Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 26 January 2014

Bullard on the 'Death of a Theory'

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.


  1. On point (i), unfortunately Bullard does not go much beyond saying that the "rambunctious and contentitous" nature of US politics makes rising public spending and then cutting it back again again according to the demands of fiscal stimulus is not really a runner.

    However, we can guess at what he means, as lots of other people have said the same thing at greater length. In the country that invented the term "pork-barrel politics" turning the tap off, once turned on, is easier said than done (in China it would be much easier).

    Contrast the UK. If you look at the expenditure of every government since 1950 pretty much the same pattern is found. We get a fiscal stimulus according the political timetable, not the economic one. 2009, let it be noted, was the year before the election. Darling's plan for post 2010 was to cut investment spending. What Darling planned and what Osborne did (which is not the same as what Darling planned and what Osborne planned) were very similar. Cuts don't happen in election years.

    That does not mean that EZ austerity is not deeply stupid and counterproductive. Nor does it mean that we can't say that with hindsight Osborne's cuts in investment spending were not a mistake (they were, but not that significant in the greater scheme of things, the bigger factors were commodity prices and the EZ crisis). But it does mean that fiscal policy in a democracy is never going to nicely match on to the short term needs of fiscal stabilization. Because of that it needs to be very much a last resort, looked upon when done by politicians with a healthy amount of scepticism and the claims made for it not to be overstated.

    1. Re fiscal stimulus being determined by who wins the latest punch up in Congress between gangs of economic illiterates, that just underlines the wisdom of Positive Money’s system for determining fiscal and monetary stimulus. That is to have both determined by a committee of independent economists.

      As to purely political matters, like what proportion of GDP is allocated to public spending and how that is split as between defence, education, law enforcement, etc, Positive Money’s system leaves those political decisions entirely in the hands of politicians and the electorate.

    2. > That is to have both determined by a committee of independent economists.

      Alas, as we continue to see, there still appears to be a large number of 'independent' economists who believe that the most effective stimulus is to dramatically cut government spending on anything that benefits the bottom 90% of the income spectrum, preferably to zero.

      Do you have some insight as to how we would end up choosing economists who actually wanted the economy to recover, and to those who, assuming that they do want that, would be able to come up with a plan for that which does not involve the words 'and then the confidence fairy comes down and gives everybody a million dollars'?

  2. Bullard is not clear on what he means when talking about the kind of 'fine-tuned' policies that would be required to make fiscal policy effective. But I do agree that there are some real world restrictions which could cause stimulative fiscal policy to have serious negative consequences. Particularly, we need to emphasis that the spending is on infrastructure - it is a movement from future to current spending

  3. There is that paper 'The Fed’s Real Reaction Function: Monetary Policy, Inflation, Unemployment, Inequality – and Presidential Politics' (2007) by James K. Galbraith, Olivier Giovannoni, and Ann J. Russo which argues the Fed is biased towards the Republican Party.

    Stefan Collini has said of the UK that "since perhaps the 1970s, certainly the 1980s, official discourse has become increasingly colonised by an economistic idiom, which is derived not strictly from economic theory proper, but rather from the language of management schools, business consultants and financial journalism."

    It is a sorry state of affairs to think that many central bankers would find themselves since 2008 added to Collini's list.

    You can see what happens when the Labour Party proposes to raise the higher rate of income tax from 45/40p to 50p - do central bankers want to find themselves as part of that raucous collective?

    There is something of a self-fulfilling prophecy with central bankers who take political decisions to avoid their decisions becoming political - and the endpoint of their political behaviour is nationalisation.

  4. Whence the assumption (made by both Bullard and (I think) Prof. W-L) that taxes are “distortionary”? Obviously taxes CAN BE distortionary: e.g. a tax just on red cars. On the other a tax on everyone’s income would be pretty much distortion free.

    Second, Prof W-L’s idea that public investment should be boosted in a recession implies that public investment projects can be implemented quicker than private spending can be boosted.

    My hunch is that if household incomes are boosted today, you’d see at least an initial effect by this time next month. In contrast, it can take years to get public investment projects off the ground.

  5. On the one hand it's admirable of Bullard to engage bloggers and economists like Wren-Lewis and Tim Duy. On the other I disagree with what he says.

    In the U.S. the rightwing made fiscal policy actively harmful and tight in part by emphasizing deficits. The sequester hurt demand and in 2009-2010 the Federal govenment could have provided more aid to state governments which were forced to balance their budgets and lay off teachers and cops, etc. Obama's stimulus was essentially nullified by 50 little Hoovers. If fiscal policy had been better, the Federal Reserve might not have had to resort to unconventional monetary policy like QE.

  6. The Market Fiscalist26 January 2014 at 17:53

    I don't get iii) either.

