Fiscal policy camps
In an email exchange with fellow economists from around the place I made the following wild conjectures on why fiscal stimulus could be seen as a good idea – but isn’t necessarily first best. Feel free to read and critique 😉
Email one – fiscal policy, and why it may be preferable
This link discusses some of the modern justification for “demand side” policies during a significant recession.
Note, when they say “demand side policies” this can mean either monetary policy or the government buying things.
The people that want higher fiscal policy fall into two (often intersecting) camps:
- They just want higher government spending to start with,
- They believe that once interest rates are close to zero we hit a “liquidity trap”.
I don’t believe in liquidity traps per see, as when we have a liquidity trap the issue is that we can’t cut interest rates. However, we can “print money” and buy things with that money – and if the real interest rate doesn’t fall (nominal rates – inflation) then we are effectively getting higher production for nothing …
That is the key – we could create inflation to get out of the environment. Now in the liquidity trap view there are two reasons why we have a liquidity trap:
- We can’t print money and buy stuff to create inflation
- We won’t print money to buy stuff and create inflation
The first view is just weird. The second view is actually fairly accurate – central banks are nervous about “just printing money” as they get attacked about “hyperinflation”. Of course, there is a gap between “deflation” and “hyperinflation” but if central banks just start printing money, and inflation expectations get loose as a result, we will have a more unstable environment.
As a result, fiscal policy can be seen as preferable if we think printing money would cause instability.
Email two – batting for New Keynesians
Here is more from Thoma,
He has good points, but I think he is too negative about the ability to adapt New Keynesian models – New Keynesian models are frameworks, the problem is that we haven’t got sophisticated enough descriptive knowledge to really get the most out of the framework.
Krugman is here:
http://krugman.blogs.nytimes.com/2010/05/24/oy-macro/
He is writing as someone who pushed fiscal policy, and refused to really listen to/fairly represent the other side. Deep down Krugman is in the “the zero rate doesn’t have to matter, but policy will be such that the zero rate is a constraint” camp. But he acts as if he is in the “at zero monetary policy is useless” camp.
I would add a third reason people might want fiscal policy during a recession:
3. They believe that an immediate aggregate demand stimulus would be beneficial and fiscal policy operates more quickly than monetary policy.
For myself, I don’t buy any of the three arguments.
1. Wanting higher government spending is an argument for higher government spending period, not for counter-cyclical government spending.
2. Even if a liquidity trap could make monetary policy impotent in theory, in practice, we only ever see very shrot-run interest rates approaching zero. As long as the central bank has open-market operations for securities with longer maturity horizons in its policy-level aresnal, low overnight rates should not be a constraint.
3. Fiscal policy may well operate with smaller lags, but that also makes it a very unwieldy instrument to use to fine-tune demand as it implies large swings in government expendtiure and taxes.
@Seamus Hogan
Excellent point Seamus. I had missed that third, central, element of the debate around stimulus.
As you say in your critique of it, it isn’t clear whether the practical lag is any shorter. In fact, I am not entirely convinced on the lag argument myself.
Actually, I am currently a LOT less convinced about the difference in lags than I was during the crisis:
http://www.tvhe.co.nz/2008/12/11/make-expansionary-fiscal-policy-work-give-it-to-the-technocrats/
Hmmm, interesting 😀
great post. I have been reading a lot of Krugman’s views lately, though I don’t necessarily agree with what is said (esp in the NZ context), he nonetheless has a particularly interesting viewpoint.
the difference in lags is more related to how much debt is on fixed or floating rates. i.e. if it were al floating I doubt the lag would be much at all, whereas if it is all fixed there could be a significant lag. then again, maybe people would spend less almost immediately because they have an expectation of future higher interest rates.
I am not entirely convinced there is much of a lag either.
@steve
“I have been reading a lot of Krugman’s views lately, though I don’t necessarily agree with what is said (esp in the NZ context), he nonetheless has a particularly interesting viewpoint.”
Very true. Krugman is a very smart man – although I find he can be a bit aggressive with some people who disagree. I think he talks with political barriers in mind a lot of the time.
The good thing with Krugman is he understands open economy macro – something many economists in the US just miss out!
“the difference in lags is more related to how much debt is on fixed or floating rates”
Steve. That is definitely true regarding the income impact of lags – which is part of the stabilisation mechanism.
However the “marginal impact” does not really matter on current terms – because we are looking at the marginal borrower. In that sense, adjusting the OCR can still have a good impact at helping smooth intertemporal consumption in this sense.
FWIW, I think Krugman also had an argument as to why quantitative easing wouldn’t be sufficient on it’s own. It’s late and I’m tired – so the risk I’ll mangle his arguments is high (and those really interested are better to trawl his blog and find what he actually wrote) but I think his point was simply that in a deflationary environment (or one close to it) people will hold money (rather than spend it). So printing more might not have that much traction as a form of stimulus.
In my mind one of the most important reasons to be open to some form of fiscal stimulus/deficit spending in a recession is simply the need to mitigate the social costs of these events. Recessions mean less government revenue at the same time as they bring increased need for government services (particularly welfare). If running a deficit means you don’t have to cut these services when people need them most, and if it isn’t going to dramatically slow recovery or lead to long run issues of repayment, then that’s reason enough to do it in my mind. Any stimulus is a bonus.
@terence
Hi Terence,
Indeed, Mankiw said the same thing. However, this is a marginal argument on money printing – not a global argument.
If prices aren’t chaning, and we keep printing money, the incentive to hoard is going to fall as more money is printed. If we just keep printing and printing, eventually people will spend it. Either this will push prices up, lead to an increase in output, or (more likely) a mix. So we can just keep printing, and printing, and printing, until something happens 😉
“In my mind one of the most important reasons to be open to some form of fiscal stimulus/deficit spending in a recession is simply the need to mitigate the social costs of these events”
Agreed – and I feel that this is the primary reason why we have the type of automatic stabilisers in place that we do 🙂