The case for more stimulus

This is a long post... a sort of summary of the debate surrounding continuation of expansionary policies. With the US economy getting better much slower than required (especially to get normalcy restored in the job market), the debate about further expansionary stimulus measures has picked up.

The deficit hawks point to the burgeoning public debts and raise the spectre of sovereign defaults (made more salient by the problems facing the PIIGS in Europe) and unhinged inflationary expectations. They call for an immediate end to all stimulus spending and initiation of measures to rein back the deficits through spending cuts and interest rate increases to pre-empt inflation.

On the other side are those who point to the bitter decade-long experience of Japan with deflation and economic stagnation in the nineties, and caution against any premature exit from the expansionary stimulus policies of the last two years. They worry that the household and business balance sheets are so badly damaged and the unemployment rates too high that any fears of "crowding-out" of private investments and inflation are unfounded. They advocate continuation of the expansionary fiscal policies to boost aggregate demand and create jobs (and also prevent lay-offs) and further loosening of monetary policy to keep credit flowing, longer-term interest rates low, and even stoke some inflation. They point to the declining trend in prices and stable long-term bond yields to justify their claim.

However, the debate on the relative effectiveness of fiscal and monetary policies, continues to rage unabated. I have already blogged about the problems faced by monetary policy when facing the zero-bound in nominal interest rates. Economists like Joseph Gagnon, advocate further monetary easing in Japan, euro-zone and US through large purchases of long-term bonds (pdf here) by the central banks to reduce long-term interest rates. He points to the extremely anemic economic environment and the very low inflation rates in these countries to argue for such expansionary policies.

Unlike normal times, increasing the monetary base when faced with the zero-bound in nominal interest rates will have an expansionary impact only if "people believe it signals higher inflation later". However, as Mark Thoma writes, the Fed's carefully constructed, stellar inflation fighting reputation raises serious doubts on its credibility to commit itself to future inflation. People are most likely to think that the Fed will pull the levers at the first signs of inflation gathering steam. Politically too, the paranoia about inflation, active even when deflation is staring us, cannot be avoided when prices start to rise.

All this means that fiscal policy becomes the preferred option, especially when interest rates have lost traction. However, as Mark Thoma explains, during normal times, with both full-price adjustment classical models and sticky-price New Keynesian models and an inflation targeting central bank, fiscal policy generates multipliers less than one,

"When government spending goes up during normal times, inflation increases, and sharp increases in the real interest rate are needed to return inflation to its target value. The sharp increase in the real interest rate offsets the increase in output brought about by the increase in government spending, and this is what makes the multiplier small in this case. Under reasonable parametrizations, there "really isn’t much fiscal policy can do."

More particularly, with strict inflation targeting, the multiplier is less than one. When the Fed follows a Taylor rule instead of strict inflation targeting, the multiplier is larger, but still less than one (though not always, it could even be less than the multiplier for strict inflation targeting under some conditions). If monetary policy maintains a constant real rate instead of following a Taylor rule, the multiplier is equal to one. This means that during normal times, sticky price models predict fiscal policy multipliers of a magnitude less than or equal to one, with the exact magnitude depending upon the rule the Fed follows, i.e. how the real interest rate responds to fiscal policy changes."

However, as Micheal Woodford and others have found, things change when the interest rate is touching the zero-bound. As Mark Thoma writes, this happens because the expectations of increase in fiscal spending raises inflationary expectations and thereby lowers real interest rates,

"In general, at the zero bound fiscal policy multipliers are greater than one, and this remains true under strict inflation targeting... The larger multiplier occurs because the increase in government spending increases inflation (more precisely it reduces the rate of deflation). If the crisis is expected to last another period with some probability, as it will in the model, then government spending is expected to persist as well and expected inflation will rise. The increase in expected inflation lowers the real interest rate when the zero bound is a constraint (even with strict inflation targeting), and the lower real interest rate generates additional economic activity.

