A man for any season: Before it was about “expansionary austerity”. Now it´s convenient to call for “self-financing fiscal stimulus”

In a “Man for all seasons”, we get the story of Thomas More  who stood up to King Henry VIII when the King rejected the Roman Catholic Church to obtain a divorce and remarriage.

Now we have a duo – Larry Summers and Brad Delong – that “adapt” to the season at hand. In their just released paper – Fiscal Policy in a Depressed Economy – they say that in the “liquity trap” situation America is in today temporary stimulus “may actually be self-financing”.

Interestingly, when he was number two to Rubin (and later top Treasury honcho) during the Clinton Presidency (1993 – 2000), Larry Summers peddled “stimulative austerity”, the idea that to cut deficits would lower interest rates by enough to produce stronger growth.

“Stimulative austerity” worked wonders, but not by lowering long term real interest rates. The charts below shows that in early 1998 deficits turned into surpluses (at the time long term CBO long term projections had surpluses extending over the years). Note that deficit reduction/surplus generation came predominantly from a decrease in government expenditures. To Keynesians that should be contractionary, not expansionary.

But note that Summers saw increased growth conditioned on rates coming down. That excessive attention to the level of interest rates is, according to market monetarism precepts, highly misleading. So Summers had his “wish come true”, but not from the reasons he advanced.

In the background, both then and today, there lurks monetary policy. Again, according to market monetarists precepts, to gauge the so called “stance” of monetary policy look at market indicators. “Stimulative” monetary policy will be associated with rising (not falling) real interest rates and asset prices (stock prices, for example).

The next chart shows what was happening to those objects at the time Federal government surpluses became a fixture of the environment. Real rates quickly reversed and stock prices “flourished”.

The next chart shows the behavior of NGDP (nominal spending) relative to the trend path. At about the time the fiscal surplus showed up, nominal spending began to grow above trend, an almost sure fire way to gauge the stance of monetary policy. In fact, those years mark the one mistake (in my view) Alan Greenspan made during his long tenure, resulting in a period of instability within the “Great Moderation” (see here for a discussion).

You may think Summers got it right by advocating “stimulative austerity”. But his indicator variable – interest rates – moved in the “wrong” direction. Yes, you guessed, monetary policy did it! And it´s monetary policy that can turn things around today. So that´s where the advocates of fiscal stimulus should band together and stop wasting precious time.

Note that inflation stops falling, the natural result of an increase in productivity, as soon as monetary policy becomes “easy”. One could say that the Fed was being symmetrical, expanding MP because inflation was below “target”. But this episode just shows how misleading inflation targeting can be, especially when the economy is buffeted by (positive or negative) supply shocks. And unemployment falls well below the most liberal measure of the natural rate.

Observation: Summers and DeLongs idea of a “self-financing” deficit is not new. President Kennedy was strongly advocating tax cuts all the way from 1961 to his untimely death. The legislation was finally passed a few months after his assassination. From 1962:

“It is a paradoxical truth that tax rates are too high and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now … Cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus.”

– John F. Kennedy, Nov. 20, 1962, president’s news conference


De Long put up a comment to the effect I should have read the article. I think I read the relevant parts. Going to his site I found this succinct summary (see below). It says it all, in particular the first bullet point. If it´s because their argument applies ONLY as long as the monetary authority cannot or will not…, I would think the first best solution is not to bring in a different policy strategy, and one that has much against it, but instead “battle” for the Fed to carry out the stabilization mission.

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21 thoughts on “A man for any season: Before it was about “expansionary austerity”. Now it´s convenient to call for “self-financing fiscal stimulus”

  1. Greenspan overshot on NGDP starting in late 1998. Did Long-Term Capital and the impending Y2K bug cause the overshoot as is conventionally thought? Or did the FAVORABLE SUPPLY SHOCK of $10 oil in late 1998 lead the inflation targeters into a monetary orgy?

    • Steve All those factors played a role. But initially it was the productivity shock – a rise in productivity growth after 1995 – that brought inflation down AND growth up which got people (even Krugman) dizzy.

  2. You’ve gotta admit the euphemism “self-financing fiscal stimulus” is so clever that it sounds like something Wall St would think up.

    Maybe we should re-brand and bring back the “self-financing housing affordability loan”, i.e., a negative amortization adjustable rate mortgage? Where are your marketing people, Goldman Sachs?

  3. Benjamin said “Additionally, it seems to me Japan tried incredible amounts of fiscal stimulus, and it was all choked off by too-tight money. This suggests monetary policy trumps fiscal policy.”
    I can´t agree more with that. If Japan is not an excellent test of the misguided Fiscal policy -or policy mix-, I don´t know what is damned to be.
    Beside that, Krugman, in 1998, was a fervent defender of monetary policy and a critical on Fiscal one in Japan. He was really a Market Monetarist!
    Perhaps he should replenish this enormous black hole in his carrer
    I must say that I admire very much Krugman.

    • “Benjamin said “Additionally, it seems to me Japan tried incredible amounts of fiscal stimulus, and it was all choked off by too-tight money. This suggests monetary policy trumps fiscal policy.”
      I can´t agree more with that. If Japan is not an excellent test of the misguided Fiscal policy -or policy mix-, I don´t know what is damned to be.”

      I don’t know…yes, monetary can overwhelm fiscal…the central bank has the last word on interest rates, after all…but the idea that Japan went all-in on fiscal stimulus seems like an overstatement.

  4. “only as long as the monetary authority cannot or will not…”

    The cases of cannot or will not are completely different. Fiscal may help with cannot, but it can’t help with will not. In other words, fiscal can’t override monetary. It can be a “blank check” which makes monetary policy credible, but the economy will recover before the first dollar is spent (or invested as the case may be)…

  5. Pingback: A man for any season: Before it was about "expansionary austerity". Now it´s convenient to call for "self-financing fiscal stimulus" « Economics Info

  6. Great title–agree 100% with the political convenience at work in the recent DeLong & Summers paper (http://symmetrycapital.net/index.php/blog/2012/03/yoga-with-brad-and-larry/).

    But isn’t it possible that following 1971-73, “fiscal” and “monetary” became two sides of the same coin? Granted, there appear to be more legal and operational constraints on the fiscal side (hence monetary policy’s perceived ‘superiority’?). But Scott Fullwiler, among others, has shown how those constraints aren’t always what they seem:


    Both fiscal and monetary operations are the only possible unlimited source (i.e., ignoring net export revenues, which are finite) of *net* financial assets (i.e., no offsetting liability associated with the creation of a new unit of money or other sovereign liability). However, as Sumner points out, most conventional monetary policy operations do not add to net financial assets, e.g., an interest rate target is not additive, nor are repo operations. So as long as those remain the policy tools of choice, fiscal policy needs to assume the role that, for example, gold mines once did.

  7. If there is a liquidity trap, the central bank CANNOT carry out stabilization. You can battle all you want but still the central bank CANNOT carry out stabilization.

    And yes, all the evidence of the last four years indicates there is a liquid trap.

    • MkeC, I don’t consider myself a market monetarist, but it sure seems to me that a liquidity trap is entirely voluntary (i.e., self-imposed) for a sovereign issuer. Then again, I tend to conflate fiscal and monetary policy as two sides of the same coin, as noted above, due to the monopoly power of each (granted, on the fiscal side it works operationally thru the Fed, in the case of the U.S.) to add to net financial assets.

  8. Pingback: Banana republic watch-Economic News | Coffee At Joe's

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