Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 29 January 2012

Annoying Anti-Stimulus Arguments: Numbers 1 and 2

Unfortunately this may be the beginning of a series. I will try and keep it short and to the point. I will also avoid mentioning anyone in particular who has made these arguments – you know who you are! These arguments are annoying because they keep being made, despite the fact that they have shown to be inadequate over and over again.

No. 1   Arguments that ignore the zero lower bound for interest rates.

                There are good arguments for saying that if monetary policy is free to do its job, then countercyclical fiscal policy is both unnecessary and welfare reducing. I have written on the subject. But having written those papers, I could see immediately the importance of that proviso about monetary policy. At the zero lower bound for interest rates (in a liquidity trap), monetary policy is clearly not free to do its job, and so different conclusions apply. See Eggertson and Woodford (2004). If the argument assumes that, despite the zero bound, monetary policy can do all that is required, then this should be said so explicitly, because it is somewhat counterfactual.
                For exactly the same reasons, these arguments against countercyclical fiscal policy do not apply to individual countries in a monetary union. If monetary policy is set by the ECB, it cannot ensure output is at its natural level (‘full employment’) in each individual Eurozone country. There is a large literature on this, which I have contributed to, but a standard reference would be Gali and Monacelli (2008). There, as in most of this literature, countercyclical fiscal policy in the face of country specific shocks is welfare improving.

No.2    Arguments that say stimulus is just Econ 101, and the profession has moved on.

                I have in the past been very critical of the gap between undergraduate teaching in macro and teaching at masters/PhD level. I think it is quite wrong to teach things to undergraduates that we then tell graduate students are incorrect. But the analysis of fiscal stimulus is not one of these. I know this because my work on fiscal policy uses microfounded New Keynesian models of the type Woodford and others analyse. It is not the same as old fashioned Keynesian analysis, but it can give similar answers for similar reasons. I gave an example here.
                So when I teach Keynesian theory to undergraduates, I am not thinking ‘this is nonsense, as they may find out when they are older’. I’m teaching them simple, non-microfounded models that are a rough approximation to many more advanced, microfounded models. If the argument is that these approximations do not hold in the case of fiscal stimulus, then the argument should be explicit about why. It is just not good enough to say we have better models now, without saying what those models are, and why they make a difference. 
If the argument is that New Keynesian models are wrong, say so, and say why. If the argument is that New Keynesian models would give different answers to Econ 101 reasoning, be specific about which models, and say why they give different answers. If the argument is that state of the art New Keynesian analysis does not support fiscal stimulus at a zero lower bound, then it is simply false: again, see Eggertson and Woodford (2004).


  1. I think it's only fair to include a few annoying pro-stimulus arguments. The first is a corollary to No. 1:

    A) Arguments that invoke the zero lower bound but that ignore inflation.

    Unlike in the US and most of Europe, inflation in the UK has been well above target for the past couple of years (and generally higher than BoE forecasts) so it's not obvious that the ZLB is relevant. That is, it's not clear that the Bank would (or should) reduce interest rates even if it were possible.

    Another annoying pro-stimulus argument might be:

    B) Arguments that ignore the possibility that temporary fiscal stimulus leads to a permanent increase in government spending.

    As Milton Friedman said, "there's nothing so permanent as a temporary government program." Since 1997, we have seen a massive increase in government. If the government expands its activities in the form of stimulus, the likelihood is that it will find an excuse to keep spending after the recession. If people recognize this, the stimulus effect will be reduced. More importantly, it undermines the important task of reducing the size of government to a sensible level.

    Finally, how about:

    C) Pro-stimulus arguments that ignore the possibility of tax cuts.

    Assuming Ricardian equivalence is unlikely to hold (especially in the current circumstances) tax cuts can stimulate demand without the problems associated with increased spending (which also includes the lack of "shovel-ready projects, the possibilities for corruption etc.). In addition, well-chosen tax cuts can have supply-side incentive effects which provide a further boost to output.

    1. Item B above is a political argument. It says, essentially, that we cannot do here and now what needs to be done, because we are too weak or disfunctionally organized to do what will be necessary later. That may be true, but it does not undermine the economic model nor does it mitigate the unspeakable waste of a prolonged deep recession.

