Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 27 July 2012

The macroeconomic magic button

In a recent post on the Eurozone, I talked about an idea from Greek economist Yanis Varoufakis, where he imagined leaders were presented with a magic button that would end their countries macroeconomic woes. He said that leaders in the US and UK would surely press the button, but he was doubtful about Germany. I commented as an aside that I thought he was wrong about the UK, because that button exists, and it is called balanced budget fiscal expansion. (I think he is right about the US, if the only hand needed to press the button was the President. However my arguments below probably also apply to many Republicans.)

The idea is to temporarily increase government spending, and pay for it completely by temporarily raising taxes. There is no increase in government budget deficits or debt. This may seem like giving with one hand and taking with the other, but it has the effect of raising demand, because some of the taxes come from reduced saving, rather than lower consumption. Once demand rises, incomes increase, and theory suggests that in a closed economy the multiplier would be one. (For those who want more detail, see here, and for specific past proposals to implement this policy, see here for the UK and here for the US.) The only argument I have seen that it would not raise demand is if all consumers believed the tax increase was permanent. That seems highly unlikely.

Of course many of us would argue that debt financed fiscal expansion is also a magic button, but many other people do genuinely worry about government debt. With the balanced budget button they do not have to.

I have heard people say that the balanced budget multiplier might be quite a lot less than one in an open economy like the UK. But this depends entirely on where the extra government spending goes. If it is all spent on goods or services produced in the UK, the multiplier is still one.

So why is the government not pushing this button? The answer is that I do not know for sure, because as far as I know they have not addressed this question. That in itself is quite revealing. The obvious thought is that no Chancellor likes raising taxes, but that alone cannot be a full answer, because this government has raised taxes.(1)

Imagine, if you can, that as a price of joining the coalition, the Liberal Democrats had insisted on having the post of Chancellor rather than deputy PM. Would the LibDem Chancellor not have pushed this magic button? The benefits are clear. The cost? Some short term political embarrassment perhaps in relaxing austerity that was before deemed unavoidable. But there is a perfect excuse – the Euro crisis. Unlike their Conservative partners, the LibDems would not be burdened with claiming that fiscal stimulus didn’t work when they were in opposition.

So I am left with only one plausible reason why the current Chancellor has not pushed the magic button and that is because he does not want to. Why? Well an obvious problem with balanced budget fiscal expansion is that it increases the size of the state. Even though it is only temporary, as a Conservative this is not something you want to do. In addition, if one of the ‘benefits’ of a debt crisis is that it gives you a pretext to shrink the size of the state, then undertaking balanced budget fiscal expansion stops that goal being achieved. You would, in this sense, be wasting a crisis.


I originally wrote this before the latest fall of 0.7% in second quarter GDP was announced. (Note for US readers, this is a quarter on previous quarter fall, not annualised!) When I saw the Chancellor talking about these figures, he was being filmed outside a government funded construction project, and I had the feeling he had been doing quite a lot of this recently. This was confirmed in this Stephanie Flanders piece. She notes that this particular construction project was agreed by his Labour predecessor, but then delayed by this Chancellor when he came into office. In addition, a major contributor to the recent GDP fall was construction, in large part because of a decline in public investment!

This reminded me of George Orwell's 1984, where he made famous the idea that the best way to disguise the true purpose of something was to call it the opposite, like the Ministry of Peace that wages perpetual war. Perhaps we are seeing the televisual equivalent. So do not be too surprised, if the UK economy carries on being this successful, to hear that the U.K. Treasury has been renamed the Ministry of Growth. 

(1) Recently the Chancellor has undertaken, with the Bank, various measures designed to stimulate private investment. These are welcome, although they are also generally consistent with the argument I'm making here. Although there may be doubts about some of these measures as an alternative to public investment, to the extent that the market for borrowing for private investment is currently distorted by excessive caution and the rebuilding of banks balance sheets, effective subsidies for borrowing make sense. However their uncertain overall impact means they are no magic button.


  1. There is a better magic button, it's called deficit spending with newly created money; no taxes, no debt. No country will press this button however, due to irrational fears of hyperinflation.

