Michael Darda’s Fiscal Advice for the FED

There is wee bit in Michael Darda’s latest that I might agree with – but given the following, I have two questions for him and the rest of NRO Financial:

If Congress doesn’t act to extend the 2003 tax cuts, tax rates on capital will rise, which would depress after-tax rates of return to capital and stunt growth … A sensitive-indicators approach at the Fed and lower tax rates on the factors of production would sustain and deepen the expansion. However, higher tariffs, a trade war, and a tax hike on capital could end it. In this vein, the Bush administration should take a stiff stand against protectionism in all its forms and lobby relentlessly for the extension of the 2003 tax cuts. Anything less wouldn’t be prudent – or pro-growth.

Question 1: why do the NRO pundits continue to lecture Chairman Ben on the virtues of tax cuts when most of us know that the Federal Reserve sets monetary policy and not fiscal policy?

Question 2: if keeping tax rates low is giving people their money back so they can consume more as George Bush repeatedly says even as he is clueless as to how to reduce government spending, do the NRO pundits think an inward shift of the national savings schedule will lower interest rates and increase investment?

OK – we’ve been done this road many times so let’s go to where Darda and I partially agree (with strong interest in partially):

The neo-mercantilist flat-earth society, which includes members of both parties, doesn’t seem to understand that a fixed (and now sliding) peg for the Chinese yuan simply means that China outsources its monetary policy to the Fed … Fixity is the antithesis of manipulation, not the cause of it. Apparently a passing grade in Economics 101 isn’t a prerequisite for ascending to the U.S. Senate. As Nobel Laureate Robert Mundell recently argued, an appreciation of the yuan could impose deflationary pressures on the Chinese economy, fan tensions in rural areas, and cut China’s growth rate. The result likely would be slower Chinese growth and lower incomes, which would cut the demand for U.S. exports – precisely the opposite of the intended effect. While a modest appreciation of the yuan probably would carry few risks given the dive in the dollar’s value during the last few years, a significant appreciation would surely be deflationary. It is also quite telling that the strongest advocates of yuan appreciation (or tariffs on Chinese goods) never advocated a devaluation of the currency when China was dragged into deflation by the steady appreciation of the greenback. In other words, the protectionists in Congress want it both ways, which means they are both inconsistent and wrong.

Our partial agreement is in two areas: (a) we both oppose trade protection; and (b) we both love to cite the collected works of Robert Mundell. But I suspect Darda and I have different views as to what these collected works should tell us. Mundell examined the different implications of fixed versus floating exchange rates for the transmission of macroeconomic policies such as fiscal policy (which is not set by the FED), monetary policy (what Chairman Ben does address), and trade protection policies. For example – under floating exchange rates, the fiscal stimulus from the Bush tax cuts would tend to be dissipated to the other nations such as China – which would mean it was not as effective at raising U.S. aggregate demand as much of the extra demand from the reduction in our national savings rate spilled over in the form of increased Chinese exports. But the point about allowing the yuan to appreciate is a valid one – it would reduce Chinese aggregate demand and increase aggregate demand in the U.S. But isn’t that the whole point of those who argue for letting the yuan appreciate – U.S. demand growth has been paltry whereas China’s economic growth has been very strong.

But I have one last query for the advocates of a fixed yuan. The price-specie flow argument of David Hume not withstanding, the growth rate for China’s money supply has not been the same as the growth rate for the U.S. money supply – in fact, its growth rate has exceeded 15% per year for the last several years – even with sterilization. As Brad Setser notes:

In 2005, the pace of China’s reserve growth picked up (once necessary adjustments are made for valuation), the pace of sterilization picked up commensurately and the interest rates the PBoC paid on its bills stayed quite low. That combination put less pressure than I expected on China to adjust its currency regime. The core question is whether 2005 demonstrates that it is possible, in fact, for China’s central bank to sterilize (offset the impact of rising reserves on domestic money growth) $250 billion or so in reserve growth on a sustained basis. China seems to have pulled back a bit on sterilization during the middle of the year, allowing a pick-up in broad money growth and building up bank liquidity to buffer the Chinese economy against the impact of a 2.1% revaluation.

Or as Mark Thoma suggested – the Federal Reserve is responsible for U.S. monetary policy, not the monetary policy of other nations.

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