Tyler Cowen has a series of increasingly persuasive posts criticizing the view that fiscal stimulus is the answer to our problems:
It is incorrect to argue that: “their high-savings export-oriented economy only works if someone else runs a high-debt economy and buys their stuff.” The Germans do just fine when they trade with current account surplus countries. If Portugal and Greece were more like Norway or the Netherlands, the German trade surplus might well go down, but the total value of German exports likely would go up (Germany exports mainly “normal goods”) and the German economy would do just fine.
The Germans are well aware that most of their neighbors have not managed their finances nearly as well as they have. How should we expect them to respond, if we, and others, now tell them that, after all their careful management, it is now time to run up debt to spend more money in their neighbors’ shops? (And that is in addition to significant ongoing EU transfers from Germany to poorer countries.) How would we respond to such a request?
. . .
How do we speak to the much poorer Chinese? Do we offer them aid or do we make demands on them? In this matter, the Germans to me seem more reasonable than the United States.
Some supporters of Keynesian theory act as if it is a well-established theory, as if skeptics are akin to global warming deniers. Count me as someone who believes in global warming, but has serious doubts about fiscal stimulus.
The first question is which Keynesian model? Keynes believed that fiscal stimulus almost always had a stimulative effect, because the economy was almost never at full employment. When I was in school we were taught that it was stimulative in a recession. By the 1990s the standard new Keynesian view was that fiscal policy had no effect if the central bank was doing its job, i.e. was targeting the expected inflation rate. Because fiscal stimulus works by boosting AD, and because higher AD boosts inflation expectations, any attempt to use fiscal stimulus will be thwarted by central banks that increasing focused on inflation targeting. Indeed even a flexible inflation target that also incorporated output would be enough to completely neutralize fiscal stimulus. The old Keynesians crawled into their caves, and monetary policy became the all-important stabilization tool. The General Theory had become the special theory–only applicable to cases where for some reason monetary stimulus was not an option.
Then something strange happened. Japan stumbled into a “liquidity trap” (or more specifically a condition of mild deflation and near-zero short term rates.) Interest rate-oriented monetary rules no longer worked in Japan, and the best and the brightest set out to fix the problem. Paul Krugman noticed that the Japanese were also running big fiscal deficits, and decided that fiscal stimulus might not be the solution:
But anyway, as a practical concern the main point about fiscal policy in Japan is that it is clearly nearing its limits. Over the course of the past 7 years Japan has experienced a secular trend toward ever-growing fiscal deficits; yet this has not been enough to close the savings-investment gap. One need not claim that fiscal policy is completely ineffective: as Adam Posen has emphasized, fiscal expansion has pushed up Japanese growth when tried. But how much fiscal expansion can the government afford? Between 1991 and 1996 Japan’s consolidated budget went from a surplus of 2.9 percent of GDP to a deficit of 4.3 percent, yet the economy was marked by growing excess capacity. When the Hashimoto government, alarmed by the long-run fiscal position, tried to narrow the deficit in 1997 the result was a recession; now fiscal stimulus is being tried once again. But projections already suggest that Japan may be heading for some awesome deficits – say 10 percent of GDP next fiscal year – with no end to the need for fiscal stimulus in sight. Given that Japan is already in far worse fiscal shape than, say, Brazil on every index I can think of – not just current deficit, but debt to GDP ratio and hidden liabilities arising from an aging population, the need for bank and corporate bailouts, etc., one has to wonder where the fiscal-expansion strategy is leading.
Good question! Instead the best option was for the Bank of Japan to stimulate the economy. Krugman said they must “promise to be irresponsible,” i.e. set a higher inflation target.
Then Mr. Bush came along, and Bush derangement syndrome set in among the left. He was viewed as such a singularly clueless and incompetent President that they assumed anything he supported must be bad. Bush supported big government, but more importantly he said he opposed big government. So if Bush said big government was bad, it must be good. So the old Keynesians started creeping out of their caves, and advancing their fiscal stimulus ideas. (Ironically, Bush himself was one of those old Keynesians, at least in regard to fiscal stimulus.)
