Monday, March 26, 2012

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.

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