On Fiscal policy and the ZLB (What´s he on about?)

A Mark Sadowski post

Evan Soltas writes on a theme that is much in vogue lately: “Fiscal Policy and the ZLB”:

I have been doing some reading for my undergraduate thesis, which looks at the role of credit-supply shocks in the Spain during its housing boom and bust, and I came across some interesting thoughts from Bob Hall. Commenting on research by Alan Auerbach and Yuriy Gorodnichenko, Hall makes some useful points that contradict a lot of the received wisdom about the efficacy of fiscal policy:

I conclude that the chapter uncovers a proposition of great importance in macroeconomics—that the response to government purchases is substantially greater in weak economies than in strong ones. The finding is a true challenge to current thinking. The first thing to clear away is that the finding has little to do with the current thought that the multiplier is much higher when the interest rate is at its lower bound of zero…Standard macro models have labor and product supply functions that are close to linear over the range of activity in the OECD post-1960 sample. The simple idea that output and employment are constrained at full employment is not reflected in any modern model that I know of. [Bolding is by me, not Hall.]

On the economics blogosphere, the “current thought” is also that, because monetary policy is in certain respects (that is, if only by social convention) constrained when the policy rate hits zero, fiscal policy becomes discontinuously powerful at the zero lower bound. Once the policy rate is a quarter of a percentage point, time to turn off fiscal policy, one might infer. Scott Sumner is one of the clearest and most persuasive exponents of this view—see here, for instance.

It turns out that the best evidence on fiscal policy does not support it. That conclusion is new to me, which is to say that I think I have written things that rely on that view, and I would now consider them to be wrong.


To be clear on what I mean here: First, it is a classic result that, when the efficacy of monetary policy is uncertain, it should not fully stabilize demand. Second, if the zero lower bound poses any restrictions on monetary policy, and it obviously does, if only in many indirect ways, then the appropriate amount of conservatism actually increases the risk of a future zero lower bound event rises, which is basically a function of the current policy rate. Fiscal multipliers are, as a result, well above zero when the policy rate is positive and decrease slowly and smoothly in the policy rate.

It makes sense if you think in terms of the fiscal multiplier being a measure of monetary policy incompetence. But just because monetary policymakers may be less than fully competent doesn’t mean that monetary policy is impotent.

Soltas’ reference to Scott Sumner needs explaining (perhaps even to Evan). When Scott says that the fiscal multiplier is zero above the zero lower bound he is not suggesting it is positive at the zero lower bound. Scott doesn’t believe in the liquidity trap, so when Scott says this what he is really saying is that even under the assumption of the existence of the liquidity trap, monetary policy makers should be held fully accountable for the level of nominal income away from the zero lower bound (as they clearly are now in the US). 

Seven years of US experience in steering nominal income without the use of the fed funds rate as the policy instrument should completely disabuse us of the existence of the liquidity trap. When you take into account the ability of monetary policy to offset fiscal policy, the fiscal multiplier is zero, even at the zero lower bound in interest rates.

The chart illustrates:

MS Comment

“Die Hard”

It´s not about Bruce Willis´ John McLane character but about the ZLB.


The International Monetary Fund, having just downgraded its forecast for global growth, warned the assembled G20 attendees that yet another downgrade was pending. Despite this, all that emerged from the meeting was an anodyne statement about pursuing structural reforms and avoiding beggar-thy-neighbour policies.

Once again, monetary policy was left – to use the now-familiar phrase – as the only game in town. Central banks have kept interest rates low for the better part of eight years. They have experimented with quantitative easing. In their latest contortion, they have moved real interest rates into negative territory.

The motivation is sound: someone needs to do something to keep the world economy afloat, and central banks are the only agents capable of acting. The problem is that monetary policy is approaching exhaustion. It is not clear that interest rates can be depressed much further.

The solution is straightforward. It is to fix the problem of deficient demand not by attempting to further loosen monetary conditions, but by boosting public spending.

