Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 4 May 2013

Blanchard on Fiscal Policy

I was recently rather negative about the way the IMF frames the fiscal policy debate around the  right speed of consolidation. In my view this always prioritises long run debt control over fiscal stimulus at the zero lower bound (ZLB), and so starts us off on the wrong foot when thinking about the current conjuncture. Its the spirit of 2011 rather than the spirit of 2009.

Blanchard and Leigh have a recent Vox post, which allows me to make this point in perhaps a clearer way, and also to link it to a recent piece by David Romer. The Vox post is entitled “fiscal consolidation: at what speed”, but I want to suggest the rest of the article undermines the title. The first three sections are under the subtitle “Less now, more later”. They discuss the (now familiar from the IMF) argument that fiscal multipliers will be significantly larger in current circumstances, the point that output losses are more painful when output is low, and the dangers of hysteresis. I have no quarrel with anything written here, except the subtitle, of which more below.

A more interesting section is the one subtitled “More now, less later”. This section starts by noting that the textbook case for consolidation is that high debt crowds out productive capital and increases tax distortions. Yet these issues are not discussed further. The article does not say why, but the reason is pretty obvious. While both are long term concerns, they are not relevant at the ZLB.

Instead the section focuses on default, and multiple equilibria. After running through the standard De Grauwe argument, the text then says: “This probably exaggerates the role that central banks can play: Knowing whether the market indeed exhibits the good or the bad equilibrium, and what the interest rate associated with the good equilibrium might be is far from easy to assess, and the central bank may be reluctant to take what could be excessive risk onto its balance sheet.” This is more a description of ECB excuses before OMT than an argument.

More interesting is what comes next. Does default risk actually imply more austerity now, less later? I totally agree with the following: “The evidence shows that markets, to assess risk, look at much more than just current debt and deficits. In a word, they care about credibility.” “How best to achieve credibility? A medium-term plan is clearly important. So are fiscal rules, and, where needed, retirement and public health care reforms which reduce the growth rate of spending over time. The question, in our context, is whether frontloading increases credibility.”

So here we come to a critical point. Does more now, less later, actually increase the credibility of consolidation? If it does not, then the only argument for frontloading austerity disappears. The next paragraph discusses econometric evidence from the crisis, and concludes it is ambiguous. The whole rationale for more now, less later, is hanging by a thread. And there is just one paragraph left! Let me reproduce it in full.

“The econometric evidence is rough, however, and may not carry the argument. Adjustment fatigue and the limited ability of current governments to bind the hands of future governments are also relevant. Tough decisions may need to be taken before fatigue sets in. One must realise that, in many cases, the fiscal adjustment will have to continue well beyond the tenure of the current government. Still, these arguments support doing more now.”

Is this paragraph intentionally weak and contradictory? If credible fiscal adjustment requires consolidation by future governments, why does doing more now add to credibility? You could equally well argue that overdoing it now, because of the adverse reaction it creates (‘fatigue’ !?), turns future governments (and the electorate) away from consolidation, and so it is less credible.

So what we have is an article that appears to be a classic ‘on the one hand, on the other’ type, but is in fact a convincing argument for ‘less now, more later’. Perhaps that is intentional. But even if it is, I’m still unhappy. Although the arguments on multipliers, output gaps and hysteresis appear under the subtitle ‘less now, more later’, they in fact imply ‘stimulus now, consolidation later’, once you take the ZLB seriously. If you are walking along a path, and there is a snake blocking your way, you don’t react by walking towards it more slowly!

Why does this matter? Let me refer to recent comments David Romer made about the ‘Rethinking Macro’ IMF conference, which he suggests avoided the big questions. For example he notes “I heard virtually no discussion of larger changes to the fiscal framework.” He goes on (my italics)

“Another fiscal idea that has received little attention either at the conference or in the broader policy debate is the idea of fiscal rules or constraints. For example, one can imagine some type of constitutional rule or independent agency (or a combination, with a constitutional rule enforced by an independent agency) that requires highly responsible fiscal policy in good times, and provides a mechanism for fiscal stimulus in a downturn that is credibly temporary.”
As I argued here, it is not a matter of having a fiscal rule for consolidation that allows you to just ease up a bit at the ZLB. What we need is a rule that obliges governments to switch from consolidation to stimulus at or near the ZLB. Otherwise, the next time a large crisis hits (and Romer plausibly suggests that could be sooner rather than later), we will have to go through all of this stuff once again.