    1. This is a good question that I find insufficiently discussed by serious bloggers (our host or Paul Krugman for example).
      For example, I see two questions where I'm not sure of the answer:

      a) Is there a difference between QE and the central bank handing brand new cash to the government for its spending?
      In my intuitive understanding, there should no significant difference, or perhaps some marginal side effect on rates or anticipations.

      b) How much newly created money would be tolerable without waking up the spectrum of hyperinflation?
      It is difficult to imagine that doubling the money supply would not affect the price level for example, and I'm afraid that if you finance just a fraction of the deficit with new money, it does not take long for the money supply to explode.

    2. Ed Dolan has a post at Economonitor that might help with the answers to your question b. Among other things it shows that the US Fed has basically tripled the base money supply since 2008. We have not experienced hyperinflation or even moderately high inflation as a result of that.

    3. Zorblog,

      a, Yes there is a big difference. With QE there is no guarantee that the money will actually be spent and circulated in the economy. If the government is in charge, it will for sure. With central bank independence, this policy is not so straightforward though.

      b, I don't know. But certainly there is a fear that a sudden jump in the price level could have some non-negligible consequences. Inflating away 50% of pension funds might be a very bad thing.

      jbrown981 - Well, that's not an argument immune to the Lucas critique. Just because money expansion through QE doesn't raise inflation doesn't mean that monetizing debt won't. In fact, I would say that the absence of inflation is a sign that QE doesn't really work.

    4. Zorblog, You claim that the “print money and spend it” option has been “insufficiently discussed by serious bloggers”. Not true. Advocates of Modern Monetary Theory (myself included) have been advocating this remedy for YEARS.

      jbrown981, I suggest the trebling of the U.S. monetary base to which you refer does not help answer Zorblog’s question. That’s the question as to how inflationary the money created under the “print money and spend it” option would be. Reason is that the money created under the “print money and spend it” option is a NET INCREASE in the private sector’s net financial assets. In contrast, QE has a minimal effect on PSNFA.

      In plain English, you’d feel a lot richer if someone gave you £10,000 than if someone gave you £10,000 in exchange for your £10,000 car.

    5. Ralph and pontus- no disagreement here. Was just pointing out that even with a 3x expansion of the US monetary base there has been no accelerating inflation. I agree that that is evidence that QE does not really work. I would also say that it is evidence that banks do not lend out based on reserve balances and that the money multiplier theory of bank lending is wrong.

      pontus- I did not mean to imply that monetizing government debt could not cause inflation. Actually didn't mention that at all. Would be interested in your opinion as to what would have happened to inflation had the Fed monetized the 2012 federal budget deficit. Interested in Ralph's thoughts also. And of course, Professor Wren-Lewis's.

    6. jbrown981 - The fact that QE money are immediately being held as excess reserves does not, as you seem to think, provide "evidence that banks do not lend out based on reserve balances and that the money multiplier theory of bank lending is wrong."

      We're in a liquidity trap, and mainstream economics predicted exactly this. It's hard to overthrow a theory based on evidence which support that theory!

      To your question: One possibility is that this could actually have helped the situation. A little bit of inflation would lessen all the cash hoardings, and perhaps the wheels would start spinning again. A less optimistic scenario is that investors would cr*p their pants, the dollar and the stock market would fall to greek levels, and the world economy would be in deeper troubles then ever.

    7. pontus, thank you for your reply. As to your 'less optimistic scenario', I assume you are saying that investors, fearing a fall in the value of the dollar, would liquidate their stock holdings in order to buy foreign currencies or assets denominated in such? I would point out that this could have happened in response to quantitative easing as well. But in fact the opposite seemed to happen to the stock market.

    8. I'm pretty sure there are much better magical buttons out there ;)

  2. "The idea is to temporarily increase government spending, and pay for it completely by temporarily raising taxes."
    I haven't studied any economics since 1954, when Laurie Tarshis was department head. This was the minimum anti depression macro policy advocated at that time. Just goes to show ya how much macro has advanced since then.

  3. In this post you are wondering why an idea that for even orthodox(?) economic reasons could be pursued but isn't. Despite the fact that it is designed to placate those who "genuinely worry about government debt". You point out, very politely, that there may be ideological reasons why this policy, weak though it is (giving with one hand, taking with the other), is not being implemented.

