Fiscal Vs Monetary Policy

This (and the next) is a longish (and often rambling) post... an attempt at rehearsing the story so far in one of the most fascinating economics debates of our times! It is also an attempt at linking up the relevant sources, so as to serve as a resource for future reference. So, either skip this, or bear with me!

Whoever said economics is a dismal science and for ivory tower academicians, should themselves step out of their ivory towers and open their computers and follow some of the popular economics blogs on the Internet for a day or two! We are surely living in an age of real-time academic opinion-making, if not policy-making, in economics atleast!

Since economics became to be appreciated as a formal branch of the social sciences, macroeconomic policy making during economic crisis, has been one of the most contentious issues in the subject, so far not amenable to any settled, single and widely accepted theory. The present economic crisis has re-opened the debate with an intensity and spread rarely witnessed, thanks to the ability of blogs to let the top economists and the world engage in a series of fascinating, real-time debates (and happily there seems to be no dearth of willing volunteers!).

The debate essentially has two main plots - fiscal policy Vs monetary policy, and government spending Vs tax cuts. We will examine each of the two and also a few sub-plots. We will first cover the first one in this post and the second in the next post.

Fiscal Vs Monetary Policy

Even as the sub-prime mortgage bubble burst and the economic crisis dawned, the Central Banks across the world, after some initial hesitation, were quickly off the blocks and resorted to aggressive monetary policy actions - lowering rates to almost zero bound, direct cash injections into financial institutions, purchases of troubled or distressed assets, liquidity infusions through auctions and Central Bank lending windows, relaxation of collateral standards for lending, blanket insurance on deposits etc. In the US alone, the balance sheet of the Federal Reserve has burgeoned from $900 bn to nearly $3 trillion in the space of a few months.

However, all these have had limited effect in reining in the steep slide downwards. There are ofcourse, those who claim that without these aggressive monetary loosening, the results would have been worse still. Even if this is true (and it surely is), it is a small consolation. The apparent ineffectiveness of the monetary policy in preventing a slide into an economic recession, set in motion calls for a fiscal stimulus package to bail out the economy and its various sections.

Central to the debate on fiscal and monetary policies has been a 1994 NBER Working Paper by David and Christina Romer, which examined the evidence from post-war recessions and claimed that monetary policy appeared to be more influential in economic recoveries atleast in the initial stages. The authors' claim is based on the finding that Central Banks step in early and adequately with their rate cuts, whereas policy makers take time (often well past the trough) to cobble up a politically consensual fiscal policy which often ends up being too little too late. A discussion on the Romers' position is available here.

Apart from the views against fiscal policy expounded by the Romers, the other major arguements against the utility of fiscal stimuluses include its supposed inherent lags (often more than the duration of the recession), its allocative problem (the strong possibility of pork barrel and inefficient use), and its "crowding out" of private investments. Mark Thoma (here and here), Robert Skidelsky, and Paul Krugman have made persuasive cases against all these arguements.

There are very strong arguements against the contention that infrastructure projects suffer from implementation lag and hence public investments on infrastructure may not be money well spent. Since it has now become abundantly clear that the recession and the potential-output gap will persist well into the next decade, in addition to the "shovel-ready" projects, newer projects, which take time to come on-stream, also become effective stimulus options. Econbrowser has an excellent graphical illustration of this for the US economy.

Alan Blinder has one of the best articles against the blanket critics of discretionary fiscal policy. He makes the distinction between government interventions to stabilize the economy during normal and abnormal times. Whereas monetary policy is superior to fiscal policy under normal circumstances, fiscal policy assumes much greater significance during "occasional abnormal circumstances — such as when recessions are extremely long and/or extremely deep, when nominal interest rates approach zero, or when significant weakness in aggregate demand arises abruptly".

Mark Thoma, with a similar position as Alan Blinder, argues that macroeconomic policy effects are dependent on the state of the economy - monetary policy is much less effective in recessions than at full employment, and with fiscal policy it is vice-versa. He writes, "I have a J. of Econometrics paper that finds state dependency for monetary policy (it's much less effective in recessions than at full employment), and as I've noted here many times over the last few years, I believe fiscal policy is similarly dependent on the state of the economy, though I would expect - consistent with basic Keynesian theory - that the effects run in the opposite direction. That is, unlike monetary policy, fiscal policy is most likely to be effective when the economy is sputtering (one reason is that crowding out, the main factor that undercuts fiscal policy effectiveness, will be small or non-existent), and least effective at full employment."

The different fiscal policy prescriptions have been presented by IMF, Martin Feldstein, Paul Krugman. Economix blog of the NYT has this exhaustive list of fiscal stimulus policy proposals by a number of leading economists. It also has this list of opposing view against fiscal stimulus measures. Paul Krugman makes another excellent case in favour of expansionary fiscal policies.

Amidst all this, the old, debunked and forgotten "Treasury View", that "that nothing could boost employment: not government spending, not tax cuts, not private business decisions to expand their capacity, not irrational exuberance on the part of entrepreneurs - for the unemployment rate was what it was", also got dusted up from the woodworks by no less an economist than Eugene Fama. This view works on the same "crowding out" logic - Government spending doesn’t increase aggregate demand; it only transfers spending power from one party to another by borrowing from or taxing the public; the resultant government debt (or increased taxes) absorbs private and corporate savings, which means private investment goes down by the same amount. Similarly, stimulus by lower taxes leads to lower government revenues, and hence increased government borrowing.

