Monetary, Fiscal, Trade, and Structural Policies – Old Views vs Monetary, Fiscal, Trade, and Structural Policies – Old Views vs. New Views

Before we discuss government policies, we should keep in mind two things – (i) history has shown that free markets typically do a great job in allocating goods efficiently and fairly, and (ii) governments can solve problems, but they can also worsen problems and there are numerous examples of this.

In general, free market solutions work well and that is why we should always (at the first step) respect and rely on the power of the market to solve our collective economic problems. This is not always fully appreciated, so let's consider a beautiful example of the power of free markets.

Consider a market for a generic good or service.

Equilibrium is where S = D Po Qo

But, Suppose Demanders Search for Suppliers in the Market and this is Costly D – Search Costs

Likewise, Suppliers Search for Demanders in the Market S + Search Costs D – Search Costs

S + Search Costs P0 D – Search Costs P0+ SC P0 - SC Search Costs Raise Total Prices (Price + Search Cost) and Lower Quantities S + Search Costs P0+ SC P0 P0 - SC D – Search Costs

Society is worse-off because we have trouble finding each other S + Search Costs P0+ SC P0 P0 - SC D – Search Costs

It is possible that costs are so great on both sides that there is no equilibrium and hence no market ! S + Transactions Costs D – Transactions Costs

S + Fee D – Fee P0 + SC P0 + Fee P0 - Fee P0 - SC Suppose middlemen enters the market where demanders and suppliers now pay a small fee – this creates a new box like the red one colored all in blue S + Fee P0 + SC P0 + Fee P0 - Fee P0 - SC D – Fee

The free market with the entry of middlemen gives lower total prices for consumers and higher total prices for suppliers S + Fee P0 + SC P0 + Fee P0 - Fee P0 - SC D – Fee

This is a simple, but powerful and important, aspect of free markets – all we need are free entry, profit seeking, and pure competition. Sometimes the market cannot produce an optimal result. So, let's now look at some economic reasons why we need a government.

Economic Reasons for Government? (1) Provide Public Goods and Deal with Market Failure (2) Internalize Market Externalities (3) Provide a System of Justice and Enforcement of Contracts (4) Ensure a Reasonable Distribution of Income and Wealth (5) Stabilize the Economy under Unusual Circumstances

Economic Reasons for Government (1) Provide Public Goods and Deal with Market Failure (2) Internalize Market Externalities (3) Provide a System of Justice and Enforcement of Contracts (4) Ensure a Reasonable Distribution of Income and Wealth (5) Stabilize the Economy under Unusual Circumstances

(5) Stabilize the Economy under Unusual Circumstances The 5th reason above for government has always been controversial. Just how much do we want the government to intervene in the macroeconomy? Government intervenes by using monetary, fiscal, trade, and structural policies. These policies are constantly evolving over time.

Monetary Policy Old Policy New Policy (1) Open Market Operations (2) Control of Discount Rate (3) Control of Required Reserve Ratio (4) Jawboning (5) Taylor Rules (1) QE and QQE (2) Forward Guidance (3) ZLB and Negative Interest Rates (4) Stress Tests (5) Paying Interest on Reserves (6) Monetizing the Debt (7) Cryptocurrencies (8) Increased Capital Requirements Target: Interest Rate until zero lower bound (ZLB) reserves thereafter Instrument: Short Term Government Bonds, later Long-Term Government Bonds and MBS

Fiscal Policy Old Policy New Policy (1) Government Spending (2) Taxation – Direct vs. Indirect (3) Horizontal vs. Vertical Equity (4) Spending and Tax Multipliers (5) Pay as you go vs. fully funded systems (6) Debt to GDP dynamics (7) Cost Benefit Analysis (1) Private to Public Debt Transfers (2) Universal Basic Incomes (3) Austerity vs. Stimulus (4) Fighting Secular Stagnation (5) Industrial Policies (6) Climate Change Initiatives (7) Single Payer Health Care (8) Intergenerational Equity (9) Wealth Taxes

Trade Policy Old Policy New Policy (1) Multilateral Trade Talks (2) Fixed vs. Flexible Exchange Rates (3) Tariffication (4) Nontariff Measures (NTM) (5) IMF Conditionality (6) Inter-regional Trade (7) Inter-industry Trade (8) Gains from Specialization (1) Bilateral Trade Talks and FTAs (2) Currency Wars (3) Technology Theft and Coercion (4) Selective Protection (5) Saving and Trade Flows (6) Trade and Wage Levels (7) Trade and Free Flow of Labor

Structural Reforms Policy Old Policy New Policy (1) Washington Consensus (2) Rule of Law (3) Regulation of Industry (4) Labor Markets Reforms (5) Privatization of Industry (6) Rent Seeking (1) Demographic Challenges (2) Income/Wealth Inequality (3) Refugees and Migrant Workers (4) Government Administration (5) Inclusive vs. Extractive Institutions (6) Climate Related Regulations (7) Energy Transformation (8) Automation and AI

Conclusions 1. Monetary policy in developed countries has been very loose since 2008. Central banks have reduced nominal interest rates to extremely low levels, in some cases to negative levels. The result has been a strong fall in the velocity of money and a reduction in the rate of inflation. Growth has been anemic also. Central banks have targeted interest rates and used the payment of interest on reserves to control the growth of the quantity of money. Asset prices in developed countries have risen steadily, but there has not been a strong wealth effect. Central banks seek to raise inflation and the expectations of inflation, but this has not been very successful. 2. Fiscal policy in developed countries has also been very loose. Both deficits and debts as a percentage of GDP have risen. Fiscal policy has been promoted as a way of dealing with secular stagnation caused by demographic. productive, and technological trends. Austerity has been successful in both Greece and Ireland but is bitterly opposed in Italy. US twin deficits have risen substantially and have been successful in raising growth a bit, but this is no longer the case. Japan has had trouble with fiscal policy because of massive natural disasters and high debt levels coupled with poor demographics.

3. Trade policies have become more protective 3. Trade policies have become more protective. Bilateral trade deals such as FTAs have become more popular and multilateral trade agreements have become much less successful. The use of interest rates in monetary policy have generated currency wars and bubbles in non-tradeables. Globalization has been seen as a positive force for change to some countries, but as a negative force to other countries. Regional trade groupings have been used to help force open markets that would otherwise be impossible to free up. Service trade has been booming but involves complicated sharing of technology and is limited by a lack of IP protection. Trade in goods is also influenced by differences in environmental and labor laws. China, India, and Brazil represent important threats to established businesses in developed countries. This will continue to be a sore spot in trade policy just as it was with Germany and Japan in the 1960s – 1980s. Perhaps the world needs a separate WTO-like institution that includes the world's top 20 trading countries. There remains the issue of whether or not industrial policy is a good trade policy or whether comparative advantage can be artificially created by government. 4. The Washington Consensus has been discarded by many as too idealistic and wrongheaded in some ways. Heavy control of markets is still discouraged, but free and open markets are now considered to be discredited by the Great Recession. Climate change worries have caused some countries to adopt heavy regulation of industry to reduce carbon emissions. CO2 continues to grow in the atmosphere, and many believe this will eventually lead to runaway warming of the planet. However, the only solution being considered involves forced transfers from industrialized and manufacturing rich countries to the poor. There is also no focus on the costs of climate change and how these are calculated or mitigated. Climate change analysis is hopelessly intertwined with rent transfers and special interests along numerous dimensions. It is the only global threat anyone is discussing.