[I did this a while back but never posted it. I suddenly feel like I “shoulda hit Summers even harder.” So even though he has dropped out, I’ll take one more shot.]
I just read Summers and DeLong’s paper on fiscal stimulus.
The argument that normal-times policy-relevant fiscal multipliers should be presumed to be very small can be made more general. Optimizing central banks will be expected to offset shifts in discretionary fiscal policy””and thus lead to multiplier estimates near zero””under relatively unrestrictive conditions. Consider a government choosing monetary policy so as to achieve the best economic outcome from the set of outcomes attainable by policy P. A change in fiscal policy from baseline would change the relationship between monetary policy and the economic outcome. But unless the change in fiscal policy opens up access to an outcome not in the set P that is superior, or eliminates access to the best economic outcome in P, the government will shift its monetary policy so that it still picks the same economic outcome. It will thus engage in full monetary offset.
Note that for this point to hold, the choice of monetary policy m and the choice of fiscal policy g cannot themselves be part of the outcome the government values. A central bank that values a smooth path for interest rates (as did the pre-1979 Federal Reserve) or has preferences about the size of its balance sheet (as did the Federal Reserve under Paul Volcker) will not engage in full monetary offset. Monetary and fiscal policy must enter into the central bank’s objective only through their effects on economic outcomes for full monetary offset to hold.
So a sensible central bank will have a zero fiscal multiplier. By “sensible,” I mean a central bank that focuses like a laser on inflation and employment, and does not put the stance of monetary policy into the objective function. Bernanke and Yellen are a bit difficult to read. They may have some reservations about a large balance sheet, but on the other hand monetary stimulus can be achieved without increasing the current size of the balance sheet—by forward guidance for instance. So there’s no particular reason to believe the fiscal multiplier would not be zero, although of course it might be higher.
At the opposite extreme is someone like Larry Summers, who worries that low interest rates and a bloated balance sheet might lead to bubbles, and misallocation of investment. In that case fiscal policy could be “effective.” That sort of central banker would essentially be holding the economy hostage, much as the GOP radicals in the house are accused of doing. A central banker with that objective function would intentionally hold NGDP below the optimal path, unless and until the Federal government would assure him or her that the extra NGDP growth would be in the public sector, where (unlike the private sector) the expenditures would not be wasted on foolish projects driven by a bubble mentality. The Federal government spends money very wisely, especially when under pressure to quickly ramp up investment during temporary slumps in the economy.
PS. Lars Christensen has a very good post on why the Japanese should not try to artificially push wages higher.