Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 10 June 2014

Monetarist vs Fiscalist

Giles Wilkes (ex special advisor to Vince Cable, Business Secretary in the current UK government and LibDem) has a post that compares those he calls ‘fiscalists’ like myself and Jonathan Portes to market monetarists (MM). His post follows some comments and a post by Mark Sadowski responding to an earlier post of mine where Mark took exception to my saying “the major factor behind the second Eurozone recession is not [controversial] : contractionary fiscal policy”. You find much the same debate in this post by Scott Sumner, attacking (mainly) Paul Krugman.

I think Giles Wilkes gets a lot of things right, but I thought it might be useful to set out as clearly as I can how I see the nature of the disagreement. The first, and probably the most important, thing to say is that the disagreement is not about whether fiscal contraction is contractionary, if the monetary authority does nothing. (See, for example, Lars Christensen here.)That is actually what I meant with my statement about the Eurozone recession, which linked to a study that calculated the impact of austerity holding monetary policy ‘constant’. This is so important because, in their enthusiasm to denounce countercyclical fiscal policy, MM often give the impression of thinking otherwise.

The disagreement is over what monetary policy is capable of doing. The second thing to say is that this is all about the particular circumstances of the Zero Lower Bound (ZLB). I do not like the label fiscalist for this reason - it implies a belief that fiscal policy is always better than monetary policy as a means of stabilising the economy. (Giles Wilkes is not the first to use this term - see for example Cardiff Garcia, who includes more protagonists.) Now there may be some economists who think this, but I certainly do not, and nor I believe does Paul Krugman or Jonathan Portes. I described in this article what I called the consensus assignment: that monetary policy should look after stabilising aggregate demand and fiscal policy should be all about debt stabilisation, and there I described recent research (e.g.) which I think strongly supports this assignment. However there has always been a key caveat to that assignment - it does not apply at the ZLB.

Before talking about that, let me illustrate why language can confuse matters. Suppose we had fiscal austerity well away from the ZLB. Suppose further that for some reason the monetary authority did not take measures to offset the impact this had on aggregate demand, and there was a recession as a result. I suspect a MM would tend to say that this recession was caused by monetary policy, even though monetary policy had not ‘done anything’. (In this they follow in the tradition of that great monetarist, Milton Friedman, who liked to say that monetary policy caused the Great Depression.) The reason they would say that is not because fiscal policy has no effect, but because it is the duty of monetary policy to offset shocks like fiscal austerity. That is why fiscal policy multipliers should always be zero, because monetary policy should make them so. So Mark Sadowski got upset with my statement because in his view ECB policy failed to counteract the impact of Eurozone austerity, and could have done so, which meant the  recession in 2012/3 was down to monetary policy, not fiscal policy.

So we come to the heart of the disagreement - the ability of monetary policy to offset fiscal actions at the ZLB. This is all about the effectiveness of unconventional monetary policy (UMP), which is both Quantitative Easing and what I call forward commitment (promising positive output gaps in the future: see David Beckworth here). I do not want to go over these arguments again, partly because I have already written about them elsewhere (e.g. here, here and here). Instead I just want to make an observation about asymmetry.

Economists like Paul Krugman, Jonathan Portes and myself (and there are many others) do not argue against using UMP. Indeed PK pioneered the idea of forward commitment for Japan, and I have been as critical as anyone about ECB policy. We do not argue that fiscal policy will be so effective as to make unconventional monetary policy unnecessary, and so write countless posts criticising those promoting UCM. To take a specific example, I happen to think that the recent ECB moves will have less impact on the Eurozone than continuing fiscal austerity, but I do not say the ECB is wasting its time as a result. They should do more.   

I’m interested in this asymmetry, and where it comes from. Why do MM hate fiscal expansion at the ZLB so much? It could be ideological (see Noah Smith here), but I suspect something else matters. I think it has something to do with monetarism, by which I mean a belief that money is at the heart of issues to do with stabilisation and inflation. MM is not about controlling the money supply as monetarism originally was, but I think many other aspects of monetarism survive. My own view is more Wicksellian (or perhaps Woodfordian), whence the failure to be able to lower interest rates below zero naturally appears central. To those not trained as macroeconomists (and perhaps some that are) these sentences will appear mysterious, so if this idea survives comments I may come back to it later.   


