Britain discovers the near-zero fiscal multiplier

It’s now generally accepted that the fiscal stimulus multiplier is roughly zero in countries where the central bank targets inflation.

[Well, at least in graduate level economics, not undergrad textbooks.  And of course we live in a world ruled mostly by people who never got beyond undergrad economics.]

Some economists continue to insist that fiscal stimulus can work in the special case where interest rates are stuck at zero.  But that argument doesn’t apply if the country is able to do unconventional monetary stimulus such as currency depreciation and/or QE.  We haven’t yet figured that out, but the new British government seems to understand:

The independent Office for Budget Responsibility (OBR), which now oversees Treasury forecasts, delivered an encouraging verdict in June on the probable economic impact of the budget. Though it trimmed GDP growth forecasts made on the basis of Labour’s policies, from 1.3% to 1.2% in 2010 and from 2.6% to 2.3% in 2011, the downward adjustment was surprisingly small given Mr Osborne’s accelerated fiscal consolidation.

And why do they think the fiscal austerity will have such a small impact?

In its quarterly take on the economy on August 11th, the Bank of England lowered its growth forecast, but still expects a respectable recovery. Presenting its Inflation Report, Mervyn King, the bank’s governor, played down the importance of Mr Osborne’s extra austerity in the downward revision to growth. The government thinks its harsh fiscal policies will permit more monetary balm, whether through resuming the policy of quantitative easing or keeping interest rates lower for longer. Judging by this week’s report, the central bank is in no mood to tighten policy and takes the view that the rise in inflation will eventually be doused by spare capacity.

Of course in a perfect world the BOE would more than offset the fiscal stimulus, pushing expected NGDP growth even higher.  We’re not there yet, but we are moving in the “right” direction.


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20 Responses to “Britain discovers the near-zero fiscal multiplier”

  1. Gravatar of W. Peden W. Peden
    18. September 2010 at 09:14

    I wouldn’t be surprised if the BoE at least cracks out some QE and maybe some other measures if the international situation pressures Britain towards a double-dip. George Osborne, if he’s read Tory party history, should know that cuts in interest rates in 1981 and 1982 meant that the UK bucked the world trend and came out of a deep recession at a time of fiscal consolidation. In fact, I like to think of the 1981 budget and aftermath as the premiere example of the primarcy of monetary policy over fiscal policy.

  2. Gravatar of scott sumner scott sumner
    18. September 2010 at 09:47

    W. Peden, Good point. I think the British have always had a better understanding of this interrelationship than us Americans.

  3. Gravatar of JimP JimP
    18. September 2010 at 10:44

    on ETFs –

    I know this is totally off topic for this blog – but I just read the most amazing article on the dangers of ETFs and wanted to post it – cause I am quite sure some people here do invest in them.

    http://ftalphaville.ft.com/blog/2010/09/18/346406/can-an-etf-collapse/

    Lots of people suspect there is less physical gold in the gold ETFs than they need to cover the shares. This article would imply that that is true of every ETF around.

  4. Gravatar of Andy Harless Andy Harless
    18. September 2010 at 11:47

    Since the UK is a relatively small open economy, there shouldn’t be much question: the central bank can successfully pursue any nominal target it chooses, regardless of the zero lower bound, since it has the exchange rate as a potential instrument. The US is in rather a different situation, being a large economy whose trading partners may be inclined to offset the effects of forex market interventions (or the indirect effects of QE in the forex markets). Of course, we can get into the usual argument about what the Fed is doing and can do. I will agree at least that if the Fed were doing level targeting, the US fiscal multiplier would be near zero too, but given the Fed’s current policy, I think it’s far from zero.

    For one who takes my view of the Fed’s current policy and who takes that policy as given, Britain’s fiscal policy has important implications even though its domestic multiplier is near zero. The consequence of an effectively pursued monetary policy target is that the aggregate demand impact of Britain’s fiscal policy falls entirely on the rest of the world. British fiscal consolidation contributes to the international savings glut, which, in the absence of aggressive central bank reaction functions elsewhere, exacerbates the problem of insufficient aggregate demand. The domestic multiplier is near zero, but the world multiplier is not.

