Fiscal Policy in a Depressed Economy
22 Mar 2012-Vol. 2012, Iss: 1, pp 233-297
TL;DR: In a depressed economy, with short-term nominal interest rates at their zero lower bound, ample cyclical unemployment, and excess capacity, increased government purchases would be neither offset by the monetary authority raising interest rates nor neutralized by supply-side bottlenecks.
Abstract: In a depressed economy, with short-term nominal interest rates at their zero lower bound, ample cyclical unemployment, and excess capacity, increased government purchases would be neither offset by the monetary authority raising interest rates nor neutralized by supply-side bottlenecks Then even a small amount of hysteresis—even a small shadow cast on future potential output by the cyclical downturn—means, by simple arithmetic, that expansionary fiscal policy is likely to be self-financing Even if it is not, it is highly likely to pass the sensible benefit-cost test of raising the present value of future potential output Thus, at the zero bound, where the central bank cannot or will not but in any event does not perform its full role in stabilization policy, fiscal policy has the stabilization policy mission that others have convincingly argued it lacks in normal times Whereas many economists have assumed that the path of potential output is invariant to even a deep and prolonged downturn, the available evidence raises a strong fear that hysteresis is indeed a factor Although nothing in our analysis calls into question the importance of sustainable fiscal policies, it strongly suggests the need for caution regarding the pace of fiscal consolidation
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TL;DR: The origin and propagation of the European sovereign debt crisis can be attributed to the flawed original design of the euro as discussed by the authors, and there was an incomplete understanding of the fragility of a monetary union under crisis conditions, especially in the absence of banking union and other European-level buffer mechanisms.
Abstract: The origin and propagation of the European sovereign debt crisis can be attributed to the flawed original design of the euro. In particular, there was an incomplete understanding of the fragility of a monetary union under crisis conditions, especially in the absence of banking union and other European-level buffer mechanisms. Moreover, the inherent messiness involved in proposing and implementing incremental multicountry crisis management responses on the fly has been an important destabilizing factor throughout the crisis. After diagnosing the situation, we consider reforms that might improve the resilience of the euro area to future fiscal shocks.
839 citations
TL;DR: The authors investigated whether U.S. government spending multipliers differ according to two potentially important features of the economy: (1) the amount of slack and (2) whether interest rates are near the zero lower bound.
Abstract: This paper investigates whether U.S. government spending multipliers differ according to two potentially important features of the economy: (1) the amount of slack and (2) whether interest rates are near the zero lower bound. We shed light on these questions by analyzing new quarterly historical U.S. data covering multiple large wars and deep recessions. We estimate a state-dependent model in which impulse responses and multipliers depend on the average dynamics of the economy in each state. We find no evidence that multipliers differ by the amount of slack in the economy. These results are robust to many alternative specifications. The results are less clear for the zero lower bound. For the entire sample, there is no evidence of elevated multipliers near the zero lower bound. When World War II is excluded, some point estimates suggest higher multipliers during the zero lower bound state, but they are not statistically different from the normal state. Our results imply that, contrary to recent conjecture, government spending multipliers were not necessarily higher than average during the Great Recession.
657 citations
TL;DR: This article used an instrumental variable approach to study whether public debt has a causal effect on economic growth in a sample of OECD countries and found that there is no evidence that public debt is associated with economic growth.
451 citations
TL;DR: In this article, the authors focus on the costs of public debt when safe interest rates are low and develop four main arguments for public debt rollovers, including the existence of multiple equilibria where investors believe debt to be risky and, by requiring a risk premium, increase the fiscal burden and make debt effectively more risky.
Abstract: This lecture focuses on the costs of public debt when safe interest rates are low. I develop four main arguments. First, I show that the current US situation, in which safe interest rates are expected to remain below growth rates for a long time, is more the historical norm than the exception. If the future is like the past, this implies that debt rollovers, that is the issuance of debt without a later increase in taxes, may well be feasible. Put bluntly, public debt may have no fiscal cost. Second, even in the absence of fiscal costs, public debt reduces capital accumulation, and may therefore have welfare costs. I show that welfare costs may be smaller than typically assumed. The reason is that the safe rate is the risk-adjusted rate of return to capital. If it is lower than the growth rate, it indicates that the risk-adjusted rate of return to capital is in fact low. The average risky rate however also plays a role. I show how both the average risky rate and the average safe rate determine welfare outcomes. Third, I look at the evidence on the average risky rate, i.e., the average marginal product of capital. While the measured rate of earnings has been and is still quite high, the evidence from asset markets suggests that the marginal product of capital may be lower, with the difference reflecting either mismeasurement of capital or rents. This matters for debt: the lower the marginal product, the lower the welfare cost of debt. Fourth, I discuss a number of arguments against high public debt, and in particular the existence of multiple equilibria where investors believe debt to be risky and, by requiring a risk premium, increase the fiscal burden and make debt effectively more risky. This is a very relevant argument, but it does not have straightforward implications for the appropriate level of debt. My purpose in the lecture is not to argue for more public debt, especially in the current political environment. It is to have a richer discussion of the costs of debt and of fiscal policy than is currently the case.
