...much like the Pirate's Code.
At least I think it is. Jonathan Catalan, in commenting on a page for Steve Horwitz's Great Depression class, brings up the liquidity trap in thinking about Keynesian policy responses, as well as Keynes's doubt that it was even binding in the Great Depression. The point (he can correct me if I'm wrong on interpreting him) was that if there was no liquidity trap in the Great Depression then there was no case for fiscal stimulus and even Keynesians agree fiscal stimulus can't work.
This seems wrong to me, and in a way it's related to the hand-waving that the market monetarists do.
Fiscal stimulus gets attractive relative to monetary policy when monetary policy loses some of its oomph, namely, when it looses the interest rate channel and has only the expectations channel to rely on. Expectations may be tough to move so non-market-monetarists think fiscal policy has a shot at stepping in and really making a difference.
This is a guideline for why fiscal policy is particularly important in a liquidity trap, but it's hardly a proof of the inoperability of fiscal policy outside of a liquidity trap. That requires something extra.
Essentially it requires assumptions about the monetary policy reaction function, some very clear demarcations of what we mean by "fiscal multiplier", and the assumption that monetary policy can always meet its target (the last one is probably fine outside of a liquidity trap).
Noah Smith once summarized this interpretation (a third of three possible interpretations) of assuming fiscal policy had a zero multiplier in this way:
"Possible Claim 3: Because the Fed can, in theory, counteract any fiscal stimulus, the effect of any fiscal policy on output should be considered to be zero.Think about it - if fiscal stimulus can't work outside of a liquidity trap then why do we think automatic stabilizers are a good idea? Why do we have these lines like "you have to balance the budget over the cycle" (wrong, technically - you have to stabilize the debt over the cycle you never have to balance the budget but you get the idea).
Possible Claim 3 has two parts - a definitional part, and a theoretical part. First, it says that (3a) when we talk about the "multiplier" associated with fiscal stimulus, we should include the Fed's reaction function in the model that we use to estimate the multiplier. This is the argument made by David Romer in some remarks cited by Sumner:
As Robert Solow stresses in his remarks in this session, we should not be trying to find “the” multiplier: the effects of fiscal policy are highly regime dependent. One critical issue is the monetary regime...if [central banks are] successful [at offsetting the effects of fiscal policy], one would expect the estimated effects of fiscal policy to be close to zero.This is just saying that there are several ways to define "the multiplier" - you can talk about the multiplier while holding monetary policy constant, or you can talk about the multiplier in the context of a model that includes the Fed's reaction function. If we look in the data and see that a fiscal stimulus was followed by an increase in nominal output, we could say that "The stimulus increased output," or we could say that "The Fed increased output by choosing not to counteract the stimulus." To borrow an old NRA slogan, it's a question of whether guns kill people or people kill people.
BUT, aha! Possible Claim 3 also involves a theoretical claim. This is the claim that (3b) the Fed's reaction function is invariant to fiscal policy! To see why, consider a world in which the Fed targets a 3% growth rate for NGDP if there is no stimulus, but raises the growth rate target in the event of a stimulus. In this case, it would make perfect sense to say "fiscal stimulus increased NGDP growth," in the sense that we normally think of causality. It would make no sense to attribute the growth increase to the Fed. That would be like saying "You think you put butter on that piece of toast, but actually it was I who put butter on that piece of toast, since I could have clobbered you on the head and stopped you from putting butter on the toast, and I chose not to. Thus, you are incapable of buttering toast; only I can butter your toast." That would be a truly batty claim!"
We know fiscal policy works outside of a liquidity trap, we've just gotten so caught up in monetarist sensibilities that (1.) monetary policy is all-powerful and even more importantly (2.) monetary policy must be treated as a part of the economic system (hence the monetary policy reaction function) and not as another exogenous policy lever that we say silly things like "fiscal policy doesn't work outside of a liquidity trap".
I'm not saying we should toss monetary reaction functions out the window. There's a very good reason why they've superseded LM curves and why we might want to think about them as being in a sense more "natural" than fiscal policy. But when we make claims about the efficacy of fiscal policy we need to think more about exactly what assumptions we're making when we toss in an MP curve.
