Fiscal Policy in Depressions

Lawrence Summers and Brad DeLong have this paper which argues that in severely depressed economies, which are also constrained by the zero-interest rate bound, discretionary fiscal policy can be a powerful instrument to revive growth. They write,

In normal times central banks offset the effects of fiscal policy. This keeps the policy-relevant multiplier near zero. It leaves no space for expansionary fiscal policy as a stabilization policy tool. But when interest rates are constrained by the zero nominal lower bound, discretionary fiscal policy can be highly efficacious as a stabilization policy tool. Indeed, under what we defend as plausible assumptions of temporary expansionary fiscal policies may well reduce long-run debt-financing burdens. These conclusions derive from even modest assumptions about impact multiplier, hysteresis effects, the negative impact of expansionary fiscal policy on real interest rates, and from recognition of the impact of interest rates below growth rates on the evolution of debt-GDP ratios. While our analysis underscores the importance of governments pursuing sustainable long run fiscal policies, it suggests the need for considerable caution re-garding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero lower bound.

Following the apparent triumph of monetarism in the seventies, Keynesianism had been upstaged as the dominant macroeconomic stabilization ideology for nearly three decades till the Great Recession took hold. It was believed that front-loaded fiscal consolidation for deficit-reduction coupled with accommodatory monetary policy would help achieve price stability, positively shape expectations and restore market confidence, encourage investment and consumption, and thereby boost aggregate demand. It would help successfully combat short-term business cycle problems and address medium-term growth dimensions.

It was also believed that the multiplier of discretionary fiscal policy was small. When the economy is close to its productive level, fiscal policy induced rise in demand will run up against supply constraints, thereby fuelling inflation, and rise in interest rates. This tightening of monetary policy, at a time when the economy needs accommodatory monetary policy, will end up crowding out private investments and off-setting the aggregate demand gains due to higher government spending. In contrast, monetary policy packs a much greater punch as an economic stabilization policy instrument. However, when there is a deep economic downturn coupled with interest rates touching the zero-bound, fiscal policy assumes a different character.

As Summers and DeLong write, there are atleast three distinguishing features of the current economic situation in many developed countries that leaves monetary policy without much traction and makes discretionary fiscal policy critical.

1. The absence of supply constraints and interest behavior associated with an economy constrained by the zero-bound means that the multiplier associated with fiscal expansion is likely to be substantially greater and longer lasting. The expectations of growth returning and raising inflation, and thereby lowering real interest rates, magnifies the multiplier.

2. Even very modest hysteresis effects through which output shortfalls affect the economy's future potential have a substantial effect on estimates of the impact of expansionary fiscal policies on future debt burdens. They find evidence that mitigating protracted output losses like those suffered by the United States in recent years raises potential future output. In other words, downturns have the potential to permanently lower the potential output and the trend rate of growth - "Large recessions may create labor-market as well as capital-stock hysteresis".

For example, the longer the economy stays depressed, the more likely that workers will quit the labour force altogether. Therefore, by putting these people back to work today, stimulus generates higher taxes not just this year but for years to come, lowering the long-term debt burden.

3. Extraordinarily low levels of real interest rates raise questions about the efficacy of monetary policy as a source of stimulus, and reduce the cost of fiscal stimulus.

In this context, Paul Krugman has this nice scatterplot of the changes in GDP growth rates against the change in government consumption among Eurozone economies. The correlation is unmistakably salient.

The "long" fiscal stimulus - a belated recognition of infrastructure spending?

Prof Tyler Cowen has a strange post. He points to the inadequacy of short-term stimulus spending, however large, to tide over deleveraging balance sheet recessions. He is therefore surprised that

"For all the talk of a 'large stimulus', you don’t hear much about a 'longer stimulus'."

