Cardiff Garcia last week laid out a great taxonomy of two important camps in economics: those that emphasize the role of monetary policy and those that emphasize the role of fiscal policy in relieving economic conditions. In reality, of course, most people fall somewhere in between.
Garcia's main point is that, since we don't know what would be more effective right now, we try everything at once. That's intellectually unsatisfying because it doesn't deliver an answer to the question of monetarism versus a fiscal focus, but the real human costs of continued economic underperformance are compelling.
"Better to try everything at once, and then worry later about deciphering the causal mechanisms, post hoc," Garcia said.
First, the Fed adopts a NGDP level target. Doing so would better anchor nominal spending and income expectations and therefore minimize the chance of ever entering a liquidity trap. In other words, if the public believes the Fed will do whatever it takes to maintain a stable growth path for NGDP, then they would have no need to panic and hoard liquid assets in the first place when an adverse economic shock hits.
Second, the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.
This two-tier approach to NGDP level targeting should create a foolproof way to avoid liquidity traps. It should also reduce asset boom-bust cycles since NGDP targets avoid destablizing responses to supply shocks that often fuel swings in asset prices. This approach is consistent with Milton Friedman's vision of monetary policy, would impose a monetary policy rule, and provide a solid long-run nominal anchor. Finally, per Cardiff Garcia's request it would satisfy both fiscalists and monetarists. What is there not to like about it?
And now Ryan Advent at the Economist has chimed in with a specific policy: Put the Fed in charge of payroll taxes.
The Fed could then use the payroll tax rate as an additional policy tool when interest rates fell to near zero. Or it could use the payroll tax rate as its primary policy measure, in place of the Fed funds rate. To provide expansionary impetus to the economy when expectations for nominal output dipped below the desired level, the Fed would reduce the payroll tax rate, making it more attractive to hire and giving workers an immediate and direct lift to their pay cheques. And when expectations began to run too hot, the Fed could raise the payroll tax rate, reining in spending.
While I applaud the innovative thinking here, we need to be particularly cautious about extending direct fiscal authority to the Federal Reserve. For one thing, this would be a delegation of tax authority invested by the Constitution in Congress. We should always be hesitant when we muck with the constitutional assignment of powers.
For another, it's far from clear that the Fed would be able to use this power appropriately. Essentially, we'd be giving it a policy lever with which it has no experience and no institutional expertise. It could be that lowering tax rates would have an adverse expectations result, with people worrying more about the state of the economy when they saw the Fed exercising this new power.
Most importantly, the public backlash might be highly undesirable. The Fed would suddenly be able to raise and lower the amount of the take-home pay of many workers. Headlines would read: "Bernanke Cuts Wages." It may be that indirect economic management is more desirable in a monetary authority than anything this direct, transparent and therefore easily politicized.
—By CNBC's John Carney. Follow him on Twitter @Carney.