Brad DeLong:

At the zero lower bound on safe nominal short-term interest rates, an expansionary fiscal policy impetus of d percent of current GDP will:

  1. raise current output by (μ)d,
  2. raise future output by (φμ)d, and
  3. raise the debt to GDP ratio by a proportional amount ΔD = (1 – μτ – μφ)d,

where μ is the Keynesian multiplier, τ is the tax rate, and φ is the hysteresis coefficient.

It will then require a commitment of (r-g)ΔD percent of future output the service the additional debt, where r is the real interest rate on government debt and g is the growth rate of the economy. The debt service can be raised through explicit and fiscal deadweight loss-inducing taxation, through inflation–a tax on outside money balances accompanied by disruption of the unit of account–or through financial repression–a tax on the banking system but also imposes financial distortions.

That is the simple arithmetic of expansionary fiscal policy in a liquidity trap.

The question of whether and how much expansionary fiscal policy a government facing a liquidity trap should engage and then becomes a technocratic one of calculating uncertain benefits and uncertain costs.

Larry Summers:

Today’s risks of embedded low inflation tilting towards deflation and of secular stagnation in output growth are at least as serious as the inflation problem of the 1970s. They too will require shifts in policy paradigms if they are to be resolved.

In all likelihood the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates and, in extremis, further experimentation with unconventional monetary policies.

Krugman (3 years ago):

I’ve often argued on this blog and in the column that now is a particularly bad time to cut spending, because unlike in normal times, the adverse effects on demand can’t be offset by cutting interest rates. One way to highlight the point is to compare where we are now with a historical episode: the fairly large cuts in federal purchases of goods and services that took place in the early 1990s, as the US military shrank with the end of the Cold War. Here’s federal consumption and investment spending as a share of potential GDP (blue, left scale) versus the Fed funds rate (red, right scale):

Die Hard_1

The Fed could and did cut rates, helping to cushion the impact of spending cuts. It can’t do anything like this now, because the Fed funds rate has already been cut more or less to zero in an attempt to fight the effects of financial crisis.

Austerity right now is a really, really bad idea.

They all “forget” that monetary policy is the “Bruce McLane” in this story. Larry Summers evokes monetary policy experimentation “in extremis”! But that´s the present situation, when everyone else has “given up” on it!

The charts below indicate, contra Krugman (and all ZLB advocates), that it was monetary policy as defined by NGDP growth, not interest rates, that allowed RGDP growth to come back robustly from the 1990/91 recession, even while government expenditures was being crushed.

Die Hard_2

At present, tight monetary policy (despite extremely low interest rates), even if accompanied by relatively (to the 1990s) high government expenditures, is what keeps real growth compressed!

Is “zero” an unavoidable magnet or sign of Central Bank incompetence?

Matt O´Brien has a wonderful post – The Federal Reserve is trying to do what nobody else has been able to do – which opens with this picture:

Zero Attractor

And writes:

But wait, why is raising rates from zero so difficult? It seems like you should just be able to … raise them from zero. Well, there are two problems with that. The first is that an economy that needs zero interest rates is probably an economy that needs even more than zero interest rates. It probably needs negative interest rates, like the U.S. did, but can’t get them since central banks can’t cut rates that far without lenders hoarding money rather than paying people to borrow it. Now, it’s true that central banks can make up for at least some of that by buying bonds with newly-printed money, but they don’t like to do that. The result is that economies with zero interest rates don’t get as much monetary stimulus as they need, so they don’t grow as much as they could. And since rates follow growth, that means there isn’t as much pressure for rates to rise once they do fall to zero.

The next sentence says everything about their incompetence:

The second reason lifting off is hard to do is that central bankers want to do it too much. They just don’t like zero interest rates. Central bankers, after all, are supposed to be the ones taking away the punch bowl just as the party gets going, not plying recovering alcoholics with bottomless booze. Or at least that’s what they tell themselves.

To top it off, today the alternative measure of inflation, the CPI, declined 0.1% in August over July. The core version showed an increase of 0.1%!

The Fed just doesn´t get that its incompetence is contributing to the fall in oil (and commodity) prices!