    So now I think I see the real value of the orthodox economic analysis of the balanced budget fiscal expansion is. It is to expose the solely ideological basis for the objection to policy that might help people in this economy. This is excellent- it is great to win a debate using your opposition's own arguments against them! Having won that argument it might be time to advocate more truely effective policies.

  4. Just want to add that in the U.S. we don't have "temporary." Most spending the government enacts is sustained long after its time should have expired. Ditto with taxation. Income taxes were "temporary" to fund WWII but when Congress realized how much revenue they generated, the promise of "temporary" was conveniently forgotten.

    Good column!

  5. U.S. Income taxes became permanent with the 16th amendment in 1913. The country hadn't event entered WWI, let alone WWII. They were never intended to be temporary.

  6. Simon - great post. But I don't see why we need to scare the political horses by talking only about tax rises. As per the SMF plan, we can also cut low-multiplier transfers - particularly since these will need to be axed in the post 2015 spending round in any case.

  7. Increased taxes on the wealthy, an increased progressive tax rate, would be stimulatory.
    The wealthy save a higher proportion of their income, which, if taxed, would be spent by the government, and stimulate demand. I believe the multiplier to be greater than one. Demand must increase before investments will be made.

    This is not talked about because the wealthy, except for the marginal regions of the Internet, control the medium of discourse.

    They also largely control government, and will prevent any increase in their taxes from happening. They mistake money for power, to all our misfortune. They would rather have the citizens of the world in debt to them, than pay taxes. They would rather have power through coercion, than good will.

    1. "I believe the multiplier to be greater than one."

      If the tax is targeted to fall mostly on the nation's biggest savers (the Top 1%-5% of income earners), surely the multiplier would be much greater than one, since their marginal propensity to save is much greater than that of poorer folks who spend nearly all of their income.

    2. Yeah, and if richer people save more, where does that saving go?

      My biggest pet peeves with post-keynesian stuff is their failure to see that a spent or lent dollar is a dollar received by someone else.

      Arguing that a certain group has a "lower propensity to consume" says nothing in the aggregate. Either they lend that additional money out to someone else, or they invest it. Only in very precarious situations does that additional saving fall out of the system (in a liquidity trap).

      And arguing that a fall in nominal wages reduces demand is equally stupid. Lower wages means larger profits, and profits are income to entrepreneurs. The demand effect is unchanged. (unless, again, we're in a very particular situation).

  8. Prof Simon, You ask why government has not pressed the button. Part of the answer is fear of inflation, isn’t it? Another part of the answer is that the London based political elite would much rather channel stimulus money into the pockets of those they meet at cocktail parties (i.e banksters and holders of big chunks of government debt) than into the pockets of those ghastly people living on council estates in Northumberland. And the banksters spend £92m a year on lobbying amongst other things to make sure the money is channelled in the “right” direction. See:

  9. "The only argument I have seen that it would not raise demand is if all consumers believed the tax increase was permanent."

    I'm frankly surprised, Simon, that you and other progressive economists, like Paul Krugman, have accepted the assumptions underlying "consumption smoothing" with so few objections.

    Based on faulty assumptions regarding their "real wealth", some wealthy individuals might want to cut back significantly on current consumption in the face of a big tax increase in order to keep their lifetime savings at what they perceive to be a desirable level. But what about those who are not misled by such simplistic assumptions?

    If all rich people face the same permanent increase in their tax burden, then the prices of all those things the wealthy like to buy with their "extra income" (like luxuries/assets) would drop to levels that they could afford with their lower disposable incomes. Markets clear.

    Yachts and mansions and beach front property do not disappear. They would remain as available after the tax hike as they would following the tax hike. In a closed economy, the wealthy, as a class, would lose none of their purchasing power. The same number of luxuries/assets would be purchased, only at lower prices.

    (In an open economy, a tax could could theoretically be placed on foreign purchases of domestically-produced assets/luxuries, protecting the domestic purchasing power of the homeland's wealthy from the enhanced spending power of wealthy foreign consumers.)

    A permanent reduction in the disposable incomes of the wealthy through increased taxation would not necessarily deprive them of any significant reduction in the spending power of their lifetime savings, making a reduction in current consumption unnecessary, especially given the lower prices that could be expected.

