The Stimulus Muddle

An awful lot of words have been expended on whether the stimulus package will “work,” and yet we don’t seem to be getting any closer to a consensus.  Chinn used a textbook approach to clarify the debate, while McArdle and Sachs have questioned the value of the goods produced by the stimulus package.  But maybe we are all looking in the wrong place.  Perhaps even the more specific question “will it boost measured GDP?” is so ambiguous that no consensus is possible.

Until recently, the upper echelon of macro theorists had begun to focus more and more on forward-looking monetary rules.  Few people seem to appreciate the fact that under such a policy regime the “multiplier” is precisely zero, even without Ricardian equivalence and without full employment.    If the Fed is always setting policy in such a way as to equate its price and/or spending target with its forecast, then fiscal policy becomes just another extraneous shock, which needs to be offset by adjusting the fed funds target.

The problem is that the “stimulus” is aimed at the demand side, the same side of the economy that monetary policy influences.  If my nine-year old daughter reaches over and pushes the steering wheel while I am driving, I push back equally hard to make sure the car continues straight down the road.  When massive fiscal expansion went head to head with tight money in 1981-82, it wasn’t hard to see which policy was more muscular.  Nominal growth plummeted dramatically.

Krugman would say that none of this matters.  We are in a liquidity trap and the Fed won’t push back against fiscal expansion.  But it’s not quite that simple.  Even with zero rates, monetary policy could do much more if unconventional procedures were adopted.  More importantly, monetary policy will have a lot to say about the long term path of the economy.  And future expected growth in aggregate demand is one of the most important determinants of near term growth in aggregate demand.  Monetary policy is never really out of the picture.  Stocks rose roughly 5% in December when the Fed eased a bit more aggressively than expected–even though Krugman had already argued that monetary policy had become irrelevant.

In a sense, we already know all there is to know about how well the stimulus package will work.  The prices of financial assets and commodities should immediately incorporate the expected impact of the stimulus, and I think it’s fair to say they are underwhelmed.  To be fair, there is evidence that the stock market favors the stimulus (although there is even more evidence that they favor an aggressive move by the Fed.)

Let’s say we get the bad recession and slow recovery that everyone expects.  Will the stimulus have worked?  How would we know?  I recall that Krugman argued that Japan might have gone into a deep depression without it’s heavy infrastructure spending.  But does anyone actually believe that “Helicopter Ben”, expert on the Great Depression, would allow the U.S. to go into a deep depression if the stimulus package failed?  We would almost certainly see massive open market purchases of all sorts of unconventional assets long before that occurred.  I’m surprised the that the Fed hasn’t done more already, although given the inertia of large institutions I suppose I should not be.

The best argument against the stimulus package is a classical opportunity cost argument–even if the stimulus package can work, there is some unconventional monetary policy big enough to boost nominal GDP just as much, and without ballooning the deficit.  FDR found a way to use monetary policy in 1933, we can do the same today.  Fiscal stimulus may be better than nothing, but it’s a sad comment on our profession that it has even come to this.



7 Responses to “The Stimulus Muddle”

  1. Gravatar of Boonton Boonton
    25. February 2009 at 09:19

    Thank you for this blog, this is by far some of the best, most interesting economics stuff I’ve read in a long time. The only bad thing is that with so many interesting posts I have yet more to distract me from getting my job done and now even less time to read other people’s stuff!

    Anyway, your monetarist POV is very interesting. Let me ask you this, though, suppose you are President but the Federal Reserve has been captured and held by a political enemy who is too stingy to properly loosen monetary policy. In that case would you turn to fiscal stimulus to counter the deflationary impulse caused by the evil Federal Reserve head? Would you say that fiscal policy has no impact either way and the only real power is running the Fed?

  2. Gravatar of ssumner ssumner
    25. February 2009 at 19:02

    Boonton, Good question. I would try some supply-side fiscal stimulus. Singapore has a really neat countercyclical fiscal policy–they usually run big budget surpluses, so they can afford to sharply cut payroll tax rates during recessions. This reduces the amount of unemployment during recessions. Mankiw mentioned this sort of policy.

    I’m not sure what I’d do if you only allowed me to do demand side fiscal policy. I suppose if things got bad enough I might do it out of desperation. But I don’t really feel qualified to answer this question (and I am not sure anyone else is qualified either, as the effects of demand side policy are very difficult to estimate.) It might even depend on whether by “not using monetary policy” you meant holding interest rates fixed, or holding the money supply fixed. The interest rates fixed case is more promising–as fiscal expansion might force up rates, requiring the Fed to increase the money supply to hold them at the target level.

  3. Gravatar of Boonton Boonton
    26. February 2009 at 11:20

    It sounds like all this fretting over the stimulus is a bit silly. If the Federal Reserve would say, buy $800B of 30 year bonds it would solve all of our problems. The Fed would effectively be bypassing the usual first targets of monetary stimulus (Wall Street) and giving it to the diverse array of actors impacted by the stimulus bill (payroll workers, state and local governments, various Federal agencies etc.).

  4. Gravatar of ssumner ssumner
    26. February 2009 at 18:11

    Boonton, The key isn’t so much the exact amount they buy, but rather the commitment to buy enough to hit their objectives. But I agree that fiscal stimulus isn’t the way to go.

  5. Gravatar of Boonton Boonton
    3. March 2009 at 14:40

    But at some point they seem to be two sides of the same coin. Suppose Congress continues with an extensive stimulus. The classical answer would be that the debt would have to be serviced either with extensive taxation or extensive money printing. If the stimulus was sufficient enough so that money printing would not cause hyper-inflation then you have basically what you are advocating.

    What I think is an important difference, though, is that fiscal stimulus is allocated by the democratic process whereas in this case monetary stimulus isn’t. If the Fed decides to use unconventional monetary policy to buy up CDO’s, subprime loans, making sweetheart loans to AIG and Citibank big enough to finally push them into solvency, then we emerge from the wreckage with no clear answer to the ‘too big to fail’ problem.

    On the other hand, for all its faults the stimulus spreads the money out among a diverse group of people (payroll workers, state and local gov’ts, construction contractors, various agencies etc.). This type of stimulus, ironically, seems a lot more market driven to me than stimulating giant Wall Street institutions. The goods and services produced by this stimulus will be spread out throughout the economy giving no particular group especially massive political power.

  6. Gravatar of ssumner ssumner
    5. March 2009 at 12:26

    Boonton, I think we agree on one point. I’d prefer a clean monetary stimulus buying government debt, rather than have the Fed pick through all sorts of risky garbage.

    The problem with fiscal stimulus is that it forces big taxes increases in the future, which will hurt our economy. Monetary policy does not necessarily do that.

  7. Gravatar of TheMoneyIllusion » Newly fashionable ideas TheMoneyIllusion » Newly fashionable ideas
    21. October 2010 at 09:46

    […] recall these ideas as being particularly fashionable in early 2009, when I argued that both sides of the fiscal stimulus debate were missing the point.  I’m glad to see they […]

Leave a Reply