  1. Excellent post. I share your views about MM's take on fiscal policy. The true fiscalists are the Modern Monetary Theoriest. They're the mirror image of the MMs: everything could and should be done via fiscal policy and they look askance at monetary policy.

    Maybe the market monetarists feel that those of us of the more eclectic consensus are letting central bankers off the hook? The MMTers go on about how the focus on monetary policy lets the fiscal authorities off the hook. Everyone should be on the hook!

    1. I agree with your claim that MMTers are the mirror image of MMers in that Scott Sumner throws hissy fits at the mention of MMT...:-) However, I don’t agree that MMTers are “true fiscalists”. I read and comment on several blogs per day written by self-confessed MMTers, and my impression is that they advocate COMBINING fiscal and monetary policy, rather than concentrating just on fiscal. That is, they claim that in a recession, government and central bank should simply create new money and spend it (and/or cut taxes).

    2. Yes I agree. They believe that "government-created" money should be allocated by the government whereas the MMs believe it should be allocated by the banks.

      The banks wouldn't have much to do in an MMT world, no?

    3. No, MMs claim the central bank should buy private sector held assets when stimulus is needed. So it’s the CENTRAL bank that “allocates” new money there.

      Re your point that banks would not have “much to do in an MMT world”, that’s correct, I think. I.e. commercial banks are not affected in the first instance given stimulus MMT style. That is stimulus initially goes to taxpayers (if stimulus takes the form of tax cuts) or to whoever receives public sector spending if stimulus takes the form of more public sector spending.

  2. Isn't this about the debate within political liberalism over the effectiveness of the Euro versus floating exchange rates?

    That was why the LibDems joined the coalition; and just as intellectual liberalism was watching the preventable (see Krugman in 1998 on the Euro's probable economic failure once its first recession comes) flaws within the project, political LibDems are left without their technocratic economic solution and stuck within the maws of political strife.

  3. MM arguments seem to involve many unconventional tools at the zero bound. Why do they not consider fiscal stimulus as simply another of those tools. This would be clearer in a world where the central bank was given the power to mandate the fiscal deficit number every year. Allocation of fiscal monies would still be the job of elected officials but budget caps hold and the ceiling is set by the central bank in a manner similar to their ability to set short term interest rates.

    In this world there is no doubt that full responsibility for setting demand is with the central bank. Hence in the real world the objection to fiscal stimulus by MM must be found in the separation of power issue. Maybe MM don't trust elected officials as a matter of principal or maybe they feel in the interaction between two independent bodies trying to increase demand is detrimental, maybe by diluting ultimate responsibility for the resulting mess.

  4. Some MMs do consider fiscal tools like helicopter drops tied to a NGDP level target.

  5. Simon, You ask “Why do MM hate fiscal expansion at the ZLB so much?” I’ve been similarly puzzled for some time. Though to be more accurate, I suggest MMers hate fiscal policy, full stop. I.e. it’s not just at ZLB that they hate it.

    I went through various MM arguments and tried to demolish them on my own blog here:

    Also, MM seems to claim that the big weakness in fiscal policy is that it is not good at fine tuning. E.g. see my discussion with Scott Summner here:

    Now that’s a fair enough claim if it’s backed up by decent evidence (e.g. to the effect that lags in the case of fiscal policy are longer or more uncertain than in the case of monetary policy). But MM devotes next to no effort to actually producing that evidence.

  6. It seems like you agree with the following proposition:
    (1) Away from the ZLB monetary policy can fully offset fiscal policy.
    But the ECB was never at the ZLB in 2011/2012. Going into the second recession its policy rate was 1%, and it hiked it to 1.5%. So even if I agreed that monetary policy is powerless at the ZLB, in the case of the EZ it was clearly a central banking failure.

    On the topic of QE, I think Japan is showing just how powerful it can be. Annualised growth of over 6% driven mainly by domestic demand. Anyone see that coming?

    The whole narrative of the crisis makes perfect sense if you assume Monetary policy is powerful. First the crises was precipitated by the worlds central banks tightening in response to an Oil Shock. This led to falling total spending, which compromised banks balance sheets by pushing up default rates. Then the worlds CB's dropped the ball by not loosening immediately. They were lured into inaction by the stability of inflation expectations, but that was really only measuring the markets belief that the Central Banks would intervene to hit their target. A think cannot be both a policy goal and an indicator of the stance of policy (A rewording of the Lucas Critique).

