Arnold Kling  

One-Sentence Macro Policy

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Tyler Cowen writes,


I believe the "zero bound" is perhaps the single largest "red herring" in the economics profession today.

If you understand that sentence, you know everything you need to know about Tyler's case against fiscal stimulus.

In case you do not understand that sentence, let me unpack it. Let us start with the Keynesian assumption that the economy suffers from a lack of aggregate demand. As a cure, we could use monetary expansion, fiscal expansion, or both. The more we use fiscal policy, the more we crowd out private investment and the closer we get to the brink of a sovereign debt crisis.

So the argument for using fiscal expansion instead of monetary expansion needs to be pretty compelling. Consider two arguments:

1. We should be happy about a larger public sector and a smaller private sector.

2. At low interest rates fiscal policy is very effective (no crowding out) and monetary policy may be ineffective (liquidity trap).

When Tyler says that (2) is a "red herring," he is implying that it is a stalking horse for (1).
[UPDATE: Scott Sumner says that the solution is to force the Fed to have an explicit target.


Let's suppose the Congress instructed the Fed to target 2% inflation. Now assume Congress wants more growth because we are in a recession, but because inflation is currently 2% the Fed doesn't want to ease. The fiscal authorities could instruct the central bank to aim for 2% inflation in the long run, but allow a bit more inflation during the current recession, at the expense of a bit less that 2% inflation during the subsequent years. In other words the Fed would still have some discretion, even though their long-run mandate would be 2% inflation.

I think it would be simpler just to set an inflation target and stick to it. In today's environment, that would require a more expansionary monetary policy.]


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COMMENTS (13 to date)
Duablin writes:

The whole matter reminds me of a different kind of cure.

"Essentially, this theory held that the human body was filled with four basic substances, called four humors, which are in balance when a person is healthy. All diseases and disabilities resulted from an excess or deficit of one of these four humors."

http://en.wikipedia.org/wiki/Humorism

Boonton writes:

I think your argument falls into the trap of making monetary stimulus seem like a free lunch with no drawbacks. One pretty obvious problem is the 'liquidity trap' or phrased slightly better it's quite easy for newly created money to never get spent on real demand but simply disappear into various types of financial paper. If, for example, banks simply think the economy is too bad to make real loans they can simply stash their excess reserves in Treasuries and high grade, already existing, debts. Sure their return will be low but they will be safe.

AS a result it may take a huge amount of monetary stimulus to push the economy. As the central bank starts using vehicles other than very short term Treasury paper to push cash into the economy, the danger increases that when recovery happens that mountain of paper will start overheating things quickly. The central banks ability to tighten will be constrained by the fact that it may not be able to sell some of its longer term assets for as much cash as it used to buy them.

Your argument against fiscal policy is that it may increase the chance of a debt crises at some point in the future. I don't think you have a single historical example of this. By that I mean a country that had a debt crises due to fiscal stimulus in the face of a deflationary recession. I suspect you will find that all debt crises that have already happened can be linked to:

1. Chronic borrowing regardless of the health of the economy, in that case fiscal stimulus isn't the problem but the long term budgetary practices of the country. As such a country will have a debt crises regardless of whether or not it stimulates, it might as well stimulate now and enjoy the added output from putting people back to work.

2. Borrowing in a currency other than you're own. This leaves you at the mercy of exchange rates which can suddenly turn against you. However this danger exists whether or not you stimulate as we have had plenty of countries that were not particularly bad suddenly fall into crises as 'hot money' flew out and left their currency much lower. I'm not sure what the best policy is for such a country to follow in a recession. I imagine such countries depend heavily on exports so they may be at the mercy of the rest of the world more than the US and other larger economies are.

Additionally using fiscal policy provides a check. A gov't that gets too attached to fiscal stimulus can be quickly checked by a Fed. getting tough on inflation. In theory I suppose the gov't could check a central bank that decided to overstimulate the money supply. It could, for example, hike up taxes to make the deficit a surplus thereby adsorbing some of the cash the Fed is printing wildly. It could even take the cash out of circulation by running a surplus and stashing it in vaults.

This, though, is an example of something that's theoretically possible but is not really worth considering in the face of the historical record. We know that gov'ts rarely chide their central banks for being too loose. We know that more often than not it is the central bankers who are more conservative, more stingy with monetary looseness than politicians. Advocating having the central bank push down on the gas pedal before the gov't in the name of reducing risk is like trying to make a car safer by removing the braking system on the grounds that it makes the car lighter and a lighter car is easier to stop!

Ted writes:

This whole post makes no sense to me.

Firstly, there is about zero evidence that fiscal expansion has had any "crowding out" effect. If we were seeing crowding out, this would be a good thing since it would mean economic activity is up and we could pull out stimulus immediately (whether congress would is a different issue, of course).

