Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 10 May 2018

Fiscal policy remains in the stone age

Or maybe the middle ages, but certainly not anything more recent than the 1920s. Keynes advocated using fiscal expansion in what he called a liquidity trap in the 1930s. Nowadays we use a different terminology, and talk about the need for fiscal expansion when nominal interest rates are stuck at the Zero Lower Bound or Effective Lower Bound. (I slightly prefer the latter terminology because it is up to central banks to decide at what point reducing nominal interest rates further would be risky or counterproductive.) The logic is the same today as it was in the 1930s. When monetary policy loses its reliable and effective instrument to manage the economy, you need to bring in the next best reliable and effective instrument: fiscal policy.

The Eurozone as a whole is currently at the effective lower bound. Rates are just below zero and the ECB is creating money for large scale purchases of assets: a monetary policy instrument whose impact is much more uncertain than interest rate changes or fiscal policy changes (but certainly better than nothing). The reason monetary policy is at maximum stimulus setting is that Eurozone core inflation seems stuck at 1% or below. Time, clearly, for fiscal policy to start lending a hand with some fiscal stimulus.

Yet the goal of the new German Finance minister, from the supposedly left wing Social Democrats, is to achieve a budget surplus of 1%. To achieve that he is cutting public investment from 37.9 billion euros in the coming year to 33.5 billion euros by 2020. Yet German infrastructure, once world renowned, is falling apart. Its broadband connectivity could be greatly improved.

The macroeconomic case for a more expansionary German fiscal policy is overwhelming. Germany has a current account surplus of around 8% of GDP. There are some structural reasons why you might expect some current account surplus in Germany, but the IMF estimates that these structural factors account for less than half of the current surplus. It estimates that a third of the excess surplus is a result of an overly tight fiscal policy. As Guntram Wolff points out, the main counterpart to the surplus is saving by the corporate sector. Perhaps more public investment might encourage additional private investment.

But this is not another article about how Germany needs to expand to help the rest of the Eurozone. The problem, as Matthew Klein points out, is that the whole of the Eurozone is doing the same. In the area as a whole, the fiscal position is as tight as it was in the pre-crisis boom. Unemployment in the Eurozone is still too high. And the reason fiscal policy is too tight is that key Eurozone policymakers think that is the right thing to do. “The right deficit is zero” says the French finance minister. He goes on: “ Since France is not in an economic crisis, we need to have a balanced budget, so that we can afford a deficit in tougher times.” You hear the same in Germany: the economy is booming so we must have budget surpluses.

A booming economy is not one that is growing fast, but is one where the level of output and employment is above the level compatible with staying at target inflation. Measures of the output gap are only estimates of what that level is: underlying inflation is the ultimate guide. Core inflation is well below target right now, which is why interest rates are at their effective lower bound. This is why the actions and rhetoric of most European (and UK) finance ministers are simply wrong.

You would think that causing a second recession after the one following the GFC would have been a wake up call for European finance ministers to learn some macroeconomics. (Yes, I know that the ECB raising rates in 2011 did not help, but I expect most macro models will tell you the collective fiscal contraction did most of the harm.) Yet what little learning there has been is not to make huge mistakes but only large ones: we should balance the budget when there is no crisis.

This is not a dispute between left and right as it is now in the UK, but a problem with the policy consensus in Europe. What we are seeing I suspect is a potent combination of two forces: a German obsession with balancing the budget which has it roots in currently dominant ordoliberal/neoliberal ideology, and Keynes famous practical men: advisers who learnt what economics they have in an era of the great moderation where the worst economic problem we had was relatively benign deficit bias. Fighting the last war and all that.


  1. The problem continues to be a fundamental misunderstanding of monetary/fiscal issues and macroeconomics as a whole. You Sir are what we call a Deficit Dove (like say Paul Krugman). You think deficits matter but only in boom times. The truth is deficits and sovereign debt are never an issue with a sovereign that issues, borrows in, and floats its own currency (like the EU should be and the US and UK are). The sovereign debt shouldn't even be measured. Italy I'm told is still suffering from what? 40% unemployment? That's criminal. The solution is simple and straightforward and the Pup spells it out here:

    The Pup also goes on a rant regarding intergenerational equity regarding Federal Debt:

  2. So to summarize, Europe's elite might as well be replaced with Laurel, Hardy, the Marx Brothers and the Simpsons....:-)

    But it's even better across the Atlantic: the Republicans having complained 24/7 about the evils of the deficit for years (when a deficit was actually needed in order to deal with the recession) are now running a monster deficit just when it's not needed. I honestly couldn't make a bigger shambles of it if I tried.

  3. Excellent piece. Fully agree with the German and collective EZ perspective. But what about outliers like Greece, where the deficit bias was not so benign?

  4. "You hear the same in Germany: the economy is booming so we must have budget surpluses."

    One thing I think you perhaps understate is that, unlike the US and UK economies, there is much greater German government intervention in resource allocation - even if there are strict rules on fiscal balance and monetary growth. In particular there is a closer relationship between banks, firms, unions and governments, particular in relation to the financing of government capital expenditure, which is an important motivator of private capital expenditure. For these reasons applying a NAIRU type analysis to the German economy is probably inappropriate.

    Similarly with the high degree of government intervention in the economy - particularly in relation to resource allocation, and given its collective approach to decision making, it is wrong to consider this economy as neo-liberal. It is actually in many ways a very socialist system.

    Really, a good understanding of the German budgetary system (which I might also add is highly decentralised) and how government expenditure is financed is crucial, and I would argue far more helpful than the application of neo-classical models which will almost certainly mislead.

    A balanced budget maybe - but when you look at how this is financed, you will probably find it is actually quite expansionary.

    Some German German contributors would be helpful here in this discussion - ie ones who know the system well, not those who have just come back from years at MIT.


  5. I think the fiscal "rule" is only approximately correct. I think that fiscal policy should be "expansionary" when the effective public sector ("effective meaning central government and sub central units) has options for spending with NPV's greater than 0 with the costs and benefits of these opportunities evaluated at shadow prices and the discount rate being the borrowing rate for the horizon of the opportunity. In practice this will work out to the rule you suggest. When the borrowing rate is low because the central bank has reduced rates of various maturities in order to bring the price level UP to target and or resources are unemployed at their market prices (I assume a “dual mandate” for monetary policy) the public sector will be borrowing to finance investments in the positive NPV opportunities it faces. Conversely, when resources are fully employed and the central bank has raised rates to bring the price level DOWN to target the public sector will find many fewer opportunities with positive NPV and borrowing will fall, perhaps even becoming a surplus.


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