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Regaining the great moderation

Russ Abbott, Professor of Computer Science, California State University, Los Angeles

From the late 1980s until the recent financial crisis the economy enjoyed what has been called a great moderation—steady GDP growth accompanied by low inflation and reduced business cycle volatility. We are now struggling through an extended “great recession.” Can we find our way back to the happier days of the great moderation? I believe we can. We can re-establish a great moderation by allowing the Federal Reserve Board to influence aggregate demand by varying a national value-added (or sales) surcharge or rebate.

The Fed is often given much of the credit for the great moderation. When the economy slows, the Fed reduces interest rates by buying government bonds. Since the Fed creates ex nihilo the money it uses to buy the bonds this injects new money into the economy. Lower interest rates and an increased money supply encourage investment and stimulate the economy.

When inflation threatens, the Fed sells bonds, thereby raising interest rates and extracting money from the economy. The money received for the bonds vanishes in nihilum from whence it came. Higher interest rates and a reduced supply of money slow the economy.

In other words, we rely on the Fed to adjust the economy by conjuring and abolishing money and by raising and lowering interest rates. Strange as it may sound—and uncomfortable as it makes those who favor a gold standard feel—this sleight of hand works; economists of all political leanings agree that such monetary adjustments are both appropriate and effective.

Intervention in the bond market moves money into or out of the broader economy only indirectly. In fact, much of the money the Fed has recently injected into the economy sits idle in virtual bank vaults. Furthermore, raising and lowering interest rates affects only that part of the economy that is sensitive to what are usually small changes in rates.

Why not a more direct approach? Ideally one would like the Fed to be able to raise and lower what’s called aggregate demand—the willingness of potential buyers to spend money on goods and services. In a recession, there is insufficient demand—and people are laid off. During inflation there is too much demand—and  prices rise.  If it could affect demand the Fed could moderate the economy directly.

Consider a national value-added (or sales) surcharge/rebate controlled by the Fed.

         When the economy slumps, as now, the Fed would establish or increase the rebate rate. By offering a rebate for every purchase the Fed would increase the money supply while in effect putting the economy on sale.

         When inflation threatens, the Fed would establish or increase the surcharge rate. This would both raise effective prices and extract money from the economy.

        When the economy is balanced, there would be neither a surcharge nor a rebate.

Basic economics tells us that price levels effect demand—higher prices reduce demand, and lower prices increase demand. A surcharge/rebate would have exactly that effect. It would give the Fed the power to increase or decrease demand as needed. This strategy has a number of advantages.

         There would be no liquidity trap—the  situation in which the Fed finds its options limited as interest rates approach zero. The Fed could always provide additional support by increasing the rebate rate.

         It should be more politically acceptable since the surcharge/rebate would be neither a tax nor a government expenditure. The money would go to and come from the Fed, not the Treasury.  

         Since the surcharge/rebate would be spread over the entire economy it would be minimally distorting. Even interest rates would float freely. We would continue to rely on the market to do what it does best—allocate available resources.

         It’s direct and immediate. When the Fed changes the surcharge/rebate rate, money would flow immediately into or out of the economy, and prices would immediately rise or fall. The program would function like a controlled IV drip/drain.

         It takes advantage of expectations.  When the Fed raises the surcharge, people would reduce their buying for two reasons. Prices, in fact, are higher; and expecting that the higher surcharge will be temporary, they might try to wait it out. Similarly, when the Fed offers a rebate, people would act quickly, knowing that the rebate will last only until the economy improves.

         It would be on the right side of inflation. By adding money to the economy in the form of price reductions, the overall price level is kept in check.  Yet even though buyers get a bargain sellers suffer no reduction in income. On the other side, a surcharge discourages buyers but does not enrich sellers—again avoiding inflation.

         The surcharge/rebate could be made semi-automatic: higher prices would trigger an automatic surcharge; higher unemployment would trigger an automatic rebate.

         A surcharge/rebate futures market could be established so that the economy could tell us where it’s headed. As businesses use that market for planning, the economy might become self-stabilizing. 

How would such a program be implemented? The simplest way is to layer it on top of existing sales taxes. The mechanism is in place in most states. This suggests an additional benefit.

         The Fed could tailor rates state-by-state depending on each state’s economic condition. It could even target individual zip codes—although either of these might be politically more difficult.

A value-added surcharge/rebate system would provide the Fed with a simple yet effective means to tune the economy. Such a system should be acceptable to most mainstream economists. And it should be relatively straightforward to implement. I suspect that were we simply to commit to such a program, the economy would begin to improve in anticipation.