These are unique economic times. Ever since the global financial crisis that began in 2007/2008, economies in the western world have provided much food for thought for economists. Economies such as the US and UK have provided examples of economies recovering from housing bubbles and large build-up of private debt. The Eurozone has highlighted the pitfalls of rushing into a currency union. In term of monetary policy, the US, UK and even the EU, have hit the limits of conventional monetary policy and are now into untested waters.
It is in the context of this uniqueness that Brad DeLong and Larry Summers have modelled the efficacy of fiscal policy in a depressed economy. Currently in the US, the economy finds itself in a liquidity trap – a situation where interest rates are effectively at zero yet the economy is below it’s potential. Thus, conventional monetary policy is not an option to stimulate the economy back to its natural level of output.
Context is the key for fiscal stimulus
With the economy in this situation, the DeLong and Summers (hereafter D&S) provide a model that demonstrates the apparent self-financing of fiscal stimulus. The key point to understand is that the fiscal multiplier – how much of dollar of government spending is translated into as it circulates in the economy – is highly context dependent. When an economy is at full employment and its potential level of GDP, an extra dollar of government spending will most likely lead to crowding out of private spending, as it would raise interest rates. However, crucially, when the economy is far below potential, meaning the conspicuous absence of supply constraints, the fiscal multiplier would not be zero as in the previous situation, but it is likely to be significantly higher. High enough to be self-financing for the government in the future through increased revenue.
The model – how is self-financing achieved
From the D&S paper, a summary of the model is presented below:
A temporary increase in government spending boosts aggregate demand in a depressed economy via four effects:
The standard short term aggregate demand multiplier; Second, there are “hysteresis” effects: a depressed economy is one in which investment is low; in which the capital stock is growing slowly; and in which workers without employment are seeing their skills, their weak-tie networks they use to match themselves with vacancies in the labor market, and their morale decays. Third, financing the expansion of government purchases in the present period increases the national debt. The fourth effect is a knock-on consequence of the second. Higher future-period output from the smaller hysteresis shadow cast on the economy because expanded government purchases reduce the size of the present-period depression means that the taxes levied to finance baseline government programs and to amortize the pre-existing national debt bring in more revenue.
The fiscal multiplier
D&S state that fiscal policy is more potent when interest rates are constrained by the zero lower bound. Using the IS-MP framework advocated by David Romer, the authors reveal the importance of the monetary policy reaction function under these unique economic circumstances. In normal times, the MP curve would be just about vertical, as the monetary authority aims to maintains its credibility on price control, and thus would offset any fiscal expansion. With interest rates at the zero lower bound, and a commitment from the monetary authorities to hold interests rates low, this reaction function is downward sloping. Hence, when fiscal expansion is applied, the resulting impact on output is magnified due to the slope of this curve. The authors also cite the affects of fiscal expansion on inflation expectations, citing work by such economists as Paul Krugman, which also imply a fiscal multiplier above previous estimates. The authors conclude that the fiscal multiplier is likely to be larger than those estimated when the zero lower bound is not relevant.
D&S discuss the evidence that hysteresis affects output through both lost investment and a diminished labour market. In the US, there has been a sharp downturn in private investment which is casting a shadow on future output. This investment shortfall results in a lower rate of potential output. Even if investment returns to normal levels, the lost investment and it’s positive effects on the economy will not be recovered. The longer that fixed investment is depressed, the more long term damage that this is doing to future output.
The hysteresis effect on employment is via the transformation from cyclical to structural unemployment. This employment scarring occurs as workers that are unemployed start to lose their skills, confidence and contacts with the labour market. The longer this occurs, the more of these workers that are lost permanently from the workforce. This reduces potential output as it raises the natural level of unemployment that the economy oscillates around.
Interest rates and Growth
D&S question the efficacy of extraordinarily low rates on economic growth as a source of stimulus. This brings into question the primary use of monetary policy for economic stimulus. D&S point to the concerns of monetary stimulus for the distortion of the financial sector and possibility of asset bubbles. Finally, in a severely depressed economy, D&S conclude that expansionary fiscal policy is unlikely to be offset by monetary policy, which reduces the costs of fiscal stimulus.
One counter-argument that D&S present is the critique that temporary fiscal stimulus is likely to be quasi-permanent. They respond to this critique with considerable evidence. They refer to evidence of the 2009 Recovery Act, where most of the local and state support has already been withdrawn and Federal infrastructure spending is winding down. They do acknowledge that their work does not shed insight onto the issue of fiscal credibility and by way of example, how big a stimulus could be before credibility was lost. While this is difficult to test empirically, the authors note this as a needed area of future research.
In summary, the authors present a very convincing model and theoretical picture of how under certain conditions, government spending can be self-financing. This has major policy ramifications – for countries like the US that are struggling to maintain a recovery from the crisis, and even for the UK and the European Union, where austerity is taking place in a depressed economy. Perhaps the best evidence of this model in practice is that the European economies that have embarked on austerity are also having difficulty hitting their targets for the budget deficit. It seems they have overestimated the revenue that would be coming in. In other words, they have misinterpreted the current positions of their economies and the effects of government austerity on revenue.