He has this concern about short-term pump priming, whatever its size,

"The problem with a 'too small' stimulus is that you get an initial economic boost, but when the stimulus expires the economy slumps back down, as indeed happened in mid 2011. Ideally a stimulus employs some idle labor, stops it from depreciating, and tides those workers over until they can look for other jobs in fundamentally better economic conditions... If conditions are not improving soon, the ability of the stimulus to 'buy time' for those workers isn’t worth much... We end up having spent a lot of money to postpone our adjustment problems, rather than achieving takeoff. Deleveraging recessions last a long time, as shown by Rogoff and Reinhart. The need for continuing deleveraging implies that even a stimulus twice the size of ARRA won’t turn the tide."

In the circumstances, his suggestion,

"In those cases a well-designed stimulus program should not be so 'timely'. For a given presented expected value sum spent on stimulus, it is better to spread it out across the years. It is better to help a smaller set of workers for five years (or however many years it takes for most of the deleveraging to end), after which they are reemployable, than to temporarily boost a larger number of workers for two years, and then leave them back in the dust because deleveraging is still going on."

Here we go! There appears to be, to put it very charitably, an element of selective amnesia in Tyler's post here. This is effectively an admission of ideological failure (or, is it an error of judgement?) and an advocacy for focusing stimulus spending on creating durable public infrastructure assets atleast now.



In some sense, it is a classic case of the two-handed economist at work, albeit with a time lag in the action of the two hands. The one hand which had considered, debated and opposed the same when the ARRA was being formulated now appears to have changed track and embraced infrastructure spending when the earlier assumptions were proved wrong.



As early as late 2008, when the ARRA was being conceptualized, there was an intense and often acrimonious debate about the nature of the stimulus. Conservatives, who even then opposed any fiscal action, were willing to go only as far as tax cuts. They had opposed it on the grounds that there was no shelf of "shovel ready" infrastructure projects and that such spending takes time before its shows any stimulus effect on the economy. Marginal Revolution itself had directly posted and linked to several such views. In contrast, liberal economists like Paul Krugman, Mark Thoma and Brad DeLong felt that the recession was likely to persist for long and therefore preferred direct spending in infrastructure assets.



From hindsight, even the most conservative of economists would admit that the best course of fiscal policy action in late 2008 would have been to spend money on public infrastructure creation. The ultra-low interest rates, now certain to persist well into 2013 and atleast for a couple of years beyond that, would have provided unbelievably cheap financing for atleast 7-8 years. If in 2006, Congressmen and academics had been offered the prospect of accessing interest free loan for 8-10 years to repair America's battered infrastructure, many of them would have readily grabbed that opportunity. In fact, even the China-bashing Americans would have derived some vicarious pleasure from the realization that China was subsidizing America's infrastructure creation by offering virtually interest free loans!



In fact, Tyler's invocation of Reinhart-Rogoff now to fortify his argument about the pernicious nature of deleveraging recessions, appears to be a case of "what is sauce for the goose (is not) sauce for the gander"! Interestingly, Messers Krugman and Co had then invoked precisely the same duo to base their claim for infrastructure spending based stimulus. They had argued, based on the substantial body of empirical evidence presented by Reinhart-Rogoff about the average lengths of banking crisis induced recessions, that the Great Recession was likely to be a long drawn out one and therefore there was enough time for infrastructure spending to be effective.



The ideal course of action in late 2008 would have been to adopt a two-pronged approach, one which many of the aforementioned liberal/Keynesian economists did advocate, involving long-term stimulus on infrastructure creation and automatic stabilizers like unemployment insurance and food stamps to cushion the worst hit by the recession. Any tax cuts and other stimulus spending would have been an additional bonus.



I am inclined to believe that the impact of such spending on the economy as a whole would have been positive in many dimensions. Apart from the fact that it would have repaired or replaced the country's battered infrastructure, it would also have generated a significant multiplier on the economy on many fronts. It would have brought to work idle resources, encouraged businesses to not postpone investments, spurred market confidence (yes, the "confidence fairy"!) in the long-term health of the country, and so on. Given the fact that these investments were in any case necessary, one would also have to add the opportunity cost benefits of the ultra-low interest rates to calculate the multiplier.



In view of all the aforementioned, the final paragraph to Tyler's post is a sad commentary of the dark age of macroeconomics,

"Oddly, there is not much discussion about the length of fiscal stimulus. But there should be."