      Item A: Inflation within limits is salutary. The loss of real wealth in a recession (i.e. failure to produce real goods and services, and to employ our people at a rate approaching capacity) is certainly much worse than the distortions caused by a mild inflation. It is the universal way to de-leverage in a less destructive way than any achievable alternative.

      Item C: Your corruption objection simply argues for better supervision, it is not an argument for tax cuts over spending as stimulus. Besides, tax policy is just as prone to corruption. As for a lack of projects, this recession has been going on more than three years. It doesn't imply that we shouldn't use direct spending stimulus, it argues that we should get moving! If tax cuts are such an ideal stimulus, then the U.S. must be more stimulated than a teenaged boy on a nude beach.

    2. A assumes that people make purchasing decisions on the inflation rate rather than their available savings, plus their income, plus the availability of credit. I'm sure that there are some such economic actors, but they are extremely rare. Since inflation increases consumption, it makes sense to increase investment, so we would imagine supply siders would favor high inflation.

      B is a rather bizarre argument claiming that if any temporary thing could conceivably become permanent, then it must be avoided on those grounds alone, not on the benefits that might accrue from it. Thus, buying a house that would entail continuing maintenance payments would be an a priori bad decision, even though it might be the most cost effective means of obtaining shelter. Perhaps we should put term limits on articles of incorporation based on this argument.

      C is the usual tax cut fantasy stuff, arguing that giving Bill Gates an extra billion dollars will increase the number of take out burgers he eats for dinner. The last thirty years of reality have completely invalidated this. If tax cuts have some plus side, it is probably that they cure rift valley fever and economists enamored of them should start clinical trials ASAP.

  2. The zero nominal bound is an institutional fiction. It "exists" because central banks like to communicate their monetary policy stance by targeting some base rate or whatever. When that interest rate hits zero, the central bank can no longer communicate looser policy in those terms. But such interests rates were always a distraction. Nominal expenditure (i.e. aggregate demand) is a product of the supply of and demand for money. What the liquidity trap hypothesis implies is that when the targeted interest rate hits zero, any increase in the money supply will be exactly matched by an offsetting increase in money demand.

    There is a certain amount of truth to the liquidity trap hypothesis so long as the central bank limits itself to purchasing assets which are extremely close substitutes for money, e.g. short-term T-bills with a .2 percent interest rate. In that special case, something like a liquidity trap more or less prevails: the central bank can't communicate looser policy and its asset purchases are neutral toward nominal expenditure.

    The solution begins by communicating looser policy by a different metric, such as inflation or nominal GDP. (A 3 percent nominal GDP level target would be ideal, in my opinion). This would help decrease money demand today by creating expectations of higher nominal expenditure in the future. Then the central bank needs to begin purchasing assets which are not such close substitutes for money, because the sellers of those assets are less likely to just hoard the cash.

    Money is the medium of exchange. Its generally accepted in exchange even by people who have no desire for the money itself, because they expect that it can be readily exchanged for something they do want. The upshot is that central banks need to purchase assets from people who don't want to sit on larger cash balances, but only want money as a means to express their pent up demand for other goods and services.

    The lower nominal bound is only as constraining as central banks let it be.

  3. Hi Simon: I have a response for you:

    Wow! My post is very much in tune with both comments above.

  4. Can you please give us examples of fiscal stimulus that actually worked during recessions? I can't think of any off the top of my head. From this I mean the stimulus was used and then afterwards, it caused the economy to be "less bad" than predicted without the stimulus. Every example I can think of, the stimulus was used and then the economy became worse than the modelers predicted.

    1. Australia. China. Various Asian countries.

      And btw, 'From this I mean the stimulus was used and then afterwards, it caused the economy to be "less bad" than predicted without the stimulus. Every example I can think of, the stimulus was used and then the economy became worse than the modelers predicted.' seems unnecessarily restrictive to me. What if the demand shock was greater than anticipated, like the US and the UK?

      Remember, Krugman wrote that the stimulus was too small, it was big enough to stave off depression but not recession, and that the anti - stimulus advocates would then use this as an example of failure. He wrote this BEFORE the stimulus took effect.

  5. Isn't the real argument about how stimulus is implemented rather than if?

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