Note that the source of the increase in expected inflation is the expected increase in government spending in the next time period. All that's required for expected inflation to rise is that fiscal policy is expected to persist another period. However, the Fed won't do anything in response to the rise in inflation expectations because under the assumptions of the model the target interest rate remains negative."

The case in favor of fiscal policy (over monetary policy) is explored in detail with numerous links here and here. The IMF too recently examined the impacts of fiscal policy across economies, under various conditions, and came to favorable conclusions about the effectiveness of fiscal stimulus spending policies. The IMF's latest fiscal monitor too captures the favorable impact of the stimuluses.

Among fiscal policy options tax cuts and direct spending have been amongst the most popular. This is despite the fact that welfare spending through automatic stabilizers like food stamps, unemployment insurance, and nutritional support for children, may be more effective in containing the most debilitating effects of a recession. As the length of the slowdown increases and unemployment rates remain stubbornly high, assistance to state and local governments are fast emerging as an important source of fiscal policy intervention.

Mark Thoma points here and here to the problem posed by the deteriorating fiscal positions of state and local governments in the US that reflects in the rising job losses in those areas. The expansionary impact of federal fiscal stimulus is being countervailed by the contractionary impact of spending cuts by state and local governments.



In the search for swift-acting fiscal stimulus interventions with large multipliers (and socio-economic impact), assistance to state and local governments would surely be amongst the most effective.

And as Brad De Long writes, when faced with high unemployment rates, weak investment and spending environment, and anemic growth expectations, short-run deficits may be more expansionary and beneficial in the long run and belt tightening contractionary and harmful. In these times, he calls for prescriptions suited for "depression economics", wherein the beneficial effects of government spending and tax cuts will more than off-set the harmful effects of increased debt burden.

He compares the arithmetic of the relative costs of fiscal expansions during normal times and during the present times (where rules of "depression economics" applies) and finds that while "expansionary deficit-boosting fiscal policy is simply a non-starter in normal times", it generates "more income and employment now... in return for sacrificing only a tiny bit of production each year in the future, when we believe that we will be richer and will mind the reduction significantly less".

This is because, unlike normal times, more government spending now will not lead the Federal Reserve to raise interest rates to fight inflation, there is no "crowding out", boost to production (from a spending program) creates a substantial reflow in taxes that makes the spending program a bargain, and the government can borrow at "uniquely favorable terms" and thereby keep debt serrvice burdens manageable. His conclusion

"Each dollar of missing production and each unemployed worker right now is much, much more painful to the country and a much greater loss to human welfare than a dollar of missed production and an unemployed worker in normal times."

Tyler Cowen writes that reduction in real interest rates will not make much of a difference in investment decisions of businesses since the investment determining constraint is the "hurdle rate", which does not change by much despite the recession. He points to the fact that the "hurdle rate" in investments is in the range of 20-30% (to account for agency problems and related transaction costs) and therefore small reductions in interest rates have limited impact. In Econ 101 terms, real interest rates become a largely non-binding constraint since the elasticity of new projects to changes in real interest rates is very low (at the prevailing hurdle rates).

However, a logical extension of this line of arguement would mean that interest rates are always a non-binding constraint on investment decisions. Since the "hurdle rates" are in the range of 20-30% even during normal times, any small interest rate changes (and rate changes will always be small, a few tens of basis points, when compared to the "hurdle rate") will have no impact on the investment decision.

In another post, he also feels that the real issue is lack of trust, which has forced businesses to under-invest and households to under-spend. This lack of trust causes consumers, companies and financial firms to be more cautious than they’d otherwise be, and results in sub-par growth and occasional market frights. This is what economists like Robert Shiller have been pointing to for some time now, and what Keynes himself alluded to when he referred to the depressing role of "animal spirits".

And since the challenge is to get the "animal spirits" active and market-confidence restored, as is increasingly becoming evident (especially when faced with the zero-bound), aggressive fiscal policy interventions are required, irrespective of the what the short-run deficit. The alternative to this is the strong possibility of slipping ever deeper into recession and thereby increasing the costs (and deepening the fiscal strains) of recovery.

See also David Leonhardt here and here.