“Should We Rethink Fiscal Policy?”

Yves here. One has to wonder who the royal “we” is in the headline, and in context, it is Serious Economists.

What this post unintentionally illustrates how much inertia there is in orthodox economic thinking. In late 2012, and reconfirmed in 2013, Olivier Blanchard, the IMF’s chief economist, effectively admitted that austerity in Europe was a failure because, in econo-speak, “fiscal multipliers were greater than one.” That meant that cutting government spending would lead to even greater declines in GDP, making debt to GDP ratios worse. Conversely, deficit spending would actually lower debt to GDP ratios, by virtue of the economies growing even faster than the increase in borrowings.

Blanchard tried to square the circle and shield the IMF from blame by depicting this outcome as if it was a special case that applied only to deeply recessionary economies. But pray tell, when exactly is the IMF called in to do salvage operations? When economies are sick! So this was a major indictment of one of the big elements of the standard IMF playbook.

Yet there’s only been some minor shifts in the willingness to engage in more aggressive fiscal policy. Far too many articles and papers treat “fiscal consolidation” which is code for “austerity” as if it worked. Some European leaders are at least now talking up the need for more deficit spending, but it hasn’t translated to a shift in practice. And as you can see from the summary of articles below, even though more and more economists are approving of a more active fiscal stance, this shift comes four years after the IMF cleared its throat, and is still pretty cautious.

By Silvia Merler, recently an Economic Analyst in DG Economic and Financial Affairs of the European Commission. Originally published at Bruegel

Ángel Ubide makes the case for active fiscal policy. The pre-crisis consensus on the use and scope of fiscal policy was that the business cycle would be managed by monetary policy, while fiscal policy would focus solely on debt sustainability. In that world, fiscal policy was asymmetric. That was a world of growth near potential, inflation at or above target, and positive nominal and real interest rates, which created economic rules like the Eurozone’s Stability and Growth Pact. But we don’t live in that world anymore: we live in a world of persistent insufficiency of demand, too-low inflation, and neutral real interest rates that are likely to be zero or even negative. In this world, fiscal policy has to contribute to supporting aggregate demand and protecting against deflationary risks because monetary policy alone cannot do it. If we apply the old framework to today’s reality, if we fail to stimulate the economy, we risk that hysteresis transforms persistent weakness in demand into lower potential growth.

Ubide argues that a well-designed expansionary fiscal policy stance can contribute to better economic outcomes in three ways. First, it can boost potential growth with multi-year public investment packages that raise productivity. Second, it can help monetary policy become more effective by increasing the supply of government bonds and raising the equilibrium real interest rate. Third, it can contribute to reducing income inequality. A typical criticism of this call for active fiscal policy is that there is no fiscal policy space, especially in the Eurozone. This is a debatable statement, given the very strong demand for government bonds that is pushing long-term interest rates to record low levels.  And, in any case, it is time to create the fiscal space by accelerating the creation of a European fiscal policy, including Eurobonds.

Lawrence Summers and Antonio Fatas have a new paper out on the permanent effects of fiscal consolidation. Their question is whether cyclical (demand) shocks can have permanent effects through hysteresis effects. The presence of hysteresis was originally discussed in the context of labour markets: Blanchard and Summers (1986) argued that cyclical unemployment could turn into long-term unemployment, making a cyclical shock persistent or even permanent. Fatas and Summers argue that we can think about a broader concept of hysteresis, one that includes the effects on productivity and capital accumulation dynamics and establishes a much stronger connection between economic crises and long-term growth trends. A reasonable hypothesis is that the forces that drive long-term growth slow down during recessions, so that a temporary slowdown results in a permanent impact on GDP levels, leading to hysteresis.

The global financial crisis has permanently lowered the path of GDP in all advanced economies. The Eurozone is a good example: relative to the 1999-2007 trend, Eurozone GDP today is about 15% below that level and potential has been revised downwards by a similar magnitude. In response to rising government debt levels, many countries have been engaging at the same time in fiscal consolidations that have had a negative impact on growth rates. Fatas and Summers’ paper empirically explores the connections between these two facts, and results provide support for the presence of strong hysteresis effects of fiscal policy. The large size of the effects points in the direction of self-defeating fiscal consolidations: attempts to reduce debt via fiscal consolidations have very likely resulted in a higher debt to GDP ratio through their long-term negative impact on output.

Brad DeLong has a write up of a recent IMF conference on “fiscal Policy in the new normal”, essentially revolving around the role for fiscal policy in a world where the global recovery has been anemic and monetary policy has been stretched to extremes. In a “new normal” of prolonged slow growth, should we rethink fiscal policy in terms of both its countercyclical role and its effectiveness in boosting productivity and catalyzing longer-term inclusive growth?