The intellectual leaders of this movement tried to create a more respectable model to dress up their big government policy views. The far-fetched idea of an “expectations trap” was developed; the idea that markets would understand that central bankers were too conservative to implement higher inflation targets during deflation. It was never explained how fiscal stimulus would work in that case. If central banks are really that afraid of inflation, wouldn’t they also tighten up when fiscal stimulus threatened to boost aggregate demand? And indeed didn’t the Fed do exactly that in 1936-37 when they doubled reserve requirements in response to stronger aggregate demand supposedly coming from fiscal stimulus? And didn’t the BOJ tighten monetary policy three times in response to fears of inflation (not actual inflation!) during the past decade? So yes, conservative central banks may be a problem for monetary policy, but they are equally bad news for fiscal stimulus.
With pure theory not offering any answers here, we must turn to the empirical evidence. The opponents of fiscal stimulus dug up one case after another where fiscal stimulus didn’t seem to work, or where fiscal contraction was associated with strong growth. Each time the Keynesian said “that doesn’t count; they weren’t at the zero bound.” OK, so in the entire history if the world we basically have three cases to work with:
1. The US in the 1930s
2. Japan post-1994
3. The period since September 2008
The Great Depression lasted 12 years–so it can hardly be used to show that any policy (fiscal or monetary) is successful at ending recessions faster than they would end without stimulus. Some point to the effects of WWII. Yes, if you suddenly draft 13 million men into the military (the equivalent of 30 million today!) and give industry a blank check to produce as much military supplies as they can at profitable prices, you will get a big drop in unemployment. No one disputes that. Of course you will also get a drop in consumption, and isn’t the whole point of the multiplier to boost consumption and living standards?
What about the Japanese case? Japan ran large budget deficits, causing their national debt to balloon to over 100% of GDP. Even worse for the Keynesians, they did exactly the sort of deficit spending that is supposed to be the most potent, building infrastructure. And 16 years later, Japan is still in deflation. But of course that’s not how Keynesians see things. Today Krugman doesn’t emphasize how much they spent, how little they accomplished, and how big their debts have become, but exactly the opposite. They really never tried hard enough. Sure they paved over the once beautiful countryside with wasteful highway and bridge projects, but it wasn’t enough. If stimulus didn’t work, the answer seems no longer to be more money or more inflation, but rather more fiscal stimulus, more infrastructure, more concrete, still more concrete, and even more concrete.
And of course the same happened in America. After the $700 billion stimulus was passed unemployment rose by much more than was predicted to occur if no stimulus was enacted. The recovery was half as fast as the 1983-84 recovery, despite stimulus being twice as large (deficits of 6% of GDP then vs. 12% of GDP this time.) But again there were excuses—the economy had unexpectedly gotten much worse before the stimulus money was actually spent. OK, but I thought the new Keynesian models that all this is based on were predicated on the stimulative effect beginning when the policy was announced, not when the money was spent? Isn’t that the Woodford/Eggertsson approach; the model that the smarter new Keynesians now point too?
So we have a theory that shrinks to the point where it is only applicable in liquidity traps, and then disappears entirely if central banks use unconventional policy tools and/or try to subvert fiscal stimulus with monetary tightness. In other words, you must assume a bizarre reaction function from the central bank to even make it work in theory. Then you have little or no empirical evidence of fiscal stimulus actually working in even those rarefied zero rate bound environments. There may be some utopia where the General Theory is applicable; unfortunately we don’t seem to live there. (I presume everyone knows the literal meaning of utopia.) Ross Douthat has a similar take:
Technically, they could be right “” but only in the same way that it’s possible that the Iraq War would have been a ringing success if only we’d invaded with a million extra soldiers. The theory is unfalsifiable because the policy course is imaginary. Maybe in some parallel universe there’s a Congress that would be willing to borrow and spend trillions in stimulus dollars, despite record deficits, if that’s what liberal economists said the situation required. But not in this one.
We don’t need more concrete, we need our central banks to commit to higher prices and NGDP.