437 citations
Cites background from "Fiscal Policy in a Depressed Econom..."
...The basic results are summarized in Figures 7 to 10 below....
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...These effects is shown in Figures (13) and (14), which show the average welfare effects of successful and unsuccessful debt rollovers, for the linear and the CobbDouglas case....
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...Second, at the effective lower bound, monetary authorities did not feel they should increase interest rates in response to the fiscal expansion.38 The second front, explored by DeLong and Summers (2012) has revisited the effect of fiscal expansions on output and debt in the presence of hysteresis....
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...33 Figures 9 and 10 do the same, but now for the Cobb-Douglas case....
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...These effects are shown in Figures 13 and 14, which show the average welfare effects of successful and unsuccessful debt rollovers, for the linear and Cobb-Douglas cases....
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References
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1,702 citations
Posted Content•
TL;DR: The authors argue that if wages are largely set by bargaining between insiders and firms, shocks which affect actual unemployment tend also to affect equilibrium unemployment, which implies that shocks have much more persistent effects on unemployment than standard theories can possibly explain.
Abstract: European unemployment has been steadily increasing for the last 15 years and isexpected to remain very high for many years to come. In this paper, we argue thatthis fact implies that shocks have much more persistent effects on unemployment thanstandard theories can possibly explain. We develop a theory which can explain suchpersistence, and which is based on the distinction between insiders and outsiders inwage bargaining. We argue that if wages are largely set by bargaining betweeninsiders and firms, shocks which affect actual unemployment tend also to affectequilibrium unemployment. We then confront the theory to both the detailed facts ofthe European situation as well as to earlier periods of high persistent unemploymentsuch as the Great Depression in the US.
1,695 citations
"Fiscal Policy in a Depressed Econom..." refers background in this paper
...Even so, the bottom-up evidence of persistent effects of downturns on potential output indicates a value for h that is at or above the top of the range considered in section I. Top-down evidence for hysteresis in Europe was provided by Olivier Blanchard and Summers (1986)....
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...An alternative also put forward by Blanchard and Summers (1986) focuses on how the long-term unemployed become detached from the labor market....
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...However, the labor market dynamics of the past two and a half years raise the possibility that the United States is not so immune after all from the considerations raised by Blanchard and Summers (1986)....
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...The U.S. economy in the aftermath of the 2008–09 crisis thus appears not to be repeating the exceptional rapid rebound that used to distinguish it from the sclerotic Western Europe analyzed by Blanchard and Summers (1986)....
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...Blanchard, Olivier, and Lawrence Summers....
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01 Jan 1998
TL;DR: In the early years of macroeconomics as a discipline, the liquidity trap-that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes-played a central role as mentioned in this paper.
Abstract: In the early years of macroeconomics as a discipline, the liquidity trap-that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes-played a central role. Hicks (1937), in introducing both the IS-LM model and the liquidity trap, identified the assumption that monetary policy was ineffective, rather than the assumed downward inflexibility of prices, as the central difference between " Mr. Keynes and the classics ". It has often been pointed out that the Alice-in-Wonderland character of early Keynesianism, with its paradoxes of thrift, widow's cruses, and so on, depended on the explicit or implicit assumption of an accommodative monetary policy; it has less often been pointed out that in the late 1930s and early 1940s it seemed quite natural to assume that money was irrelevant at the margin. After all, at the end of the 30s interest rates were hard up against the zero constraint: the average rate on Treasury bills during 1940 was 0.014 percent. Since then, however, the liquidity trap has steadily receded both as a memory and as a subject of economic research. Partly this is because in the generally inflationary decades after World War II nominal interest rates stayed comfortably above zero, and central banks therefore no longer found themselves " pushing on a string ". Also, the experience of the 30s itself was reinterpreted, most notably by Friedman and Schwartz (1963); emphasizing broad aggregates rather than interest rates or monetary base, they argued in effect that the Depression was caused by monetary contraction, that the Fed could have prevented it, and implicitly that even after the great slump a sufficiently aggressive monetary expansion could have reversed it. To the extent that modern
1,650 citations
22 Mar 2003
TL;DR: The question of the proper conduct of monetary policy in the presence of a lower bound of zero for overnight nominal interest rates has recently become a topic of lively interest as mentioned in this paper, and the question of how policy should be conducted when the zero bound is reached or when the possibility of reaching it can no longer be ignored.