Brad DeLong also looks in depth at the role of fiscal policy in the (post-2009) US recovery. The near-consensus policy rule for fiscal policy’s countercyclical role back in 2008 was simple: it had none. Automatic stabilizers were allowed to function, were even encouraged, but an opinion crystallized that fiscal policy should be set according to “classical” principles: rightsizing the state, levying taxes efficiently, and achieving long run fiscal balance, with countercyclical fiscal policy was to be restricted to automatic stabilizers. Why? For three reasons: discretionary fiscal policy was unnecessary as a countercyclical policy tool, because monetary policy could do the job; discretionary fiscal policy was ineffective as a countercyclical policy tool, because decision and implementation lags were just too long; discretionary countercyclical policy was counterproductive as a countercyclical fiscal policy tool, because legislators and their staffs were not competent to choose appropriate policies even when they wished to do so.

Jason Furman on the FT also argues that too many policymakers have abandoned expansionary fiscal policy as a tool for supporting growth, placing the burden on monetary policy, and he  lays down five principles to follow for a new fiscal policy. First, at a time when conventional monetary policy faces limitations in a world of lower interest rates, fiscal policy can be a particularly effective complement. Second, in today’s conditions fiscal policy may be more effective than previously understood, by “crowding in” private investment through stronger growth, which gives private companies an inducement to invest, and higher expected inflation, which lowers real interest rates and the cost of capital. Third, advanced economies have more room to expand fiscal policy than generally appreciated, as under today’s economic conditions, effectively crafted investments could raise output by more than they raise debt. Fourth, prolonged lower interest rates and economies operating below potential suggest that fiscal expansion should be more sustained, especially if it results in investment in areas that boost long-term growth. Fifth, fiscal policy is even more beneficial if co-ordinated more across countries, due to cross-border spillovers via trade and capital flows. But Furman argues that eurozone fiscal policy faces obstacles at the national level and that despite recent improvements to the EU’s stability and growth pact, it remains opaque and has become increasingly complex, capable of forcing faster deficit reduction but not co-ordinated fiscal expansion. He thinks active fiscal policy and mechanisms such as eurozone-wide unemployment insurance, better co-ordination between countries or a simplified pact that allows an emphasis on near-term growth are all worth considering.

Meanwhile, Igor Masten and Ana Grdović Gnip stress test the EU fiscal framework, to see if the cyclically adjusted budget balance (CABB) is a good measure of discretionary fiscal policy. Their results show that the official EC methodology performs poorly when it is asked to determine the fiscal policy stance. On average, it wrongly signals either the expansive or restrictive fiscal policy stance roughly 40% of the time. This is because the EC methodology mis-attributes much of the cyclical variation in the budget balance to discretionary fiscal policy. They also argue that the provisions of the SGP seem to be too stringent for compliance with the Maastricht 3% deficit-to-GDP limit. The stringency of the SGP provisions, combined with a weak capacity of the CABB to capture discretionary fiscal policy measures, yields suboptimal conditions for macroeconomic stabilisation: the official EC methodology mis-signals the violation of the SGP structural deficit limit in about 25% of cases. Masten and Grdović Gnip conclude that the CABB estimation methodology needs revision – explicitly incorporating a structural description of discretionary fiscal policy –  and that the SGP limits are too tight for effective fiscal stabilisation. According to the prediction of the model they set up, allowing for a bigger role for discretionary policy could enhance the stabilisation efficiency of fiscal policy without jeopardising compliance with the Maastricht Treaty.

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  1. casino implosion

    I think we were all way too impatient in expecting the fallout of the Great Crash to have immediate effects on politics and economics. History teaches that this stuff takes a long time, but it happens.

    1. KYrocky

      There were immediate effects: the investors that mattered were bailed out and criminals were absolved of their crimes. The precedent has been set. Those things took no time at all, and once done, well, there was no real desire to burn the bridges that would allow the same things to occur again.

    1. Quiet

      Not exactly. They compared ww2 to the war on terror. In dollar terms that might make sense, but it’s ridiculous in terms of manpower. It’s as though they chose a poor example on purpose.

  2. RabidGandhi

    If there is “inertia in orthodox thinking” it is definitely not in evidence in IMF practise. The IMF just returned to Argentina, like a jackal to a half-eaten corpse, and we were treated to an exact repeat of the nostrums of the 1990s: nice job laying off 400,000 people and hiking utilities on the poorest. You should work on cutting the deficit more next year, woo the confidence fairy, good to end populism, yadda yadda…. Ditto in Brazil and Peru, Venezuela to follow.