Secondly, why would you believe that the stimulus implies a larger public sector? It's fairly clear that almost all of the stimulus is a temporary expansionary, and most of expenditure spending is done through private companies. I don't know how fiscal expansion implies a larger public sector going forward - let alone a smaller private sector.

Thirdly, any arguments for fiscal stimulus does NOT require a believe that monetary policy is ineffective at zero interest rates. All it requires is a believe that the Federal Reserve will not use the expectations channel and will only adjust policy through interest rate setting in the present. And guess what - this assumption has proven absolutely correct hasn't it? You could argue that Congress should override the policy of the FOMC and commit to a higher inflation target, but it's debatable whether Congress has the credibility with the public to pull of expectations management, nor is it clear we'd want to open the Pandora'x Box of congressionally-set monetary policy.

My preference by far and away is monetary stimulus, but it's not like fiscal stimulus is just some scheme to create bigger government. It's advocated because some individuals correctly realized the Fed wouldn't do their job once the zero lower bound hit. It has nothing to do with the assumption monetary policy doesn't work at the zero lower bound.

By the way, we aren't even close to a sovereign debt crisis so that's almost the most absurd argument ever against fiscal stimulus. Was the higher taxes argument not dramatic enough?

Norman writes:

Ted said "[...] any arguments for fiscal stimulus does NOT require a believe that monetary policy is ineffective at zero interest rates. All it requires is a believe that the Federal Reserve will not use the expectations channel and will only adjust policy through interest rate setting in the present."

Actually, if we are arguing what *ought* to happen, then what the Fed is willing to do in actuality is irrelevant. By this argument, we shouldn't argue for fiscal stimulus either so long as we believe Congress is unwilling to pass it.

If, on the other hand, our arguments are designed to be persuasive to policymakers, then we should argue for either monetary or fiscal stimulus based on (1) which we expect to be more effective if our advice is taken, and (2) whether we think Congress or the Fed is more likely to be persuaded to action. Assuming one or the other isn't listening misses the point.

Boonton writes:

Secondly, why would you believe that the stimulus implies a larger public sector? It's fairly clear that almost all of the stimulus is a temporary expansionary, and most of expenditure spending is done through private companies. I don't know how fiscal expansion implies a larger public sector going forward - let alone a smaller private sector.

This is a good point. Fiscal stimulus has several dynamics that make mitigate against an expanded public sector:

1. Specific projects are by definition temporary. The Hoover dam can only be built once. Once its done the stimulus is more or less over. Trying to replace it with an equal project elsewhere requires overcoming a lot of political hurdles.

1.1 Likewise many stimulus provisions have built in sunset provisions. Obama's unemployment extensions and payroll tax cuts expire automatically as did the homebuyers credit and the cash for clunkers program. Whatever you think of their merits, you can't argue that it would be politically costless to do those programs again.

2. Stimulus spending is usually discretionary. Discretionary spending is almost always hit first when Congress wants to demonstrate it is cutting spending.

3. As I pointed out elsewhere, the 'ATM Theory of Gov't spending' does not hold. When tax revenues go up (as they do in recoveries), political pressure to spend actually drops, even reverses.


By the way, we aren't even close to a sovereign debt crisis so that's almost the most absurd argument ever against fiscal stimulus. Was the higher taxes argument not dramatic enough?

Kling's threat of a US sovereign debt crises is based on forecasts of entitlement spending and economic growth decades away. If these forecasts are true then the crises is in multiple trillion dollars of debt on a scale so large that even if the entire Federal debt were wiped to $0 today there would still be a crises in the distant future.

If thise prediction is true then the impact of stimulus spending today is about as great as the impact of one quart of motor oil poured in the Gulf of Mexico.

Lord writes:

Hardly. The issue is effective monetary policy looks increasing like fiscal policy at times like these.

Boonton writes:

It would appear that monetary policy is primarily directed at those who borrow money to buy things (hopefully real investment but also consumption). But fiscal policy is not necessarily directed towards those seeking to incur additional debt. In other words you can take a job of digging a ditch, dig the ditch and collect a paycheck. The ditch may or maynot be a good a idea but once its dug it's done and a sunk cost, move on.

Compare that, though, to dropping rates so low some person or company goes out and borrows a lot of money to dig a ditch. The ditch is now dug but the person or company is saddled with the debt to pay back...even if that debt was borrowed at a fixed, low interest rate. If the recession began with a lot of people suffering from high debt levels the amount of monetary stimulus needed to dig a ditch becomes that much higher.

Even if digging the ditch stimulated the economy to full employment, paying the debt is burdensome if the ditch wasn't a very productive investment the person who borrowed the money has no claims on other sectors of the economy that are surging.