  1. When discussing default it is surely crucial to distinguish between Eurozone governments, where default is very plausible, and countries with sovereign currencies and floating exchange rates, where default is VERY unlikely since these countries can never be forced to default. It has to be a political decision.

  2. More stimulus now means more debt now. And should also mean less expenditure later and reduced (earlier higher) debt later.

    With the latter we have probably the main problem. More than half the Western world the latter is not really credible.
    Markets simply donot believe that higher say Italian or French spending now means later a higher reduction. Probably with as main reason (calculated guess) that structural changes of unaffordable measures simply are postponed as much as possible for basically political/electoral reasons.
    Maybe bondmarkets give another impression, however unlike most CBankers seem to think real new investments are hardly taken place. Long term illiquid investment, is the proof of the pudding, not bubbling exchanges (short term) as what we see now.
    It is all financial investments which can basically even for huge investors be disposed off in a few weeks unlike real investments.

    From the other side debt levels look to be coming in critical areas for a lot of countries. Meaning that at last it creates medium term say 5-10 years more risk. If marketconceptions change before debt is repayed and/or reduced otherwise you have a problem.
    If there is another considerable size shock event (bank collapse; new worldwide recession things like that) only a few countries are able to take another 20,30,40% of GDP hit.
    Simply a difficult balancing act and one different from country to country.

    Clinton got away with it. Probably as the plan looked credible at that time and because of the special status of the US. Doubtful that will work now especially for say Southern Europe.

    The US is probably in a lot better position to do a thing like that (or get away with it, which works similar) than most European countries. So I donot think there can be a general rule. Markets are very likely to react different to different countries.

    If you want money for stimulus (any stimulus of the present sort and magnitude) the plan has to be credible. Which means that it has to be credible that lateron cuts will be made and debt reduced. At this moment in a lot of countries this is simply not that way. So before there is a rule that extra stimulus will take place, another rule that assures repayment/debtreduction should be in place.

    We have to keep in mind that this is a roughly once in a century sort of crisis. It is good that we get some ideas how to react in future, but with setting future policies for the big one we should be very careful. Probably better that for 'normal' dips policies are in place.
    And furthermore that heavy unbalances are attacked and not with all sort of artificial stuff are sort of solved often by creating the next problem. Now we have ended up in a situation that there are several important imbalances of which the solutions available simply bite each other. Hard to see how uncompetitiveness can be solved by other ways than getting considerably cheaper (meaning lower wages, very likely
    lower GDP, and subsequently lower tax revenue and more expenditure in a welfarestate). And so there are several more.

    That people fear almost 6 year in the crisis that it has not been solved is a proper indication that the methods used are not very successful. A lot needs to be revised imho.
    Probably by labelling everything TBTF it takes too long till we get to the bottom of the crisis. Which most likely has led to changed investor behaviour from normally seeing a proper indication of an upturn as sufficient to first want to see hard evidence therof. With also as a big difference with the 30's that both resulted in getting factories etc. Closed (iso scaled down), but subsequent capacity increases took in the 30's place inside the own country (and now in China and India and Co, as most of the West is simply uncompetitive compared to EMs, while these now also present a growing market of considerable size).

  3. Instead of viewing government debt as a burden on the private sector it should be viewed for what it really represents. It represents the accumulate net savings of the private sector. It would be more accurate to term government debt private sector savings kept in the most secure place available to any saver. There is no reason why this 'debt' even needs to be paid back, just as there is no need for a commercial bank to pay back all its depositors simultaneously. We don't call our deposits and commercial banks 'bank debt' or consider them to by onerous debts that we will eventually have to pay back. Why do we do this for our deposits held by the government?

  4. To tag on to Romer's comment, the problem of the European "Stability" Pact is that it not only does not allow for fiscal stimulus in a downturn (credibly temporary or not), but it also does not require responsible fiscal policy in good times, because in good times 3% is not any constraint, while in bad times it's a constraint when there shouldn't be one. So it's not just a bad stability pact, it's the complete opposite of a stability pact. Of course we now see in real time how much of an instability (not to mention incredible, or should I say uncredible) pact this is.