    Meanwhile, it’s more than irking that these witch doctors (L. Summers for chrissakes?) get paid to have sudden epiphanies that all their previous cyanide prescriptions were misguided. Wasn’t there some British dude who said all this stuff a hundred years ago? Rhymes with Shaun Laynard Bleynes?

    1. Plenue

      noun: inertia

      a tendency to do nothing or to remain unchanged.
      “the bureaucratic inertia of government”
      synonyms: inactivity, inaction, inertness; More
      unchanged state, stationary condition, stasis
      “by the nature of its own inertia, the coal industry has remained an unshakable constant”
      a property of matter by which it continues in its existing state of rest or uniform motion in a straight line, unless that state is changed by an external force.
      resistance to change in some other physical property.
      “the thermal inertia of the oceans will delay the full rise in temperature for a few decades”

    2. Jay

      Its about time someone took the imf to the courts. I’m almost tempted to believe the imf does its nonsense on purpose

  3. John k

    DeLong has his finger on it…
    Auto stabilizers should be encouraged…
    Let’s beef them up, and not wait for recession to go national or global. Each of the 13 Feds monitors their own patch, so when one is seen to be turning down the signal should go to treasury to open the spigot locally… Maybe cut FICA locally, roads, etc.

    And let’s stop talking about grand bargains that cut the stabilizers.

    Just a first step… Need to move on and explain why the reserve currency must continually be in deficit so long as the global economy insists on saving in that currency.

    1. JTMcPhee

      Who is “us,” and how’s it going happen that “let’s” is going to do ANYthing about ANYthing of moment?

  4. Jesper

    Lengthen paid time-off, it will lead to shortage of workers thus leading to higher wages. Higher wages leads to increased spending -> economy is boosted.

    Or continue with creating the division between the ‘lazy unemployed’ and the low-paid while competing in a race to the bottom.

  5. Dick Burkhart

    All these guys simply assume that economic growth can and should continue. They ignore fundamental limits-to-growth, which easily explain the global economic slowdown we are experiencing, in addition to the much tougher times ahead.

    1. Saltcreep

      Exactly. And we’re even shrinking those fundamental limits through the destructive, polluting, extractive and wasteful nature of our production, commerce and consumption.

      Not only are energy and resources steadily becoming more difficult to extract than they were previously, as we consume the easiest sources first, we are on track to be the next extinction level event for the other species that share the planet with us. The 2016 Living Planet report by the WWF shows an almost 60% average decline in wildlife populations of fish, amphibians, reptiles, birds and mammals between 1970 and 2012:

      Debt has provided an illusion of wealth and profitability that has created incentives for us to carry on increasing our resource depletion and destruction of the natural world we depend on for our own survival far beyond limits that would otherwise have enforced themselves. The longer we’re able to extend our debt financed destruction the more devastating the eventual correction will be.

  6. Scott Frasier

    Too much of conventional economics relies on generic comparisons and linear extrapolation.

    First, the US, Europe, and Japan are not the same as Venezuela or Peru. Deficit spending in self-sufficient economies is different from deficit spending in commodity states.

    Second, infrastructure investment is different, if spend reasonably wisely, from just sending out checks to people or regulating prices arbitrarily.

    Third, the real GDP boost from deficit spending is not linear with a constant multiplier. Spending in a deep recession produces much bigger gains than attempting to boost the economy near the top. This isn’t really controversial, but austerity proponents refuse to acknowledge the fact.

    1. Synoia

      linear extrapolation. True. Chaos theory applies.

      infrastructure investment is different That’s because it is investment. Compare it with War expense (fuel, munitions and short lived equipment) for a full picture. Those Tanks and Aircraft cost much to run, and do not have a 30 to 50 year life.

      Real GDP boost from deficit spending is not linear with a constant multiplier True, but non-linear feedback always surprises those who expect linear results (Who could have known?). There must be some system conditions where the multiplier is >1 and some when it is < 1. (the multiplier will never = 1).

      We agree, with caveats.

  7. craazyman

    How about “we” spend $5 trillion on economic research grants, provided of course that all proposals receiving funding include a range of experimental programs designed to stimulate aggregate demand through broad-based fiscal stimulus programs.

    That should do it. haha. They’d even ignore the circularity..

    1. craazyboy

      Yup. Until governments can figure out how to spend money the right way, I want the freshly printed cash coming straight to me so I can give it a try.

  8. BashBanksBuyBTC

    “The global financial crisis has permanently lowered the path of GDP in all advanced economies. The Eurozone is a good example: relative to the 1999-2007 trend, Eurozone GDP today is about 15% below that level and potential has been revised downwards by a similar magnitude.”