The fiscal option seems more transparent and less risky in the long term under these conditions. You don't have to stimulate by forcing debt on anyone but the Federal gov't. If the ditch is a great idea then the gov't collects additional tax revenue from both the income earned by the ditch and the larger economy's recovery. If the ditch was a bad idea then the gov't still earns revenue from the larger economy's recovery. The cost of poorly thought out stimulus is lower in this case.

Andrew_M_Garland writes:

To Duablin,

You have my vote. This is a discussion of pure opinion glossed with technical terms that have no definition.

Aggregate Demand is a made-up variable in a highly abstract equation. It is a name for something that is not defined or measurable in a physical sense.

Calling government spending "stimulus" doesn't make it one, even if everyone had a definition of "stimulus". And, what is that definition?

I'm a simple city boy. I want each general term to have a physical, proven example underlying it. Otherwise, how can you have a discussion?

A robber finds it stimulating to rob. The victim finds it less so. A broken window "stimulates" the local economy, a fallacy pointed out by Frédéric Bastiat in 1850.

The primary responsibility of any economic policy is first to prove that it isn't a "broken window" scheme. Just as the primary responsibility of any business plan is to prove that it isn't a Ponzi scheme.

Boonton writes:

Andrew,

Fiscal stimulus is simply government purchases of goods and services done with an intent of increasing overall income in the economy (this can be joined with other intents as well, for example the Hoover Dam was also intended to produce a dam to supply electricity). More distant stimulus could also be indirect where the gov't increases demand through boosting the consumption power of individuals or businesses through payments to them or reduced taxes.

Monetary stimulus is even easier to understand. It is simply any increase in the creation of money.

A broken window "stimulates" the local economy, a fallacy pointed out by Frédéric Bastiat in 1850.

A broken window does no such thing. A broken window is simply a broken window. Fixing a broken window does stimulate the economy, but purposefully breaking a window does nothing but waste capital whether or not a 'stimulus program' comes along and fixes it.

Andrew_M_Garland writes:

To Boonton,

You write: "More distant stimulus could also be indirect where the gov't increases demand through boosting the consumption power of individuals or businesses through payments to them or reduced taxes.

That is the broken window fallacy.

You say the government can increase "demand" (undefined) by reducing the taxes on people.

But, in your view, reducing taxes also reduces government spending, which reduces "stimulus". What is gained?

- -
I am puzzled by the same meaning you apply to "stimulus" and "government spending".

You wrote: "Fiscal stimulus is simply government purchases of goods and services done with an intent of increasing overall income in the economy"

If "stimulus" is simply government spending, then let's just say "spending". Stimulus implies some larger economic result, some multiple of the spending. So, why confuse people?

Aren't you uncomfortable to talk about the "intent" of spending to create stimulus? Does wishing make it so?

What is spending that is not intended to be stimulating? What is the difference?

Boonton writes:

That is the broken window fallacy.

I suppose if you pay them to break windows or give chronic window breakers a tax cut. That's easily solved by not paying people to break windows.

But, in your view, reducing taxes also reduces government spending, which reduces "stimulus". What is gained?

I'm not following you. I didn't say reducing taxes reduces gov't spending. Anyway the policy is analyzed with all else being equal. If you pay someone $500 to dig a ditch that is stimulative. If you tax someone else $450 that is the opposite. If you want to deal with multiple policies then you have to net them together.

If "stimulus" is simply government spending, then let's just say "spending". Stimulus implies some larger economic result, some multiple of the spending. So, why confuse people?

Not quite, its spending with the intent of increasing overall income in the economy. This would be distinct from, say, normal spending because the gov't needs things like police, tanks, roads, etc.

Aren't you uncomfortable to talk about the "intent" of spending to create stimulus? Does wishing make it so?

Not really. There's nothing magical about intent. Added spending that happens for other reasons that accidently coincides with a deep recession would also be stimulus. After Pearl Harbor, the US ramped up military spending but that was intended to fight a war, not expand the WPA. Yet it was stimulus spending.

Let's say that the gov't is planning on increasing spending in some area for reasons that have nothing to do with stimulating the economy. Say they want to embark on a ten year program to put a man on the moon and bring him back. The policy is not stimulative in that its intent had nothing to do with macroeconomic planning. In terms of its impact on the economy it is stimulative. If the economy is operating at full employment such a program would either be inflationary, or would crowd out private investment (presumably costing us in future lost income) or would have to be 'paid for' by anti-stimulative measures to counter it such as spending cuts elsewhere, tax increases or monetary tightening.

Troy Camplin writes:

I propose "equlibrium" as the single largest red herring. There is no such thing as equlibrium in a complex dynamic evolving system. Everything that is derived from an equlibrium argument is, thus, wrong.

Boonton writes:

Why? Just because you never actually reach equilibrium doesn't mean its impact isn't real. It seems to me like a large planet with a lot of gravity that wanders around. You never actually fall into it but you'll be pulled along with it.

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