  5. Gravatar of Benjamin Cole Benjamin Cole
    18. September 2010 at 11:56

    I have noticed more mentions of QE in Brit media.
    Also, it does not seem the Brits have politicized QE; by that I mean, it is not “conservative” to prattle about tight money, nor “liberal” to call for easing or QE.
    One could hope for the same here–indeed, one would think the right-wingers would embrace QE as a way to avoid fiscal stimulus and higher taxes.

  6. Gravatar of Tyler Morrison Tyler Morrison
    18. September 2010 at 14:05

    Scott (or others):

    I’ve been looking over some of your older posts trying to find an explanation of how NGDP targeting stimulates aggregate demand. As far as I remember, expansionary monetary policy works mostly in the short run. I was wondering if someone could point me to a post that explains the mechanisms of unconventional monetary policy stimulus at an undergraduate level? Is the main mechanism that it creates a negative real interest rate which acts to discourage the general savings glut? I think I somewhat understand the theory, but am a bit foggy when it comes to real world scenario applications. Thanks, love the blog,

    TJ

  7. Gravatar of Morgan Warstler Morgan Warstler
    18. September 2010 at 15:05

    Scott, two weeks ago you STATED OUTRIGHT that if we weren’t going to have any QE, then we might as well have “fiscal stimulus” of a payroll tax.

    I’m hoping, in light of the above post, you mean that actually a tax cut is not fiscal stimulus – because the money is actually the taxpayers to begin with….

    Is this correct?

  8. Gravatar of david david
    18. September 2010 at 15:12

    I’m hoping, in light of the above post, you mean that actually a tax cut is not fiscal stimulus – because the money is actually the taxpayers to begin with…

    No, this isn’t correct and misses the meaning of the word ‘stimulus’.

  9. Gravatar of Morgan Warstler Morgan Warstler
    18. September 2010 at 19:50

    I read the above and know the fed believes like Scott that fiscal stimulus approaches zero.

    But then I remember this from Scott….

    “If we aren’t going to have monetary stimulus, what would be the best (or least bad) type of fiscal stimulus? In my view the best would be cutting the employer share of the payroll tax, as that seems to be the only way to reduce real wage costs. I view sticky nominal wages as one of the major causes of unemployment during recessions. The traditional Keynesian argument against wage cuts is that it merely leads to more deflation, without reducing real wages. I recall Gauti Eggertsson discussing this problem and Paul Krugman citing his argument. But I don’t buy the argument. The Fed controls the price level.

    You might ask why if the Fed determines the price level, they don’t just go ahead and raise the price level, instead of letting the fiscal authorities run up trillions in budget deficits (stimulus plus cyclical deficits). I can’t answer that; you’ll have to ask the inflation hawks at the Fed.”

    https://www.themoneyillusion.com/?p=6800

    ——

    And it seems to me that Scott is distinguishing between fiscal stimulus where:

    1. the Government spends money it doesn’t have on boondoggles.

    2. the Government see value in not taking as much money from the private sector.

    #2 does not fit into the British discussion as I understand it.

  10. Gravatar of david david
    19. September 2010 at 04:39

    The moral issue of property rights assignment is entirely separate from the empirical issue of how large the multiplier is. It may be the case that our moral priors imply that such and such people are the legitimate owners and taxation is theft, or imply that such and such other people are the legitimate owners are not paying taxes is theft from those people. But regardless of that debate, the size of the fiscal multiplier is an empirical issue.

  11. Gravatar of david david
    19. September 2010 at 04:43

    *and not paying taxes

    The point has been made elsewhere, much more eloquently than I have put it. You need a theory of justice to distinguish between justified and unjustified coercion, and theories of justice are not self-evident.

  12. Gravatar of scott sumner scott sumner
    19. September 2010 at 06:23

    JimP, Thanks for the info.

    Andy, You said;

    “Since the UK is a relatively small open economy, there shouldn’t be much question: the central bank can successfully pursue any nominal target it chooses, regardless of the zero lower bound, since it has the exchange rate as a potential instrument.”

    Perhaps, but this is a rather damning indictment of the previous Labour government.

    You said;

    “but given the Fed’s current policy, I think it’s far from zero.”

    In his recent speech, Bernanke strongly hinted that the Fed doesn’t want inflation to fall below 1%. It’s already at one percent. That suggests to me that fiscal austerity in the US would not be very contractionary, just as in the UK.

