Following this post, James Bullard (President of the St. Louis Fed, and member of the FOMC - the US equivalent of the Monetary Policy Committee) kindly sent me his article (pdf) entitled ‘Death of a Theory’. As the theory he is referring to is the idea of fiscal stimulus at the Zero Lower Bound (ZLB), the title tells you that the article comes to the opposite conclusion to my post. His article is clearly written, and works with the New Keynesian framework which I also use. So we do not need to worry about those who practice the demand denial that Paul Krugman talks about here. I also think the article reflects the views of many economists. For these reasons, I thought it would be useful to say why I disagree with it.
Bullard gives three reasons why “Fiscal policy should return to being set for the medium and longer run.” They are that
(i) actual political systems are ill-suited to implement the advice from the theory
(ii) monetary stabilization policy has been quite effective [at the ZLB], making fiscal experiments redundant
(iii) governments pushed distortionary taxes into the future, which in the theory reduces or eliminates the desired effects.
Let me take each in reverse order.
The standard textbook countercyclical fiscal policy involves increasing government spending now, and financing this by raising taxes once the recession is over. I have argued before that this framing is unfortunate, because it is unnecessarily complex. We need to worry about the impact of future distortionary taxes on future output, and then compare these to the output gains during the recession. Instead I have argued that we should focus on what I call a ‘pure’ countercyclical increase in government spending, where the additional current spending today is financed by reduced spending (not higher taxes) in the future. Bringing forward public investment is the exemplar of such a policy, which is perhaps one reason why it commands such widespread support.
So criticism (iii) is specific to one particular form of countercyclical fiscal policy. Point (ii) is generic. However we need to be careful about what is being claimed here. Does ‘quite effective’ mean has some effect, or does it mean as effective as conventional policy? I agree with the former, but not the latter. Nor do not think Bullard tries to claim the latter. Yet the latter is what you need if you want to assert that fiscal policy is unnecessary, because fiscal policy is unnecessary only when it is dominated by monetary action. By dominated I mean that monetary policy can do everything that fiscal policy can do, but with more certainty and at less cost. I know of no reason why this should be true for unconventional monetary policy. As an example, in the Werning paper I discussed here, forward commitment monetary policy works best when it works with changes in government spending - it does not make fiscal action unnecessary.
But we do not need to get into theory here. We just need to look at what has happened since 2008, and what is still happening in the Eurozone. There are three possible explanations for the deep and prolonged recession:
a) Monetary policymakers have been particularly inept
b) Monetary policy makers have succeeded in finding the optimal combination of inflation and output, so the recession was just an unfortunate consequence of an inflationary shock
c) The ZLB has created limitations to what monetary policymakers can do
I do not agree with (a). I suspect the only people who believe (b) are central bankers.
I find the first of Bullard’s criticisms the most perplexing. There is a perfectly sensible argument which says that for fine tuning demand, monetary policy is more flexible than fiscal policy. I have no problem with this. However what we are talking about today is a very large and prolonged recession. The fiscal actions that are required are not fine tuning. Furthermore, in both the US and the UK we had in 2009 governments acting to implement countercyclical fiscal policies, and by most accounts these did indeed stimulate demand, although not by enough to end the recession. Now perhaps ‘ill-suited’ is code for ‘many politicians dislike this policy’. But if it is, then you do not talk about the ‘death of a theory’, but instead you discuss the political problems of implementing a theory.
To see why this distinction is so important, consider what has happened since 2010. We have had cuts in government spending in varying degrees across countries, and where the cuts have been largest, the recession has been more severe. That is the ‘dying theory’ working, and politicians for whatever reason choosing to go against it. What worries me about the ‘monetary policy is still all you need’ line is that (to put it most politely) it encourages these misguided policy actions. That is not good for most people in the economy, but it also does monetary policymakers no good either, because they promise too much.