So the moral of the story is that the liquidity trap "rule" is really more of a guideline than an actual rule.
Fiscal policy works, period. But as a matter of practice you might want to be judicious about using it and you might want to let liquidity traps guide that use.
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"Fiscal stimulus gets attractive relative to monetary policy when monetary policy loses some of its oomph, namely, when it looses the interest rate channel and has only the expectations channel to rely on."
ReplyDeleteThis brings up the question: how much of the effect of interest-rate changes or monetary policy more generally come through the interest-rate channel and how much of the effect comes from the money creation? How much research has been done on that?
Automatic counter-cyclical tax cuts (e.g. income and sale taxes) are also automatic stabilizers. But, it's a different kind of fiscal stimulus than direct spending. And, I've raised this point before (http://www.economicthought.net/blog/?p=4338), but there seems to be a net cost to fiscal stimulus if you think that monetary policy is tractable. Monetary policy is somewhat more "free market," in that the allocation of expenditure is more "market based." If we assume that the market is, generally, better at allocating resources than government, it seems to be that we should always prefer monetary to fiscal policy. (I think this point holds even at the zero lower bound; 1) unconventional monetary policy and 2) Bill Woosley has made a good case that the ZLB is really a money demand problem.)
ReplyDelete"Bill Woosley has made a good case that the ZLB is really a money demand problem"
ReplyDeleteIsn't that, like, you know, what everybody thinks?
If everyone thought that it was a straightforward money demand problem then I'm not sure why anybody thinks monetary policy is intractable. Alternatively, any monetary disequilibrium would put us at the ZLB.
DeleteThe case for spending over tax cuts as I understand it is that people want to hold their money and giving them more just gives them more to hold, without reducing slumping demand.
ReplyDeleteSuppose we ignore the rent-seeking problem inherent with fiscal policy. Abstracting away from the structural aspects misses some key things going on. An unsustainable industry decimated, with results like a huge demand shock on components like plywood and required supply shock necessary to re-establish even a sustainable level of growth in that sector. But there are more basic real world business problems. From my experience over the decades and discussions with friends, I would argue that a typical business would have to see huge increases in demand before they even think about hiring. The typical avenue during a recession is to assemble teams to find ways to increase productivity. It's very hard for demand to stimulate hiring in that situation.
It's hard to gauge monetary policy. I think Steve Hanke has a good point about the money being held up in banks by Basel III, Dodd-Frank and IOER. There is also the problem of loaning money long term when interest rates are at an all time low. Why would a bank want to do that? Based on the complaints of emerging markets, our loose monetary supply is being exported and creating inflation abroad.
"Jonathan Catalan, in commenting on a page for Steve Horwitz's Great Depression class, brings up the liquidity trap in thinking about Keynesian policy responses, as well as Keynes's doubt that it was even binding in the Great Depression. The point (he can correct me if I'm wrong on interpreting him) was that if there was no liquidity trap in the Great Depression then there was no case for fiscal stimulus and even Keynesians agree fiscal stimulus can't work"
ReplyDeleteOne can totally reject the real world existence of a liquidity trap -- when defined as the existence of an infinitely elastic or horizontal demand curve for money at some positive level of interest rates -- and still easily support and justify Keynesian economics.
Keynes himself did! And so do Post Keynesians.
Keynes:
“There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest” (Keynes, J. M. 2008 [1936]. General Theory of Employment, Interest and Money, p. 187).
See also Paul Davidson, 2002. Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham. p. 95.
Liquidity traps are in the eye of the beholder apparently. Or alternatively, one knows one when one sees one (to riff on Justice Potter).
ReplyDelete"Fiscal policy works, period.
ReplyDeleteI hope you'll pardon me for making the crudest of metaphors here, but if one were trying to control one's weight, a lot of things are guaranteed to "work," namely starvation or liposuction. But I think most of us would agree that the healthiest and most efficient approach would be to improve one's diet and exercise habits.
I certainly don't mean to say that fiscal stimulus is categorically evil. But I think judging the efficacy of a stimulus policy--monetary or fiscal--only by its short-term effects on GDP or unemployment is at least somewhat akin to evaluating a weight-control policy solely by the number on the bathroom scale.