Fed Up with Expansionary Fiscal Policy? Alan Bristow • Time to Return to the Sound Principles of Monitarism Winter 2004

In the past six months, the Federal Reserve has raised the discount rate from two percent to three and onequarter percent, reversing the downward trend of recent years. Just before this change in policy, Alan Greenspan was reconfirmed in his post at the helm. Outside of the economics classroom, however, most people never understand how it is that the government manipulates the United States’ financial health. This article aims to shed a little light on what monetary policy is and why the economics layman should care.

When it comes to regulating the economy, the government has two available options: fiscal policy and monetary policy. The former involves the expansion or reduction of government expenditure and taxation, the latter the manipulation of discount rates, reserve ratios, and the government bond market by a national bank.

The history of fiscal policy is not a proud one. Historians agree that Franklin Roosevelt’s make-work programs and expansionary spending failed to solve the Great Depression and that Ronald Reagan’s tax cuts did not deflect the recession at the end of his second term. Similarly, the policies of our current president also reflect the problems with fiscal expansionism: it runs the risk of a significant deficit, especially when tax cuts accompany hikes in spending.

The historical record of monetary policy, on the other hand, merits a closer look. In 1790, the creation of our national banking system ignited one of the first major constitutional crises in American history, when Alexander Hamilton and Thomas Jefferson disagreed sharply over whether the Constitution grants the federal government authority to charter a bank. Fortunately for monetarists, Washington agreed with Hamilton, whose brainchild found further support in the Marshall Court, which upheld the use of additional constitutional means to ensure the enumerated powers in McCulloch v. Maryland. The Constitution grants Congress the power “to coin Money [and] regulate the Value thereof.” Since the necessary and proper clause obtains in this section of our Constitution and a national bank is best equipped to fulfill these duties, a bank was a constitutional, practical solution.

Today, the Federal Reserve System acts as our instrument of monetary policy and its Chairman occupies what some have called the second most powerful office in the U.S. Six months ago, President Bush reappointed the nation’s foremost proponent of monetarism to a fifth term as the Chairman of the Board of Governors of the Federal Reserve and the Federal Open Market Committee. Dr. Alan Greenspan, defender of the economy and bipartisan appointee, deserves this unprecedented extension of his reign for a clarity of mind and clarity of message few others in Washington can boast.

Restraint has always characterized Greenspan’s policies. He has fought to check the government’s control over the banking industry, believing that Federal Reserve requirements provide adequate guidance and can do without the added bureaucratic burden of government intervention. He also discouraged investors from becoming overly optimistic about the 1990s stock market boom, declaring in a report to Congress that their unbridled investment showed “irrational exuberance.”

Greenspan’s restraint also characterizes his leadership of the Governors, which softened the first Bush’s recession as well as the recent economic downturn. His firm belief that keeping discount rates low would stimulate economic growth by encouraging the purchase of homes and real estate proved accurate.

Recently, Greenspan endorsed making President Bush’s tax cuts permanent, which represents sound supply-side economic policy when paired, as he desires, with a reduction in expenditures. In this case, Greenspan supports decreasing Social Security payments, among other cuts. Unfortunately, the proposed $521 billion budget deficit for the 2005 fiscal year demonstrates that changes in taxes and expenditures, the two methods of fiscal expansionism, combined to create massive cost overruns despite the Federal Reserve’s work to adjust the economy.

Only monetary policy, which uses little tax revenue, has shown consistent positive returns while minimizing side effects. It is time to turn to what works; we have nothing to lose but debt.

Allen Bristow is a freshman in Ezra Stiles College.