    I do take some umbrage with this excerpt–did the crisis really lower the path of GDP? At the risk of sounding pedantic, I’d argue it’s more accurate to say that unchecked financial engineering, leverage, & risk taking cooked GDP to levels in ’99-’07 that were clearly unsustainable in the long-term, levels that were not an accurate reflection of the true capacity of the global economy. In that context, the crisis represented the inflection point, correcting back to reality (and then some).

    More broadly with regards to the Summers/Fatas study, I’m admittedly skeptical of how confident we can be that this is true causation (of fiscal austerity causing permanent reductions in GDP) rather than simple correlation. It seems reasonable to think that economic output was going to take a sustained hit after 2009, regardless of fiscal policy.

    Even still, it seems a little preemptive to be talking about whether something that happened within the last decade–post ’09 fiscal policy response–has truly caused permanent GDP reductions.

  9. Anthony Stegman

    Deficit spending a la Lord Keynes implies that deficits are necessarily short lived and that surpluses are generated in the future. However, despite massive amounts of Keynesian fiscal stimulus we have not seen surpluses for a very long time. What we have seen is debt piling up. This can only end badly. One does not need a Nobel Prize in economics to understand this.

      1. BecauseTradition

        I’d go further and say we should have deficits, be they ever so small at times, ALL of the time so as to not establish the evil precedent of a balanced budget, or worse a budget surplus, ANY of the time.

        Also this “quibble”: How can we know natural interest rates in fiat if the population is not allowed to use fiat except in the form of unsafe, inconvenient physical fiat, bills and coins? We can’t unless it’s “natural” that citizens can’t use their nation’s fiat, an obvious absurdity.

      2. RBHoughton

        There is an American flag in the moon and the country is setting up a base there soon. Analysis of mineral samples show a high proportion of silver. It seems to me that the Fed might put a few million tons of silver on its books and wear Keynes’ pretty gingham dress eh?

  10. Sound of the Suburbs

    Perhaps we should all listen to the man Ben Bernanke listened to.

    His name is Richard Koo:

    He explains the mistake Christina Romer made analysing data from the Great Depression leading Central Banks to think they could get us over 2008 with monetary policy.

    In the first 12 mins.

    At 54 mins. you can see the IMF projection for Greek recovery with austerity and see the horrifying reality.

    When the US was panicking about the fiscal cliff, it was because Ben Bernanke had read Richard Koo’s book and knew cutting Government spending would drive the US economy into recession.

    The secret is in how money works, which is why hardly any economists understand either the problem or the solution.

    Money and debt are opposite sides of the same coin.
    If there is no debt there is no money.
    Money is created by loans and destroyed by repayments of those loans.

    From the BoE:

    After the system has been flooded with lots of debt with a nice housing boom, the bust gets everyone paying down debt and not borrowing.

    This makes the money supply contract making it harder to pay down the debt.

    When the repayments are larger than the new debt being taken on, the money supply starts contracting.

    The Government needs to step in as the borrower of last resort to keep the money supply stable, otherwise you head into a deflationary spiral.

    Neoclassical economists assume the money supply is constant and can be ignored, this is not true.

    1. BecauseTradition

      The Government needs to step in as the borrower of last resort … Sound of the Suburbs

      Yes, but that new debt need not and should not pay positive interest*. In fact, things could be arranged** so that the new debt collects interest, i.e. negative interest.

      Then who can complain about deficit spending that EARNS interest?

      *Since that would constitute welfare proportional to wealth, not need.
      **via even more negative interest on bank reserves thus making sovereign debt attractive by comparison.

  11. steelhead23

    I strongly auger for “active” fiscal policy to manage economic growth. However, there is another issue, perhaps even larger that fiscal policy should consider; public health. What I mean is the public’s perception of both individual and collective well-being. I have never taken a course in sociology (beyond reading The Jungle) but I perceive that when the collective view of well-being declines sufficiently, governments fail, sometimes countries fail. Hence, the public’s perception of its well-being is likely a better measure of government performance than is GDP, the scale of the national debt, or the number of Olympic medals procured. I have entirely lost faith that the U.S. government gives a hoot about public well-being, being entirely seduced by corporate lucre. But that’s just me.

  12. pslebow

    Don’t know if the 10% rule for social change applies to academia and policy makers. The deeply entrenched understanding of money, its role and creation, may take a generation to die away as reputations are based upon those orthodox theories. There are also powerful forces who do understand money but also understand that their power would evaporate should the true nature of money be understood and accepted.

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