Arnold Kling  

The Case for Fiscal Expansion

Words of Wisdom on Signaling... More Thoughts on Philanthropy...

There is an argument for fiscal expansion, which is "unemployment is bad, and Republicans are bad for wanting to cut spending, especially when there is a lot of unemployment." However, if you want to change someone's mind, you need something with more economic content to it.

From the perspective of textbook macro, the case for fiscal expansion in the United States right now would seem to rest on two points.

1. Wages are too high relative to prices, and general inflation will cure this faster than waiting around for wages to fall.

2. The Fed is powerless to cause inflation, because it cannot lower interest rates below zero.

Scott Sumner is the only economist who consistently explores these assumptions. He insists that (1) is true and (2) is false.

What is weird is that I never can find advocates of fiscal expansion articulating (1) directly. I infer that they believe (1) from posts like this one, from Mark Thoma. When you say that the problem is aggregate demand, then from a textbook perspective you are saying that real wages generically are too high. If Thoma and other advocates of fiscal expansion are saying something else, I hope they let me know.

What is also strange to me is that hardly any economist who advocates fiscal expansion will articulate (2) with a straight face. They will throw around terms like "zero bound" or "liquidity trap," but I doubt that even Paul Krugman is prepared to commit himself to the proposition that the Fed lacks the means to cause inflation if it wants.

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CATEGORIES: Macroeconomics

COMMENTS (11 to date)
Mark Thoma writes:

I've made the time consistency point repeatedly, e.g.:

"I am not sure that people believe that the government will actually create inflation in the future even if they promise to do so now. As I said in the original post, I think the inflation fighting credentials the Fed has worked so hard to earn work against them in this instance."

See, for example, here, but this is far from the only time the point has been made:

On you other point, price rigidity is enough to get non-neutralities, you don't need wage rigidity. In any case, Krugman and everyone and the rest of us have discussed this quite a bit. The question is whether lowering wages is the answer to the problem. It isn't, it makes things worse (Rajiv Sethi had a very nice discussion on this).

Greg writes:

From an econ student:

Maybe I missed this point in intermediate macro, but how does depressed aggregate demand imply real wages that are too high?

I always understood the case for fiscal expansion as the need to increase consumption capacity and make use of idle production resources on a short-term basis, just long enough to allow the normal processes of lending, borrowing, spending, and hiring to function on their own. I've always had in mind the analogy of a car engine, where under normal conditions it generates enough power on its own to charge the battery, which in turn powers the computer that runs the engine. If the battery gets too low, a temporary influx of power is needed to restart the normally self-sustaining process.

I guess what I'm missing is where real wages fit in to the picture except as a symptom of economic well-being, and intuitively I'd imagine that real wages would be rather low right now.

thruth writes:

@Mark Thoma

As I said in the original post, I think the inflation fighting credentials the Fed has worked so hard to earn work against them in this instance.

I think that's interpreting the Fed's credibility too narrowly. If the Fed were to announce an inflation targeting regime (one that was consistent with its mandate), surely its credibility would work in its favor in obtaining that target? The Fed just seems happy with the institutionalized status quo. So I would say it's insitutionalism, not credibility, that's the barrier. (Though maybe its a distinction without a difference)

Noah Yetter writes:

Even if (1) and (2) are both true, it does not follow that fiscal expansion will help. It cannot cause inflation, so what is the proposed transmission mechanism?

Gabriel rossman writes:

Also worth noting with respect to the "real wages are too high/sticky" is that a belief in expansion also tends to go together with a belief in the need to compress the income distribution (or to put it more strongly, that the current Gini is the result of regressive policy). This is partially inconsistent with the fact that unemployment is negatively correlated with skill and thus bringing unemployment down requires bringing down real wages specifically at the bottom and therefore increasing income dispersion.

I say "partially" because you could potentially have your cake and eat it too through carefully crafted T&T, but this requires throwing out the argument (which also goes with this cluster of beliefs) that T&T is not ontologically meaningful given that the state is constitutive of pre-T&T distribution through infrastructure, property rights regimes, etc.

Nick Rowe writes:

This is what a "textbook" Keynesian would/should believe:

Suppose *both* wages and prices were sticky (sounds reasonable), and the AD curve shifts left. Then real wages could stay at the right level, but output and employment would fall.

A. *If* you believe that the AD curve slopes down, then a cut in both W and P *could* be a cure for the low level of output and employment. Both W and P are "too high", relative to the position of the AD curve, even though W/P is at the right level. But, it might be quicker and simpler to shift the AD curve right, using fiscal and/or monetary policy, than to wait for W and P to fall. (Plus, you don't have to worry about the real burden of debts, etc.)

B. *If* you believe in the textbook version of the liquidity trap, then the AD curve will not slope down in a liquidity trap. It will be vertical. So a fall in W and P will not increase output and employment.

C. *If* you believe in the textbook version of the liquidity trap, where the AD curve is vertical, cuts in W and P don't help, and monetary policy is powerless, and so fiscal policy is all that is left.

That's where Keynesians are coming from. (OK, I've oversimplified). It's not that W/P is too high. Nor are W and P too high in any useful sense, because lower W and P wouldn't do any good (unless, maybe, they both got so close to zero that the Pigou effect kicked in, if the economy is still alive at that point).

[And what is wrong with this Keynesian vision? IMHO, they just lack the imagination to conceive of monetary policy as anything other than setting a short-term nominal interest rate. They see a duck, and can't see the rabbit.]

effem writes:

Why is unemployment always viewed from the angle of wages? Couldn't it just as easily be stated that corporate margin expectations are too high? I don't know of any work in this area but i'm guessing that return-on-capital expectations are just as sticky as wages. With negative real rates, these expectations should come down dramatically - returns are not what they used to be.

So here we are with record corporate profitability and high unemployment. Standard economics looks at that and says that wage-earners must bear the brunt even though real wages have been stagnant for decades.

I'm more inclined to believe return-on-capital expectations are too high.


Lord writes:

The problem with the Fed is one of will rather than power and it is institutional. We really need a redesign with the Fed having inflation fighting capability and another institution having deflation fighting capability. Barring that, a full board resignation whenever a recession occurs. It may not improve policy but would place responsibility.

Justin R. writes:

Is there any good literature that deals with the issue of the long-term efficiency of government spending, i.e. that fiscal stimulus may cause a short term pop in the economy but that this spending isn't in tune with what the private sector would have spent on, and therefore when the stimulus is ended, another slump occurs (or the economy grows more slowly than trend)?

Greg writes:

I'd be curious, too. It would ideally compare the welfare losses due to friction and inefficiencies in our semi-free market (taxes, externalities, costly information) to the welfare losses from a government-mandated allocation.

(In case you couldn't tell, I remember a lot more from micro than I do from macro)

Shayne Cook writes:

Re: 2.)
The Fed is not powerless, it is merely limited in it's capacity to create/induce a general inflation. It can invent and implement any number of "loose money" policies in addition to low/zero-bounded interest rates, but it can exert no control whatsoever over where that money flows, or even that it will flow at all. That is an unfortunate lesson Alan Greenspan learned (possibly too late) during the 2002-2005 period.

As long as the Federal Government insists on micro-managing every aspect of the U.S. economy, picking sectoral "winners and losers" as it were, loose money policies will result in flows to (unsustainable) bubbles, not general inflation.

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