The Real Exit Strategy

By Chandrashekar (Chandra) Tamirisa, (On Twitter) @c_tamirisa

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The Federal Reserve Chairman, Ben Bernanke, sometime ago outlined an exit strategy for the Fed. That strategy outlined the various mechanisms at the disposal of the Fed to withdraw monetary accommodation when it becomes necessary to do so. It said little about what the Fed can do if it indeed becomes necessary and economic recovery is not self-sustainable, especially given the fiscal situation. His subsequent monetary policy report was more of the same: transparency about the expectation of the status quo.

Elementary to economics and monetary economics is the distinction between nominal and real. Prices in fiat money are the proxies for the equilibrium price between the demand and supply of real things. The probability of the lack of realization of the real effects of the Fed’s nominal money supply is what concerns the Fed about the probability of inflation or stagflation in the future. The Fed is concerned about the nominal monetary shock leading to inflation, incapable of saying anything about its real effects. Nor can it, given the epistemological constraints of the economics profession itself. Then what to do?

In an earlier article I had outlined the concept of Keynesian monetarism. The economy needs a real monetary shock, not a nominal monetary shock. And a real monetary shock can happen either through government spending or through the central bank itself. It has happened before during World Wars I and II, largely through government spending and this can be called Keynesian monetarism. When the same can occur through the central banks, as it used to before the Federal Reserve existed, it was called monetarism.

The disillusionment with monetarism was because it had little to do with the social traumas of the business cycles. The markets rose and fell to their own rhythms and people were attuned to the expectations of good times and bad times believing in the ideology of economic liberty, similar to today’s Cato Institute. Tycoons such as J.P. Morgan controlled the nation’s finances during the great industrial boom at the turn of the century. There was no central bank until the size of the economy was so large that it grew beyond the capacity of one man to manage its vicissitudes. The panic of 1907 drove that point home. Thus was born the Fed because Sweden and the United Kingdom already had a long tradition of central banks. There was no reason why the Treasury could not do the Fed’s job but that is a different story because the creation of the Fed was influenced by a borrowed mindset from Europe.

John Maynard Keynes came along in 1936 and linked monetarism to market failure and the failure of laissez-faire economics. 1936 was also the last time the Eccles Fed had contracted money supply before FDR’s reelection for his government to more forcefully implement its agenda of economic recovery through a variety of depression-era programs. Keynesianism had strengthened FDR though FDR himself was coming to similar conclusions in parallel since his election in 1933.

Keynes had made a dramatic connection that was made with the flourish and panache of a British elitist who ambition appears to have been at once to save his country’s economic heritage tracing back to David Hume and Adam Smith from Karl Marx while replacing all three of them with himself. And he did it extraordinarily well, both in theory and practice, globally re-defining economics for generations of economists and politicians to come. Keynesianism provided a rigorous quantitative framework for economic analysis while missing key nuances, which, if explored, reveal gaping holes in the analysis of Keynes while leaving the mathematical framework untouched.

Monetarism had not caused market failure. The inability of monetarism to intervene in the markets with targeted money supply in a timely manner had caused it. Keynes’ assumption was that the markets cannot do so. That only the government can. That is only an assumption, even if that is coming from John Maynard Keynes.

It is indeed necessary for countries and their governments to be monopolists over their money supply. The supply itself cannot be left to private parties. Money is a pure public good. Keynes was correct on that count. The function of central banking, not central banks as separate institutions ― the merits of that institutional separation can be debated in the political contexts of various countries ― is indispensable.

Just as money supply indispensable, the purpose of money supply is also indispensable. It is this purpose that makes fiat money irrelevant. It does not matter if as long as it is utilized to represent the real economy perfectly. Because only real things matter, money is a convenience and an intermediary to make that happen. It is only to that extent that it is necessary. But that it is necessary does not also make it sufficient. The sufficiency condition is the real purpose of money. How this is realized is the analytical wrinkle and the gaping hole in the Keynesian assumption of the expanded role of government in that process of the realization of the utility of money, especially because the purpose of money is the distribution of incomes in a society which determines the degree of social welfare.

The structure of government regulation, therefore, pertaining to money is also a pure public good and the current debate about this is the Fed’s predicament. And this predicament is due to a history of denial by the Federal Reserve about the complementarity of money supply and regulation. The Europeans, being more Keynesian than the United States, have indeed more successfully than the United States complemented the regulation of the banking sector with money supply by their central banks and so have most mixed economies around the world, as well as those transitioning to the mixed economy model from communism. Still, this crisis has revealed that inadequacies in that model as well because of the rising government debts as outlined in my article.

Neither monetarism nor Keynesianism is conducive to the most efficient conduct of a democratic society. Keynesianism had subsumed monetarism and given its reasoning had expanded government. The reaction to it by the Chicago School of Economics was to revert it back to monetarism. Bill Clinton had come along and wanted to produce the compromise of Keynesian monetarism by manipulating the various macroeconomic policies at his disposal, primarily trade policy to affect money supply in the United States through global economic liberalization.

Trade policy had proxied for the Fed to control inflation in Clintonomics. The financial markets had employed the Fed’s money supply to support Bill Clinton’s trade policies through financial innovation to raise the growth rate through consumption and hence to raise the tax revenues of the government to help achieve the White House’s political objective of balancing the Reagan-Bush budget deficits. The overarching framework of economics, however, did not change: money supply financed government debt, which in turn was expected to lead to investment, both domestic and abroad.

The decision at any given point in time was only about how much government debt should it finance and through what policy mix. Trade policy, substituting for both foreign policy and monetary policy, had dominated that mix: the Clinton administration had attempted to geopolitically change the world through American consumption and the ability of American financial markets to keep that consumption going through consumer borrowing. So, it is time to change the rigid connection between government debt and money supply, because money can be supplied by a government monopoly in exchange for other financial instruments along with government debt.

Just as Keynes’ General Theory of Unemployment, Interest and Money had changed economic thinking during the Great Depression, so can fixing and properly reconciling monetarism and Keynes can change economic thinking once again. In practice, this can begin with the Federal Reserve reversing its policy on excess reserves to let those reserves be used to clean up the banking sector conditionally for lending to take place where it is necessary while doing so in a manner that can control inflation.

The budget commission that the administration and the Congress are contemplating about to reduce the national debt is once again the product of mainstream Keynesian economic thinking. The United States and the world need more cash over the next decade than is being supplied or can be supplied to robustly recover from this crisis. And there is no better way to supply that money than to buy back the outstanding national debt gradually over time for use where it is most needed (for example, in energy, transportation and health care), and to accomplish debt reduction.

It is indeed possible that not all of the money supply will remain the United States. To ensure that American dollars find their best uses abroad, Keynesianism monetarism must be accompanied by actively promoting the development agenda of the Department of State and the United States Agency for International Development (USAID) by bringing The World Bank Group under their purview from its current supervision by the United States Treasury. And financial regulatory reform must finish the job of the parallel changes at the Fed to institute the Fed’s experience through 2020 with smart money into law, after the crisis, by merging the monetary policy function with the Treasury. Smart money would only become smarter, once the country stops printing and minting it.

Keynesianism had harmonized the world after 1945. And so can smart money as the world learns to move on from the dollar anchor just as it did with gold to anchor itself better.

Such an exit into the new world can all begin with a simple statement by the Federal Reserve.


About Chandrashekar (Chandra) Tamirisa
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