The economic crisis has initated an intense debate (Conservatives Vs Liberals, Monetarists Vs Keynesians) about whether monetary or fiscal policy are of greater significance during times of such turmoil. It has also re-kindled the old debate about the relative importance of the various fiscal policy options, especially the respective economic multipliers of tax cuts and government spending.
Mark Thoma and Robert Skidelsky weigh in on the importance of government spending led fiscal policy over tax cuts and monetary expansion. Paul Krugman writes that we have reached a world in which monetary policy, both in US and soon in Europe, has little or no traction, and therefore fiscal policy is the only option left. James Galbraith too appears to agree.
Greg Mankiw, invoking studies by Christina and David Romer, Bob Hall and Susan Woodward, and Valerie A Ramey, argues that the tax cuts offer a higher multiplier than government spending. He claims that unlike the later which works through increases in disposable income and consumption demand, the former also incentivizes more investment demand from businesses. However, Martin Feldstein, a doyen among conservative economists, broke ranks and declared that the $168 bn tax cut dominated US fiscal stimulus of February 2008 failed because people actually ended up saving and paying off debts instead of spending it on consumption.
Mark Thoma sums up the debate about the relative utilities of the various fiscal policy options, mainly between tax cuts and government spending. Catherine Rampell in the Economix blog of NYT has the recommendations of an exhaustive list of distinguished economists.
Marginal Revolution draws attention to a recent NBER paper by Andrew Mountford and Harald Uhlig which finds that of the three fiscal policy options - deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion - deficit financed tax cuts have the highest multiplier on the GDP. Free Exchange is not impressed and takes up issue here.
The always insightful Mark Thoma has an excellent parable explaining how fiscal policy works during economic downturns and depressions. The commonest criticism against fiscal policy that it crowds out private investment may not apply to downturns and depressions, since at such times there are idle resources that are involuntarily unemployed and private investors are in any case unwilling to make any additional investments. So Paul Krugman is spot on in claiming that normal rules do not apply when the world is in depression.
The most definitive proof that monetary policy can save the economy in times of economic slowdown comes from the present crisis. Unlike the Great Depression, nobody can accuse the Central Banks across the world, individually and collectively, of not doing enough and quickly at that. We have seen the Fed and others summon all the monetary policy levers - lower rates aggressively to the zero bound; capitalize banks and financial institutions with the most liberal terms; inject liquidity through their discount windows by relaxing all lending standards; act as a market maker of last resort by purchasing troubled assets and commercial papers; and provide blanket guarantees to deposits. The amounts involved have been mind boggling - more than $1.3 trillion in the US alone, and counting!
Apart from a few hours (in a few cases, a couple of days) of market rally, the financial markets and the economy appears to have hardly acknowledged these interventions. If anything, Central Banks, and not the Governments, have been the primary players in the drama so far.
However, despite the overwhelming proof, apologists of Monetarism, will surely claim that had the Central Banks not intervened so aggressively, the situation could have been much worse!
Gary Becker takes a historical perspective, of the past fifty years, and restrains any knee-jerk aggressive government regulatory interventions that may have adverse long term consequences.
Paul Krugman draws attention to the work of Adam Posen who finds evidence that the Japanese fiscal stimulus in 1995 did actually work and increase economic growth rate. However, Tyler Cowen debates the reliability of the Japanese example, given other factors involved.
Paul Krugman gets to the basics of Eco 101 in favour of stimulus in the form of infrastructure spending and providing public goods, as opposed to stimulus in the form of tax cuts. A marginal dollar spent on public goods is worth more than a marginal dollar spent on private consumption, because in any case these are goods that a functioning society and market requires and will be under-supplied by the private sector.
Bloomberg has this excellent article tracing the roots of the Monetarist take-over of economic policy making since the seventies. And Barry Ritholtz writes the obituary for Chicago School.
Paul Krugman uses numbers to prove that the multiplier is much higher for public spending, by way of the increase in taxes ploughed back to the economy. The net stimulus is therefore smaller, or there is more bang for the buck.
Daniel Gross sums up the debate between fiscal and monetary policy and favours using both in such extraordinary times.
Here is the famous NBER working paper of 1994, at the center of debate now, by David and Christina Romer that claims that in post-war recessions, monetary policy has been more effective in the early stage of recoveries. They write, "We find that the Federal Reserve typically responds to downturns with prompt and large reductions in interest rates. Discretionary fiscal policy, in contrast, rarely reacts before the trough in economic activity, and even then the responses are usually small. Simulations using multipliers from both simple regressions and a large macroeconomic model show that the interest rate falls account for nearly all of the above-average growth that occurs early in recoveries."
Eugene Fama opposes fiscal stimulus on grounds that government debt only transfers burden from one generation to another.
Brad Delong writes about the eclipse of the Chicago School.