    We may want to assume that representative agents are rational, but what about the irrational assumptions of individuals holding lots of nominal 'wealth?' They often think that certain tax policies would reduce their purchasing power significantly, even though they actually wouldn't, not in real terms.

    It's time we heard from some economists who recognize that the Permanent Income Hypothesis is pure rubbish.

  10. James, let me extend that argument for you so the die hard minnesotans will be proud of you:

    If all poor people face the same permanent increase in transfers [coming from taxing the rich], then the prices of all those things the poor like to buy with their "meagre income" (like basic necessities) would rise to levels that they could afford with their higher disposable incomes. Markets clear.

    Tin canned tuna, beans, and potatoes do not appear out of nothing. They would remain as scarcely after the transfer as they would before the transfer. In a closed economy, the poor, as a class, would gain none of their purchasing power. The same number of basic goods would be purchased, only at higher prices.

    A permanent rise in the disposable incomes of the poor through increased transfers would not necessarily provide them with any significant improvement in the spending power of their lifetime savings, making an increase in current consumption unnecessary, especially given the higher prices that could be expected.

    As freshwater as it gets!

    [I'm sure you don't buy into this story. So tell us why things are so different for the rich and their "luxury" goods. Why is the supply of filet mignons entirely price inelastic, while pork is infinitely elastic?]

    1. "If all poor people face the same permanent increase in transfers [coming from taxing the rich], then the prices of all those things the poor like to buy with their "meagre income" (like basic necessities) would rise to levels that they could afford with their higher disposable incomes. Markets clear."

      There is actually a scenario where that would be true---if the tax increase occurred in a full employment economy. But in an economy with vast unemployed resources, the money spent by the underclass would lead to new resources being allocated to provide for their increased expressed demand.

      By the way, if the tax revenue collected from the wealthy were spent by the government not on transfers, but on real economic investments, the net result is an increase in real economic growth.

      The most important difference for the rich and their luxury goods is that those goods are, by and large, 'permanently' scarce. (Which is why they seek them out.)

      Because the wealthy always possess the largest disposable incomes in the economy, the supply side is always doing everything in its power to increase supply, so no real gain in the supply of luxuries was realized here in the States due to the big tax cuts obtained for the wealthy by the Republicans and George Bush.

      Virtually all of the extra disposable dollars they received were burnt up in pure inflation in the asset and luxury markets, flooding banks with money that they they threw are risky lenders (risk supposedly minimized by CDO's) creating the RE bubble that crashed our economy.

      There are clear reasons why it doesn't work both ways in a depressed economy.

  11. James,

    That's a more nuanced view. However, while you're right that many luxury goods are "scarce", they are not scarce in the economic sense of the word. Gucci handbags etc. are produced in a limited quantity for the sole purpose of keeping them scarce. A fall in demand will still hit Gucci hard, and they might need to sack workers. Yachts and personal jets are instead scarce because they're so damn expensive. I've read several articles in the economists in which they show how learjet etc are currently on their knees. Luxury goods tend to be the first goods that people cut down on in a crisis. Sure, they can lower their prices to keep up demand, but so can all manufacturers -- luxury goods or not. And one could even make the case that luxury goods producers are less inclined to cut prices than others (as their whole raison d'etre is high prices). Then again, if all the "rich" were consuming was renaissance art (which is a commodity in fixed supply), then all variations would take place on the price margin, and non on the quantity margin. But that's a special case, i think.

    (and the big tax cuts you are talking about happened to coincide with an economy largely operating at full capacity. and as you say, in a full employment economy, a increase in demand is merely met by an increase in prices. but the situation is different now.)

  12. When economists make generalizations---like the 'Law of Demand'---it is always possible to identify some exceptions. We understand that these exceptions do not annihilate the value of the generalizations being made. So the question is whether or not the exceptions we identify are 'significant.'

    Conservative economists are forever celebrating certain exceptions that they think are terribly significant, like their notion that consumption smoothing 'could fully counteract' Samuelson's multiplier. (In spite of their failure to demonstrate it empirically.)