    If the govt was committed to maintaining stable AD it could do by running a budget deficit (or surplus) of the appropriate size. As long as the govt successfully communicates to people that it will remain committed to this policy in the future there is no obvious reasons why people should fear that stimulus today will be matched by a tightening tomorrow beyond that which is justified by its stable AD policy..

    I do agree with Bullard though that politics and economic illiteracy render such a fiscal regime unworkable in current circumstances.

    1. I quite agree with your “there is no obvious reasons why people should fear..” point. In fact that’s what Keynes meant when he said “Look after unemployment and the budget looks after itself”. I.e. if the latter policy is adopted, there is no reason why fiscal stimulus today should be followed by raised taxes tomorrow unless inflation looked like becoming excessive.

      Or as MMTers keep saying, taxes do not fund government: they control inflation. (Of course MMTers are exaggerating to make a point there, but they do have a point).

  7. I'm going to focus on these two sentences:

    "However what we are talking about today is a very large and prolonged recession. The fiscal actions that are required are not fine tuning."

    What we have seen (some differences between the UK and US obviously) is a persistent drop below the post-WWII trend in real GDP, accompanied by a large drop in employment and labor force participation in the US. I think it's hard to argue that this is the result of a financial crisis shock (whatever that may be) propagated by a sticky price/sticky wage mechanism. But that seems to be the assumption you're making, when you call this a recession, and then jump to conclusions about what is "required." What is going on is puzzling. We have only scratched the surface in understanding the forces at work, let alone what policies might be able to do to solve whatever problem exists.

    1. I second that. Model uncertainty is a reason to limit the size of our actions as best we can. Since the effect of stimulus is to a large degree uncertain (in the Knightian sense), that's reason for caution.

      But I can't help thinking that the case for bringing infrastructure spending forward (i.e. repairing all our roads, which we're going to have to do eventually anyway) is just so strong that we clearly should just do it.

    2. Well said, Steve. And to Noah: Yes! I think that the infrastructure investment could be justified on standard NPV grounds -- I am puzzled as to why it is not getting done, especially when the finance costs are so low.

    3. I don’t understand the asymmetry between monetary and fiscal here. Monetary policy thinks we have a large demand led recession, so it has (incautiously?) embarked on extraordinary unconventional stimulus. But when it comes to fiscal policy, we (after 2009) start moving the instrument in the wrong way? I’m glad David agrees on infrastructure – but it is not getting done in part because too many economists like James Bullard say we should focus fiscal policy on the medium to long run, which means reducing deficits.

      I really think the profession has a phobia about countercyclical fiscal policy. Is it because the conventional assignment is so attractive, or because countercyclical fiscal policy is associated with the old Keynesian dinosaur?

    4. Simon asks why “the profession has a phobia about countercyclical fiscal policy.” My two cents (and I’m possibly just putting Simon’s point in different words) is that governments have a phobia about national debts. That’s thanks in part to Rogoff, Reinhart, the IMF and various other miscreants.

      Amongst the many mistakes made by the latter miscreants is that they haven’t tumbled to a point made by Keynes, namely that deficits do not necessarily result in higher debts: that is, deficits can be funded by borrowed money or printed money.

    5. In fairness, Stephen Williamson has been just as dubious about monetary policy as he is about fiscal policy. But I'm a bit surprised at Noah Smith settling down to be a young fogey. "We don't have good models, therefore we must not act" -- that's the "argument" in a nutshell. Part of the problem is that too many economists, for all their bragging about rigour, are unfamiliar with the notion of non sequitur.

      Keynes encountered this mentality and responded in style:

      "You must not press on with telephones or electricity, because this will raise the rate of interest."

      "You must not hasten with roads or housing, because this will use up opportunities for employment which we may need in later years."

      "You must not try to employ every one, because this will cause inflation."

      "You must not invest, because how can you know that it will pay?"

      "You must not do anything, because this will only mean that you can't do something else."

      "Safety First! The policy of maintaining a million unemployed has now been pursued for eight years without disaster. Why risk a change?"

      "We will not promise more than we can perform. We, therefore, promise nothing."

      This is what we are being fed with.

      They are slogans of depression and decay—the timidities and obstructions and stupidities of a sinking administrative vitality.

    6. Simon: I think it's two things. First of all, economists tend to trust the Fed to "take away the punch bowl" in good times more than they trust Congress to do so. Second, there's status quo bias: it's easy to define balanced budgets as "not doing anything", but no one knows what the natural interest rate is.

      Kevin: When you're playing with the livelihoods of millions, you better be a fogey of some sort! But I think the case for spending a bunch of money right now on infrastructure is a slam dunk, and it's kind of crazy that we haven't done it.

    7. Noah: I don't buy this. If the politics is the perceived problem, you do not write about why the economics does not work. In the past there were concerns about bias in monetary policy. The response was a huge research effort that looked at how to get round that. Yet the number of economists working on deficit bias is tiny. In addition, outside the Eurozone we are talking about exceptional circumstances here, not the routine use of fiscal stabilisation. Are the difficulties of reducing debt so large that they are worth enduring the costs of higher unemployment? Would economists also argue we should balance the budget during a war?