    Then the central banks that dramatically loosened policy, Fed, BOJ, BOE fostered a recovery through increased domestic demand. Although it took a little while, for which we can argue about the reasons, all three of those economies are on the mend with above trend growth, while the EZ has not even bottomed yet, at least if you measure the severity of recession by the size of departure from trend (which is what you should do - measuring the opportunity cost of poor policy).

    The ECB has also repeatedly muddied the waters by confusing credit policy with monetary policy.

    Regarding the debate, I think MM don't like the way that the fiscalists largely excuse Central Banks from responsibility, when they see them not only as the actors with the most freedom and highest obligation to respond, but also as one of the principal causes of the crisis. See for example, the graph of expected income growth here: which shows that Fed policy was putting downwards pressure on expected wages since 2004. This eventually had the obvious consequences for debtors ability to repay, and terminated in a debt crisis. The ECB is repeating the fed/BOE errors from 2004-2006 and fostering a sovereign debt crises through lowflation. Given the average maturity of government debt is quite high, changes in inflation are much more significant than changes in interest rates on the real debt burden. Since inflation affects the whole stock of existing debt, and interest rates only affect newly issued debt. So lowflation and zero wage growth will are driving the EZ towards another debt crisis, one which is still avertable with looser monetary policy.

  7. I don't think that MMs HATE fiscal expansion at the ZLB. Certainly not in the way that, say, Austrian School economists tend to hate any sort of stimulus under any circumstances. In fact, as far as things like bringing forward capital spending on things like roads and government buildings, it makes sense (from a public finance POV) to do this, because the best time to do that spending is when resources are cheap and interest rates are low.

    I think that the key cause of some of the tenor of the anti-fiscal stimulus language from MMs is the following: if you believe that fiscal stimulus is an inferior solution (due to cost issues, public choice issues etc.) and some group is very forthrightly arguing that fiscal stimulus is the only solution, and you disagree, then the temptation is to be very forthright in return. This is especially true if the debate is framed in terms of "(fiscal) stimulus vs. austerity", and our perspective almost always gets shoved aside for yet another rap battle between the Austerians and the Keynesians. If you're a voice in the wilderness, the temptation is to be a little uncivil.

    Furthermore, if you believe in monetary policy offset, fiscal stimulus (unsupported by the central bank) isn't a solution anyway. It's addressing the wrong problem, i.e. the problem is the central bank's behaviour. Of course, from a Keynesian perspective, the problem may well be the central bank wanting to do something but being unable for liquidity trap reasons.

    And there's still just some of the old power of the rhetoric, especially in the UK where "monetarist" can be used as a synonym for "Thatcherite" and "Keynesian" as a synonym for "social democrat". The big debates of yesteryear are over (the Keynesians won on money supply targeting and the instability of money demand, the monetarists won on the Phillips Curve and incomes policy) and the liquidity trap is one of the very few debates between the two macroeconomic schools that still has some practical importance.

    1. I think W Peden has it right. I have no fundamental objection to governments running deficits, even cyclically adjusted deficits, during a recession. Usually it will make sense for governments to do this anyway, regardless of any effect it might or might not have on aggregate demand. Tax-smoothing, or preponing government investment when real interest rates are low, etc., make sense.

      But I do not want to let central banks off the hook.

      If the central bank is targeting too low a level of aggregate demand, then fiscal policy won't help, because the central bank will offset it. And the central bank should be held responsible for targeting too low a level of aggregate demand.

      And the ZLB is only a constraint if you think of monetary policy as interest rate policy. That's the Neo-Wicksellian perspective.

      Take, for example, a standard model of a SOE. First solve that model assuming the central bank uses the nominal interest rate as its instrument to hit some AD target, with the nominal exchange rate being market-determined. Now solve the model assuming the central bank uses the nominal exchange rate as its instrument to hit the same AD target, with the nominal interest rate being market determined. An outside observer could not tell the difference between those two solutions. In both cases, if monetary policy is too tight the nominal interest rate will hit the ZLB. But in the second case the solution is obvious: just depreciate the nominal exchange rate and raise AD so that the equilibrium nominal interest rate rises above zero.

