extraction hypothesis," whereby executives relocate massive amounts of their income to stock options following a tax hike. At the same time, Reynolds shows that when marginal tax rates go down, reported income levels rise. In addition to "tax avoidance," ETI accounts for the effect that tax adjustments have on "incentives for productive activity such as work effort, research, new business start-ups, and investment in physical and human capital." These, of course, are far more difficult to measure, as are their resulting downstream effects. Yet a number of empirical studies reveal a strong inverse correlation between marginal tax rates, GDP, and "long-term real activity." In sum: ETI is higher than what most proponents of high marginal tax rates would suggest, and this is worth taking into account when we calculate "optimality" from any objective standpoint. Regardless of whether the aim of taxation is to heighten productivity or to raise government revenue, Reynolds concludes, the latter requires the former. "Income that is not created is not taxed," he writes, and the "growth of real government revenues ultimately depends on growth of taxable income and wealth."