Friday, January 18, 2008

Fiscal Policy Implies Monetary Policy

Today the president announced an initiative to launch a stimulus package for which I condemned yesterday. The good news is it’s a tax cut plan rather than a spending plan. Needless to say though we can be assured that no equal reduction in government spending with accompany these cuts. The question was never raised to either the president or Hank Paulson (I guess it’s unheard of). So how are these cuts going to be financed? Well, by selling government bonds of course. If this were the end of the story, the government would have supplied individuals with more income (money) while at the same time removing money from the system through the sale of its bonds. Net effect is more of a reallocation then some “injection” of money to the system. But maybe this is not the end of the story.

The sale of these bonds will result in the previously stated contraction of money supply relative to the target level that the Fed had previously set. Well assuming that this action doesn’t change the Fed’s target money supply or interest rate target, they will engage to counter this contraction. Their exact methods may be through different instruments than the same specific government bonds sold to finance the tax cuts, but the effect is the same (as I understand it the Fed primarily works with about 22 banks, or primary dealers, to distort overnight rates of bank “repo” agreements). The Fed has thus engaged in an inflationary measure which has devalued all outstanding money prior to their actions by the exact amount of the tax cut. In conclusion, there is a lot of hoopla about nothing. Unless there is an equal cut in spending this fiscal stimulus isn’t going to do shit.

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