      The apparent inability to get up off the ZLB constraint is all in our (modeller's) heads!

      (It doesn't have to be the exchange rate. It could be the nominal price of gold, or the stock price index, or whatever.)

  8. Reading the Scott summer post he seems unwilling to accept that the ZLB is relevant before it is actually reached. If ECB rates are at 1 or 1.5 % he seems to feel that austerity can't matter. But clearly the ZLB matters as soon as it is binding - and is binding wherever zero rates would not equate AD with AS. The fact that the ECB has not until now actually put the pedal to the metal until now does not change the fact that it lost traction in around 2008 - the fact that it could have done more does not mean that if it had doen more it would have solved the situation

  9. Scott summer says

    "Unfortunately, the facts don't fit this interpretation. The euro zone was not at the zero bound even before they began raising interest rates in 2011. Thus it was the monetary policy tightening of 2011 that drove the eurozone into the double dip recession, not the fiscal austerity"

    but the conclusion does not follow form the facts - it is clear that the ECB ought to have lowered not raised rates - but the point is this - even if they had lowered rates to zero it would not have made up the demand shortfall - messing around with 1 or 2 % point rate changes would have helped if done correctly but would not have sufficed to make AD = AS. In this sense teh ZLB was binding and the fact that rates weren't at ZLB doesnt change that.

    the Japanese point in his post is weak too - all you need to assume is that productivity growth in Japan followed global trends or roughly so to get a large output gap

  10. My response is here:

  11. From Mark Sadowski's response:

    " Monetarists are genuinely interested in the consensus assignment of monetary policy, which is aggregate demand stabilization. Fiscalists show no interest at all in the consensus assignment of fiscal policy, which is debt stabilization."

    When the economy is depressed--which implies widespread human suffering--stimulating demand might be quite a bit more important than debt stabilization. Indeed the possibility exists that stimulating demand in a depressed economy is going to address debt *more effectively* over the long term.

    1. Yes, but that's like saying "Inserting this screw is really, really important, much more important than this nail over here (possibly so important that the nail is unnecessary), so I'm going to use my hammer on the screw, since the nail isn't important, even though I have a perfectly serviceable screwdriver."

    2. No, it isn't like that at all, though I can see how it might look like that to an ideologue.

    3. Apparently anyone who understands monetary offset is now an ideologue.

    4. Dave,

      Why aren't both fiscal & monetary policy appropriate means of regulating the economy? And why should we tolerate a depressed state of affairs with widespread unemployment?

      And further, do you accept the possibility that adding debt now--if it effectively stimulates demand--could improve long term fiscal outlook?

    5. Mattski,

      I can see how all this follows from your premises, but since MMs don't agree with all of those premises (in particular, the premise that fiscal policy has an essential role at the ZLB in stimulating demand) you can't understand MMs' conclusions without considering things from our perspective.

      That's Dave's point. The disagreement is NOT one of differing on relative importance. Also, your second question to Dave suggests that you haven't properly understood even the basics of the MM position.

    6. W. Peden,

      I guess I'd ask you to either a) give a brief explanation of why you think my terms are not valid or b) point me to what you consider to be a clear and cogent explanation of the MM position.


    7. Mattski,

      No problem. In fact, I can give links to several short explanations, plus several longer ones. From Scott Sumner- (Brief intro to NGDP targeting.) (Links to his views on a variety of issues.)

      David Beckworth has a lot of good links to his blog posts on the right-hand side of his blog, but here's one just on NGDP targeting-

      - and some videos with one/both of them-

  12. "fiscal policy should be all about debt stabilisation"

    What about private debt stabilization? When the government runs surpluses private leverage tends to increase.

    1. And how many countries that are at the ZLB are running surpluses?

      Also flows are not stocks. Aside from a few countries, most Western governments are net in debt to the global and domestic private sectors, primarily because their tax-raising power makes them attractive debtors. Whether "neither a borrower nor a lender be" is actually a good doctrine for public finance is a good question, of course, but I don't think we have to worry about governments having a POSITIVE net effect on private sector leverage.


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.