PS: I just did not have to energy to mine the numerous links in MR, and Krugman, Thoma and DeLong's blogs that contain the specific material from 2008-09 that I have alluded to in the post. I guess I am lazy! Anyways, interested readers could do so from here and here.

Automatic fiscal stabilizers and counter-cyclical fiscal policy

I have blogged extensively about the utility of fiscal policy in combating aggregate demand slumps, especially when the economy is facing the zero-bound in nominal interest rates.

However, unlike the more rules-based monetary policy, fiscal policy is subjective and deeply political. The classic fiscal policy alternatives like direct government spending on infrastructure face the problem of implementation lags. In contrast, automatic stabilizers kick-in immediately, being targeted on those most likely to spend any money provided to them. It no surprise that automatic stabilizers - unemployment insurance, food stamps etc - have among the highest fiscal multipliers.

The WSJ points to the apparent success of Sweden in managing its recovery from the Great Recession and attributes it to successful expansionary policies by both the government and the Riksbank. The Swedish economy grew 5.5% in 2010 and unemployment rate has fallen from its peak of 9% to 7%. Instead of high-profile direct spending and tax cuts, the Swedish government responded swiftly with automatic stabilizers to provide income, health care and other services to people who are unemployed. The Riksbank, initially lowered rates aggressively to zero, even taking it to minus 0.25% (savers had to pay 0.25% for the privilege of keeping deposits). Its quantitative easing program was more expansionary than even the Fed - the Riksbank's balance sheet was more than 25% of GDP in the summer of 2009, compared to 15% for the Fed.

Further, unlike many other developed economies, Sweden entered the recession in excellent fiscal health - its budget had a 3.6% of GDP surplus in 2007, to 3% deficit in the US. This gave the government enough cushion to indulge in extended fiscal expansion when recession struck. This was a result of a strong commitment, borne out of the bitter experience of its banking and economic crisis in early 1990s, to maintain a counter-cyclical fiscal policy.

Clice Crook points to the example of the US, where though the Obama administration came up with a large fiscal stimulus in 2009, mostly with tax cuts and direct spending, its impact was offset by the severe fiscal tightening by the local governments. He also writes about the relative lack of influence of fiscal stabilizers in the US,

"Two factors weaken automatic stabilizers in the US. First, the government is small, so economic fluctuations, other things being equal, move fiscal quantities less. Second, states are subject to balanced-budget rules. Much of the US government has to follow a pro-cyclical fiscal policy – cutting spending and raising taxes – during a recession."

The acrimonious debates surrounding fiscal expansion in the US underlines the need for a much greater role for automatic fiscal stabilizers. However, it is also important that these automatic stabilizers have automatic sunset clauses that ensure exit from fiscal expansion when the economy recovers. Mark Thoma makes an excellent case for greater use of automatic fiscal stabilizers during recessions.

In this context, Jeffrey Frankel, Carlos A. Vegh, and Guillermo Vuletin (pdf here) examined long-term fiscal policy in 94 countries (73 developing and 21 developed countries) over the 1960-2009 period and found that "the cyclicality of a country’s fiscal policy – a sign of its riskiness – is inversely correlated with the quality of the country’s institutions".

They examined the correlation between government spending and GDP for these countries over two periods, 1960-1999 and 1999-2009, and found a significant increase in countries with negative correlation (or counter-cyclical spending) over the two periods. In fact, among developing countries, those following counter-cyclical policies increased four-fold to 35% over the two periods. The graphic below indicates the correlation between spending and GDP for these countries in the 2000-09 period, with yellow and black bars representing developing and developed countries respectively.



The increase in counter-cyclicality in the conduct of fiscal policy by developing countries is evidence of greater maturity by policy makers and policy institutionalization in these countries. This maturity is corroborated by other indicators like reduced debt-to-GDP ratios in many developing countries. The authors "find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment". They highlight the success of Chile with counter-cyclical fiscal policy and attributes it to institutional strengthening reforms since 1980s.