Abstract: THE CONSEQUENCES FOR THE PROPER conduct of monetary policy of the existence of a lower bound of zero for overnight nominal interest rates has recently become a topic of lively interest. In Japan the call rate (the overnight cash rate analogous to the federal funds rate in the United States) has been within 50 basis points of zero since October 1995, and it has been essentially equal to zero for most of the past four years (figure 1). Thus the Bank of Japan has had little room to further reduce short-term nominal interest rates in all that time. Meanwhile Japan's growth has remained anemic, and prices have continued to fall, suggesting a need for monetary stimulus. Yet the usual remedy--lower short-term nominal interest rates--is plainly unavailable. Vigorous expansion of the monetary base has also seemed to do little to stimulate demand under these circumstances: as figure l also shows, the monetary base is now more than twice as large, relative to GDP, as it was in the early 1990s. [FIGURE 1 OMITTED] In the United States, meanwhile, the federal funds rate has now been reduced to only 1 percent, and signs of recovery remain exceedingly fragile. This has led many to wonder if this country might not also soon find itself in a situation where interest rate policy is no longer available as a tool for macroeconomic stabilization. A number of other countries face similar questions. John Maynard Keynes first raised the question of what can be done to stabilize the economy when it has fallen into a liquidity trap--when interest rates have fallen to a level below which they cannot be driven by further monetary expansion--and whether monetary policy can be effective at all under such circumstances. Long treated as a mere theoretical curiosity, Keynes's question now appears to be one of urgent practical importance, but one with which theorists have become unfamiliar. The question of how policy should be conducted when the zero bound is reached--or when the possibility of reaching it can no longer be ignored--raises many fundamental issues for the theory of monetary policy. Some would argue that awareness of the possibility of hitting the zero bound calls for fundamental changes in the way policy is conducted even before the bound has been reached. For example, Paul Krugman refers to deflation as a "black hole," (1) from which an economy cannot expect to escape once it has entered. A conclusion often drawn from this pessimistic view of the efficacy of monetary policy in a liquidity trap is that it is vital to steer far clear of circumstances in which deflationary expectations could ever begin to develop--for example, by targeting a sufficiently high positive rate of inflation even under normal circumstances. Others are more sanguine about the continuing effectiveness of monetary policy even when the zero bound is reached, For example, it is often argued that deflation need not be a black hole, because monetary policy can affect aggregate spending, and hence inflation, through channels other than central bank control of short-term nominal interest rates. Thus there has been much recent discussion, with respect to both Japan and the United States--of the advantages of vigorous expansion of the monetary base even without any further reduction in interest rates, of the desirability of attempts to shift longer-term interest rates through central bank purchases of longer-maturity government securities, and even of the desirability of central bank purchases of other kinds of assets. Yet if these views are correct, they challenge much of the recent conventional wisdom regarding the conduct of monetary policy, both within central banks and among academic monetary economists. That wisdom has stressed a conception of the problem of monetary policy in terms of the appropriate adjustment of an operating target for overnight interest rates, and the prescriptions formulated for monetary policy, such as the celebrated Taylor rule, (2) are typically cast in these terms. …
1,632 citations
"Fiscal Policy in a Depressed Econom..." refers background in this paper
...4 For example, see Feldstein (2002). But even in the mid-2000s there were dissents....
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TL;DR: In this article, a simple New Keynesian-style model of debt-driven slumps is presented, situations in which an overhang of debt on the part of some agents, who are forced into rapid deleveraging, is depressing aggregate demand.
Abstract: In this paper we present a simple New Keynesian-style model of debt-driven slumps – that is, situations in which an overhang of debt on the part of some agents, who are forced into rapid deleveraging, is depressing aggregate demand. Making some agents debt-constrained is a surprisingly powerful assumption: Fisherian debt deflation, the possibility of a liquidity trap, the paradox of thrift, a Keynesiantype multiplier, and a rationale for expansionary fiscal policy all emerge naturally from the model. We argue that this approach sheds considerable light both on current economic difficulties and on historical episodes, including Japan’s lost decade (now in its 18th year) and the Great Depression itself.
1,249 citations