Montagu Norman provided a clear and stinging burial by showing how Fama made a fundamental misinterpretation of the national income accounting equaltion. In this context, a more intutive explanation for Fama's contention that stimulus expenditures "displaces other current uses of the same funds", is two-fold
1. the "current users" are "under certain extraordinary circumstances" not willing to spend the savings pool available, in which case, the money gets merely saved, without contributing to expanding the aggregate demand
2. in any case, public goods will be under-supplied (or not supplied) by the private sector, and the government has to make the required investments in them. Therefore the "displacement", is only of that share of the savings that had to be displaced to make a normal economy function.

Actually, it was Caroline Baum who had invoked it earlier in the crisis, only to be put in its place by Paul Krugman. Mark Thoma too has an excellent explanation, using the parable of a town devastated by a windstorm.

The next post will explore the other important debate, that between two different fiscal policy options - government spending and tax cuts.

Update 1
Paul Krugman uses the zero-bound and the graphic below to claim that conventional monetary policy is useless, and the need of the hour is fiscal expansionary and unconventional monetary policies.



Update 2
A primer on monetary policy is available here (pdf here).

Update 3
Economix blog draws attention to a debate on health care spending as a fiscal stimulus. Casey Mulligan argues against it, while Lawrence Summers, Dean Baker and Raj Chetty favours the Keynesian perspective.

Update 4
John Cochrane follows his Chicago School colleague Eugene Fama in resurrecting the "Treasury View" (ie. stimulus plans do not add to current resources in use but just move resources from one use (private spending) to another (government spending)). Brad De Long and Paul Krugman respond with exasperation. As Krugman says, the Savings=Investments accounting identity always holds, but "any discrepancy between desired savings and desired investment causes something to happen - GDP to fall (or rise) - that brings the two in line".

Update 5
Robert Barro sees the decline in private spending during the World War II as evidence that government expenditure (on the war) "crowds out" private spending. Paul Krugman responded here and here. He writes, "there was a war on. Consumer goods were rationed; people were urged to restrain their spending to make resources available for the war effort."

Update 6
Martin Feldstein is the most prominent conservative economist to support fiscal stimulus, saying that the current recession is much deeper than and different from previous downturns.

Update 7
Megan McArdle debates the stimulus options.

Update 8
NYT has this excellent article on the Japanese fiscal stimulus spending, espcially on public infrastructure, which saw Japan spend $6.3 trillion on construction-related public investment between 1991 and September 2008 ($2.1 trillion on public works between 1991-95 in the early part of the recovery, which led to growth touching 3% in 1996, before premature spending cuts and tax increases snuffed out growth), leading to Japan amssing public debt equivalent to 180% of its $5.5 trillion economy.

Update 9
Eugene Fama and John Cochrane take on Krugman and De Long on fiscal stimulus. Kevin Murphy and Chicago economists discuss the fiscal stimulus.

Update 10
Gary Becker and Kevin Murphy feel that the multiplier from any direct spending fiscal stimulus could be small. They also feel there will be problems in rolling them back once the crisis is over and could lead to higher taxes in the future.

Update 11
Mark Thoma brilliantly demolishes the arguement that stimulus borrowings constitute inter-generational theft. But as he rightly says, it is beneficial only if the spending is on good and useful assets, instead of being wasted on pork. In other words, the returns from the assets created should be greater than the cost of the capital.

Update 12
Alan Auerbach has this working paper on designing fiscal policies. Martin Feldstein too writes on re-thinking the role of fiscal policy. Federic Mishkin on the utility of monetary policy, especially in the initial statges of a financial crisis in counter-acting adverse feed back loops.

Update 13
Christina Romer makes the case for fiscal stimulus here.

Update 14
Richard Clarida feels that fiscal stimuluses may be a case of little bang for lots of bucks. Brad De Long feels that we need not fear about large fiscal stimuluses despite genuine concerns about bottleneck-driven inflation, capital flight-driven inflation, crowding-out of investment spending, nor reaching the limits of debt capacity.

He writes, "In all of these cases, that the stimulus is going to go wrong becomes very visible in advance. If the stimulus is going to be ineffective because it generates bottleneck-driven inflation, we can identify that problem as the price or wage of the bottleneck good or service spikes. If the stimulus is going to fail because of capital flight-driven inflation, we will see the value of the dollar collapse as foreign-exchange speculators front-run the capital flight – and then we will see import prices spike and put upward pressure on prices in the rest of the economy. If the stimulus is going to fail by crowding out private investment, we first will see the medium-term corporate interest rates relevant to financing plant expansion spike. And if it is going to impose a crushing debt repayment burden, we will see long-term Treasury bond interest rates spike instead. Right now, however, we see none of these things. No signs of bottleneck-driven or wage-push inflation gathering force. No signs of approaching rapid dollar depreciation. No signs that the stimulus is pushing up medium-term interest rates on corporate borrowing. No signs that the stimulus is pushing up long-term interest rates on government bonds."

Update 15
Brad De Long outlines the four policy options when economies are faced with recessions - fiscal policy, credit policy, monetary policy, and inflation.

Update 16 (21/3/2010)

Laurence S. Seidman and Kenneth A. Lewis finds, in the context of the stimulus spending during the Great Recession in the US, that fiscal stimulus effectively mitigates the recession and that debt as a percentage of GDP is only slightly greater with the fiscal stimulus than it would be without the stimulus.

Update 17 (27/7/2010)

Greg Mankiw has this essay examining the challenge government economists face during recessions in deciding policy - fiscal or monetary - responses. Free Exchange tries to explian the conditions when fiscal stimulus works.