    1. Just depends what your definition of stability is.
      The 3% is put in there mainly not to endanger other countries and the system as a whole (basically as an nextension of the no-bail out thingy).
      Problem is and remains that more than half the countries simply cannot be trusted with rules like you implicitly propose. There would be 80% of the time downturn and 10-15% adjustment from downturn.

      Anyway it will in practice only be possible to solve the stability in Macro sense if a proper solution is found for the stability in bail out sense. It is hard to see the new Maastricht criteria work in latter respect. So we are still far from a solution that actually might work.

      Btw as far as I know a seperate country could form a fund in good times to use in a downturn. If I am not mistaken now there are explicitly mentioned exception possible.

      That before and likely in the future a lot of countries still simply do what they like is another issue.

      Anyway a more structural comment in Macro folks dealing with what are effectively legal systems (and often political ones if you give politics one finger). Basically you havenot got a clue how to set up such a thing. Not that the EU folks were really much better in that respect.
      You are looking at a system that is almost certain to be massively abused. History shows that and (sort of) sciences dealing with the subject matter clearly indicate that. Therefor here you really need enforcement and a proper one.

      For seperate countries you have mainly the problem that governments not look further than the next election. Some counter balancing features have to be brought into it to avoid that. But at least all proceeds and costs end up in one hand one country.

      With the EZ the latter is at least an as important issue. And as history shows enforcement doesnot work. Which creates a situation that if under pressure in most situations you have a problem. The only working enforcement tool is 'ESM and ECB'. In the way that countries that are in trouble can be more or less forced into good behaviour. However that already has clearly its political limitations.
      However the tools available also under the new set up do nothing to avoid that countries get into trouble. France simply avoids for political reasons reforms and again gets away with it.
      In general enforcement simply most of the time wil not work so that system will (longer run) not work.
      Which brings me back to my earlier point. You never get to a proper Macro stability rule if there is not a proper no bail out stability rule in place first. In practice that simply looks like a sort of pre-condition.

  5. There is a whapping great piece of false logic in IMF authors’ first sentence. They say “public debt is very high, and fiscal consolidation must take place.”

    The fact that something has recently expanded (or contracted) does not prove it is not at an optimum level.

    I’ll plough thru the rest of their article, but not to learn anything: it’ll be more with a view to having a laugh at two plonkers making fools of themselves.

    Incidentally Jonathan Portes has a similarly low opinion of the IMF. Though he uses more diplomatic language than I do. See:

    1. My quarrel is with the framing, which is essentially political. The quality of the empirical economic analysis done at the IMF is excellent - indeed I'm not sure where we would be without it over the last few years. Blanchard is one of our best macroeconomists. However opinions within the IMF are very diverse, as I have noted before (, and they also like to stay on side with governments. Pushing fiscal consolidation is its bread and butter. So framing policy in this way is quite understandable from their point of view, but that does not make it right.

  6. "If you are walking along a path, and there is a snake blocking your way, you don’t react by walking towards it more slowly!"

    Why not? Is it because I am Australian?

  7. I think this post is really excellent. I'd like to pile on a bit

    1)"could be excessive risk onto its [central bank] balance sheet."

    How could central bank balance sheet risk be excessive ? (answer far below).

    In general it seems to me that the effect of huge losses by the central bank is automatic stimulus both as the losses are hidden from non Ricardian agents and because this forces and irreverseable increase in the money supply (an entity can't retire liabilities without assets). Both strike me as good, indeed excellet, effects. It is conistently assumed that state entities (the Treasury too) should be risk averse. This is assumed also by people, such as Blanchard, who think automatic stabilizers are good. As far as I can tell, this is a logical contradiction.

    Now I do think that risk bearing by the central bank can possibly be bad policy. The reason is that bearing risk creates moral hazard. But this occurs when the central bank bears endogenous risk (which become certain losses not risk with enough moral hazard). It is not a statement about the amount of riks the central bank bears.

    2) Balanced budget spending increases stimulate. Blanchard and Leigh clearly have no argument against financing increased spending with temporarily high taxes on high incomes. The case against such taxes are that they reduce labour supply (not a problem right now) and discourage saving (a benefit right now).

    Deficit scolds who accept that Keynesian stimulus stimulates never mention balanced budget stimulus. This is additional evidence (as if such evidence is needed) that the "framing ... is essentially political"

    By the way, I had two paragraphs which tried to express "framing ... political" which I deleted after reading our host's 08:06 comment.
    I wish I could write well.


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