  8. "We don't have good models, therefore we must not act"

    Basically sums it up. The mentality of economists sometimes defies belief.

    Just imagine in foreign policy: we have a nuclear attack.

    "First we better consult our model first before we respond. What is the long run steady state?"

    Thank goodness in Political Science and International Relations they do not work this way.

  9. In the case of the ECB, a) is certainly a factor. Have you forgotten the rate hikes in 2010?

  10. "actual political systems are ill-suited to implement the advice from the theory"

    I think this is an overly cynical view of democracy. I think a lot of the problems come from the other side. If economists could make persuasive and empirically well-founded arguments and engage other sectors of society more instead of saying things like ("our optimisation models which assume "rational" agents say...") we might start getting somewhere.

  11. Not using fiscal policy is also a course of action, and its consequences seem all too predictable. The most important is the continuation of the highest rate of long-term unemployment in history.

    In view of this I think that the bias in the face on uncertainty should be towards action, not inaction. Talking about e.g. distortionary future taxes fails to account for the cost of the present situation, which I regard as altogether too distorted.

  12. Concerning options a) and c), how long has the ECB been at the ZLB?


  13. Theory imho works just fine in NORMAL cycle movements.
    In a crisis as the current one where there are all sorts of unbalances it might work or it might not work. That will depend on the influence of the other unbalances. In the present one it is not really working properly or has huge side effects. We have solved the bursting of 2007-8 bubble now effectively by creating another bubble in bonds en equities and blowing up the RRE bubble again. That is not really solving a problem.
    Problem is imho more that Macro is clearly not able to make the distinction between the two (normal and have substantial structural issues).

    Or in formulae if (eg) the 'givens' are actually givens or variables and if (via other unbalances) there are no loops.

    Big problem in the current discussion is imho that way too much this crisis is put in the standard models. You have now a lot of problems that simply donot occur everytime there is a dip.
    As well as modells are likely adjusted because of it. Partly ok as not all the structural issues will be solved and play in the next crisis as well, but however are not structural (structural become part of the model). Likely however also leading to adjustments on things that under 'non structural' circumstances just will work fine.

    Anyway this crisis looks more interesting for historians in 2050 or so than for a solution of the present thing. Things are moving politically in a certain direction (I often refer to it as 'the not really end of the not really austerity'). Margins to do things are very small (even if there would not have been a LZB issue).

    At the end of the road the final conclusion might be that some dips are simply necessary to get the sand out of the machine. Keeping all sorts of activities alive that under normal circumstances would have been stopped is likely one of the main causes of the present structural problem galore. Clearly politics both fiscal and monetary is not able to properly manage this process in another way. An interesting question would be how much dross stimulus and similar measures are keeping alive. Probably a lot half at least of the Southern Europen banking sector is dysfunctional and should have been closed, but except Cyprus we only have seen one larger (not even large) bank cleaned up.

  14. "I really think the profession has a phobia about countercyclical fiscal policy. Is it because the conventional assignment is so attractive, or because countercyclical fiscal policy is associated with the old Keynesian dinosaur?"

    I think one thing we often forget is that the profession is dominated by the US. And as much as macro-economists design models that abstract from context (as Skidelsky pointed out very well), the fact is, behind them is a political and ideological context.

    I remember studying an inter-country comparison of business cycles - kondratieff waves, kuznet swings - remember them? They got influential people from various countries (Japan, Germany, the US, France, etc) to explain national differences in business cycles. The reasons for national characteristics cycles - ie large variations, short or long variations, price rather than output variation - were put down to domestic, context specific reasons. In Japan it was sectoral terms of trade effects. In Germany a corporatist labour market adjustment mechanism. In the UK, it was because of "stop -go" macro policy.

    I suspect in the US fiscal policy, even if it has aimed to be counter-cyclical, for various political and institutional reasons ends up being pro-cyclical and has led to distortionary effects.

    Given that economics is more than ever a US-dominated profession - this has clouded the academic and policy debate everywhere.

  15. "I really think the profession has a phobia about countercyclical fiscal policy. Is it because the conventional assignment is so attractive, or because countercyclical fiscal policy is associated with the old Keynesian dinosaur?"

    Ideology. Mistrust of government runs deep in the US. It's connected to the American Dream. Macro-economists efforts to abstract theory from this are forlorn. Even some famous US economists simplistically associate fiscal policy and deficits with big government.

    Worse still are neoliberal positions that simplistically and ideologically associate free markets and limited government with individual rights and democracy.

    Historians (who do not work in economics departments) have also argued that the role of the state debate - made since classical English PE came about - has unnecessarily obscured our understanding of the reasons why Britain was the first country to industrialise.


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