Monetary Policy and that Old-Time Fiscal Religion

The ongoing debt-ceiling debate has brought concerns about the sustainability of US fiscal policy to the forefront of public discussion once again. While it may be tempting to blame current budgetary problems on the federal government’s pandemic spending spree, the problems are much more fundamental. They stem from the widespread belief that the federal government is responsible for managing the economy.

Rather than wade into the current debate about the merits of raising the debt ceiling, we want to take a step back to address more fundamental questions: how did we get here, and, more importantly, what can we do about it?

Before the adoption of fiat money, adherence to the classical gold standard meant that counter-cyclical fiscal policy had little-to-no effect on the economy. If politicians tried to increase total spending by running large fiscal deficits, gold outflows would increase, neutralizing the effect of deficit spending. Moreover, running large deficits increased the risk of suspending the gold standard. As this risk increased, so too did the price of borrowing money in international capital markets. Given all of this, it should be no surprise that the US did not run perpetual deficits under the classical gold standard. 

Reinforcing the gold standard’s constraint on fiscal profligacy was what Nobel-Prize-winning economist James M. Buchanan and Richard E. Wagner call the old-time fiscal religion: the widespread belief that the government should balance its budget. To be sure, there were times when the government would need to run a large deficit, perhaps during a war, but the popular belief was that the government would quickly repay this debt.

How did we go from this old-time fiscal religion to where we are today?

The demise of the classical gold standard at the onset of World War I played a part. Without the automatic adjustment mechanism provided by gold flows, it fell to the Federal Reserve to ensure total spending remained stable. When the Federal Reserve failed to do so in 1929, the economy collapsed.

While economists offered a range of explanations for what had happened, one answer stood out from the rest. John Maynard Keynes, one of the world’s leading economists at the time, argued that market economies are prone to frequent crises, and that without counter-cyclical fiscal policy, there is no guarantee that such economies would return to full employment. According to Keynes and his followers, the solution was for governments to run deficits during economic downturns to boost total spending in the economy, and then to pay back the borrowed money after the economy recovered. The idea became known as functional finance.

This idea may sound familiar. Elected officials across the political spectrum continue to justify government spending on the grounds that it will stimulate the economy. Of course, they often ignore the second part of Keynes’ prescription: paying back the borrowed money! 

In Democracy in Deficit, Buchanan and Wagner explain why we should not be surprised that politicians reference the Keynesian prescription selectively: functional finance is not incentive-compatible. Politicians can improve their election odds with deficit spending, and have little to gain from raising taxes or cutting spending.

Whatever the merits of functional finance, it created a bias toward deficit spending in practice. Unconstrained by the gold standard and unburdened by the old-time fiscal religion, balanced budgets gave way to perpetual deficits as politicians used Keynesian reasoning to justify all sorts of government spending with little concern about how to pay for it. That is how we got to where we are today.

Where do we go from here?

In our view, the old-time fiscal religion dominated because the classical gold standard constrained politicians. Once that system collapsed, the old-time fiscal religion didn’t stand a chance. If our view is correct, restoring the old-time fiscal religion is unlikely to happen without the necessary monetary constraints to support it.

The classical gold standard isn’t coming back any time soon. However, nominal income targeting can potentially restore the old-time fiscal religion. Like the classical gold standard, this approach stabilizes total spending in the economy, rendering counter-cyclical fiscal policy unnecessary and ineffective.

Under a regime of nominal income targeting, politicians cannot justify deficit spending by pointing to the need to stimulate total spending in the economy. Should they try to do so, the offsetting reduction in total spending, brought about by a decrease in the money supply, will stymie their efforts. Nor will there be as many calls for the government to “do something” in response to recessions, as fewer recessions are likely to occur under a nominal income targeting regime. 

Of course, establishing a nominal income targeting regime is easier said than done. Doing so will require a genuine monetary rule, which has been elusive for a long time. Nonetheless, nominal income targeting can put us on the road back to the old-time fiscal religion. In our view, that is a goal worth pursuing.