    In contrast, the generalizations I'm making---(1) that different income groups can and do experience different rates of inflation, and (2) that income tax cuts for the very wealthy do little more than set off a big round of inflation in the luxury and asset markets, at the expense of real economic growth---are supported by empirical evidence:

    Re: the specific exceptions you mentioned, I acknowledge that the sellers of luxuries will psychologically desire to not sell at a lower price, but there will simply not be enough disposable income in the domestic economy to support the higher prices.

    One by one, in the medium-run, they will concede to the reality of the marketplace and will focus on cutting costs. So yes, in the short-run, demand for many luxuries will drop sharply, but then it will gradually recover as prices drop to affordable levels, enough to clear the market.

    One development that is likely to shorten the mourning period of rich people who must pay higher tax rates is a significant increase in the sales of the companies they own, driven by government investments in infrastructure and 'human capital.'

    If the increase in government spending on investments is large enough, it would eliminate unemployment (both directly and through the multiplier) and increase sales. Prosperity has its own special way of counteracting self-pity.

    It might also help (1) if any significant tax increase for the wealthy is phased in gradually over a period of time, and (2) most economists assured the wealthy that their concerns re: lost purchasing power are almost entirely due to money illusion---they are actually richer, in real terms, than they were before they started paying higher taxes

  13. James,

    "different income groups can and do experience different rates of inflation"

    I do not disagree with that statement. And no economist would.

    "income tax cuts for the very wealthy do little more than set off a big round of inflation"

    Well, that is an empirical question. You switch back and forth between a die-hard neoclassical story in which supply is vertical for goods purchased by the rich, but horizontal for goods purchased by the poor. And I don't see much evidence here apart from bold statements like "they will concede to the reality of the marketplace and will focus on cutting costs". It sounds a bit like reverse engineering to me in which you tailor a story to get the outcome you desire.

    Maybe you're right, but maybe you're wrong. The graph from Forbes didn't tell me much (apart from the fact that prices for luxury goods didn't drop much in the crisis, but normal goods did. that's the opposite of your story)

    Given that premise, a reallocation from the rick to the poor will of course raise output.

  14. "...I don't see much evidence here..."

    You are quite right. My only purpose here has been to outline the theory and encourage others to consider it. I am not aware of any research being done to determine the accuracy of my assertions and I don't have the time right now to do it myself.

    What I am relying on in my efforts to persuade is a bit of logic applied to assumptions re: market behavior that most economists seem to embrace.

    I think it is fairly well understood that supply in a particular market is indeed vertical (or nearly vertical) if/when the marginal cost of committing additional resources to the supply effort begins to increase drastically (as in a war-time economy).

    When all available human resources are fully employed, the supply in almost all industries becomes much more vertical, compared to economically depressed times.

    But when an economic recession causes a big increase in unemployment, excess capacity in the industries that serve the unemployed starts to flatten the supply curve substantially.

    (The marginal cost of hiring unemployed people is cheaper than the cost of hiring someone away from a competing industry in a full-employment economy.)

    The key point I am trying to make is that the markets that serve the wealthy are a special case, in that they almost never experience excess capacity.

    Sure, in the short-run, events can scare the wealthy into suspending their purchases for a period of time, but it is still generally true that they always have all the money they need to outbid all other participants in the economy for the scarcest goods/services.

    Let's assume that at a given point in time, suppliers of luxuries are ALREADY doing everything in their power to bring additional luxury 'experiences' to market.

    If you then throw a bunch of money at rich people, is there any good reason for us to expect that the extra revenue suppliers would reap from sales (charging what the market will bear) would be used to increase supply, when the marginal cost of doing so is rather dear?

    Of course, if there was a lot of unused capacity in the luxury markets prior to the big cash giveaway, that would be a different matter, but how often do we ever see such a thing in the luxury/asset markets?

    And yes, I also admit to using neoclassical assumptions/arguments re: the behavior of markets and inflation to argue against their 'agenda.'

  15. What about crowding out? The inefficiency/bureaucracy of Government Spending? The impact on the financial markets and UK bond yields as investors lose confidence in UK debt as it is not being reduced? And how much of a tax raise are we talking about- won’t this push people into tax evasion/avoidance even if the tax increase is only temporary.

    To me, this 'balanced budget multiplier' seems far too theoretical with little application in real life.

    Comments would be welcome?


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