    You said;

    “The consequence of an effectively pursued monetary policy target is that the aggregate demand impact of Britain’s fiscal policy falls entirely on the rest of the world. British fiscal consolidation contributes to the international savings glut, which, in the absence of aggressive central bank reaction functions elsewhere, exacerbates the problem of insufficient aggregate demand. The domestic multiplier is near zero, but the world multiplier is not.”

    There may be some truth to this, but I think it is a bit too strong. Currency depreciation has both income and substitution effects. When the US sharply devalued the dollar in 1933, the income effect was so strong that we actually sucked in far more imports than before, thus helping other economies. I’m not saying the same thing would happen in the UK, because I don’t believe they will take such an aggressive action. But a truly strong monetary stimulus, even one that involves currency depreciation, can help the rest of the world. The world was helped when China’s weak yuan policy of early 2009 led to a rapid recovery in China, and soon after in all of Asia and its suppliers in Latin America. Those that argue otherwise are viewing the world economy in zero-sum game terms. Have said all that, I agree that the ROW might prefer a given level of British fiscal stimulus to the same monetary stimulus, but I’m not sure the difference is all that great. In any case, britain needs to do the right thing (monetary stimulus) if other countries like Japan want to be suicidal, that’s their choice. The best outcome would be a world-wide race to the bottom of competitive devaluations. That would be equivalent to worldwide QE. Barry Eichengreen had a nice column on this idea.

    Benjamin, And it shouldn’t be “liberal” or “conservative” here either. Of course as you pointed out when Reagan was president the WSJ was calling for easy money.

    TJ, See if this helps at all:

    https://www.themoneyillusion.com/?p=461

    Morgan, If it is a cut in the employer share of the payroll tax, then the policy is very different from fiscal demand stimulus aimed at boosting AD. It would be trying to trigger a recovery by lowering real wage costs, not boosting inflation, as fiscal stimulus tries to do.

    David, It is a question of semantics. See my answer to Morgan.

  13. Gravatar of JimP JimP
    19. September 2010 at 08:25

    Tyler goes real public – and says what I think is true – it is a political problem – inflation needs Presidential support and Obama is (now) too weak to do it.

    But at least now the members of Congress, big readers of the NYT, will have the argument put clearly to them. This has to be a good thing.

    http://www.nytimes.com/2010/09/19/business/economy/19view.html?_r=1&ref=todayspaper

  14. Gravatar of JimP JimP
    19. September 2010 at 08:28

    And I remain convinced that an inflation/deflation debate between Obama and the Republicans is a debate Obama can win – and he should get on with it. We need Presidential and Fed boldness – lets get some.

  15. Gravatar of JimP JimP
    19. September 2010 at 08:34

    Scott could go to Washington and coach the guy.

  16. Gravatar of scott sumner scott sumner
    19. September 2010 at 10:14

    JimP, Thanks, I may do a post.

  17. Gravatar of Mark Mark
    19. September 2010 at 11:24

    re. Scott’s comments here and elsewhere about the British press having a better understanding of monetary policy than the US press. This reminds me of more general comparisons between US and UK journalism. I think that the average quality of US journalism is probably higher but that the variance of British journalism is much much greater. Most people in the UK read the Sun, Mirror, Mail, News of the World which means that the Times, Telegraph, FT address themselves to a selective readership. I suspect that the difference has to do with American geography and the British class system.

  18. Gravatar of ssumner ssumner
    20. September 2010 at 05:33

    Mark, That’s a good observation. In addition, you guys also have a deeper understanding of the exchange rate issue, for historical reasons.

  19. Gravatar of How well is fiscal austerity working in the UK? — Marginal Revolution How well is fiscal austerity working in the UK? — Marginal Revolution
    28. April 2011 at 03:16

    […] are to some extent — or completely — offset by exchange rate movements (pdf).  And the fiscal multiplier is basically zero when the central bank targets inflation.  Furthermore it is not obvious that the UK has been in a liquidity trap.   When it comes to […]

  20. Gravatar of Steve Steve
    29. January 2012 at 02:45

    It’s funny how time has a way of toppling incorrect theories like the wind topples long-dead trees rotting from the inside out.

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