This is going to be a quick follow-on to the last post on monetary policy as the only game in town. I feel like the obvious question that post doesn’t answer is this one: what other policy tools should we use? And I want to tee up that question with this post.

First, remember that the fiscal balance is mostly pre-determined. It’s almost entirely the result of things outside of the government’s control like the private sector’s desire to save net of investment and the trade balance with influence from the currency. What the government does control is the spending and taxation choices.

I would argue that making spending and taxation choices based on a debt or deficit metric – the way the eurozone does by the way – creates undesirable reflexivity. What I’m saying is that the government is supposed to make tax and spending choices to fulfill the public purpose for which it was elected. And that means that when the deficit expands during a recession, a government which responds by cutting spending or raising taxes is abrogating its duties to meet a moving target.

The target moves because, by changing spending and taxation decisions based on a deficit or debt yardstick, the government changes how the private sector acts and ends up changing the ultimate debt and deficit. Look at Greece, for example. The reason the country kept missing its deficit targets was because the government’s austerity sucked money out of the private sector. And that lowered the private sector’s spending power, which lowered tax receipts and expanded the deficit. It made the deficit a moving target.

Goodhart’s Law tells you to never use a yardstick as a target for exactly this reason.

So what DO you do? The neutral macro policy is to let the cycle just happen and do nothing. Neutral means not deviating from the overall macro policy course in response to fluctuations in the business cycle.

Now on the monetary policy side, the central bank is supposed to move rates up and down to provide the amount of accommodation consistent with the medium-term economic outlook. But that is in part dependent on the fiscal side. And if the fiscal gear is in neutral, monetary policy would be better able to do what policy makers want.