Fiscal policy part 2 – some theory

I want to do a bit of theoretical situating today to give context for Sunday’s post on fiscal policy.

One way to understand Sunday’s post is as part of a broader debate about the effectiveness of stimulus policy – the use of monetary or fiscal policy to boost demand. Let’s start with an oversimplified summary of the existing consensus. The maximum levels of output and employment an economy can achieve are determined by the total supply of land, labour and capital. Left by itself, an economy would tend to these “potential” levels over the long-run, however random shocks cause actual economic performance to fluctuate above or below this long-run average.

Accordingly, the goal for policy makers is to keep actual economic performance as close to “potential” as possible. Where a negative shock, like a recession, causes the actual economy to be below its “potential,” stimulus can boost short-run demand and nudge an economy back to its “potential” levels. Alternately, if the economy is running above its potential, policy makers can withdraw stimulus or even contract the economy.

I want to pause here and ask the obvious question for non-economists. Why would policy makers not keep stimulus running? If you can turn on the growth tap, why not keep it on?

This question hinges on the assumption that supply is relatively fixed in the short/medium term. If supply is fixed, then so is the economy’s potential. Attempting to stimulate an economy past its “potential” will create inflation, but no extra output or employment. In simplified form, more and more demand chases a fixed supply, leading to price increases but no corresponding increase in supply.

It follows then that monetary or fiscal stimulus policy cannot grow the economy long-term, nor push it to new productive heights. Instead, they should keep it finely balanced on its apriori “potential” level with periodic nudges.

For a variety of reasons, theory held that governments and discretionary fiscal policy were undesirable for this nudging role. Politicians were unreliable and might short-sightedly try to boost an economy beyond its potential. Fiscal policy came with lags, complicated politics, and the sneaking suspicion that governments were wasteful and inefficient. On the other hand, monetary policy could be changed quickly, and independent central bankers were immune to electoral pressure.

There were lots of other reasons to be skeptical about fiscal policy. Some thought far sighted consumers would realise that government spending today would eventually require tax hikes, and offset any stimulus, maybe with precautionary savings. If governments financed spending through debt it would cause interest rates to increase and choke off any growth. Government spending would crowd out private investment. The multiplier – the extra dollars each dollar of government spending might generate – was argued to be below 1. Theoretically, there was always the possibility that fiscal spending could increase long-run output, for example with infrastructure spending. In practice, there were doubts about its reliability.

Given all these problems, and with monetary policy a reliable alternative, best practice was to avoid discretionary fiscal policy as much as possible. Instead, politicians should focus on supply side reforms like deregulation and more efficient taxes.

The deep assumption at work here is that “real” growth is the product of the (long) past. There is a bias against the possibility of activity in the short-run changing the long-run potential of an economy. The long-run is king.

The result was very little room for politics or politicians in short-run macroeconomic policy.  

Fast forward to the present, the Furman and Summers paper is part of an effort to reclaim theoretical and practical space for fiscal policy. This effort tends to rely on two related arguments:

The first is the presence of ‘hysteresis,’ better thought of as scarring. According to the standard view, the short-run drop in output and employment in a recession is made up symmetrically in the boom and there are no persistent effects. Hysteresis disagrees, arguing that various forms of scarring can cause long-run potential to shrink in a recession. Imagine someone who loses their job, is unemployed for years, loses their skills, and becomes less employable. If hysteresis exists, then stimulus policy can affect long-run potential by acting quickly to end a recession, get people back into work, and stop long-term ‘scarring.’

Despite unemployment beginning to fall, labor force participation does not rebound.

The second is that that post-GFC conditions – interest rates stuck at zero and lots of idle supply – make fiscal spending more effective. With monetary policy constrained, fiscal policy is more useful and complementary. Public debt is not as bad in a world with low interest rates and lackluster private investment; fiscal policy may even pay for itself if it can boost growth in anemic economy.

Combined, this raises the theoretical possibility that fiscal demand stimulus can increase long-run output; a kind of supply expanding demand spending. From the Furman and Summers paper:

One of the interesting parts of this effort to rehabilitate fiscal policy is the way it rests, to varying degrees, on a distinction between “normal” and “abnormal.” Even these new advocates are in agreement that under normal conditions, the classical position about fiscal policy still holds. It is only our unusual post-crisis world that has created the special conditions for fiscal policy effectiveness.

I am personally uncomfortable with the notion of normality. It requires looking at economies as trans historical abstractions and then inserting reality as a series of ‘frictions’ or ‘rigidities.’ This is a useful and clarifying intellectual exercise, but I remain unconvinced about where the standard for normality has been pitched. Economies are made up of constantly evolving institutions. The rules which describe them are contingent on those changing arrangements. This does not mean there are no rules or tendencies, no consistencies or inclinations to discover, only that they are always contingent.

I’m especially skeptical when the basis for “normality” is the experience of a few developed countries between the 1980s and 2007. On either side, whether the post-war boom or the post-crisis slump, we find rather different institutions, tendencies, and experiences. I’m unconvinced about the analytical value in labeling one set normal over others.

5 thoughts on “Fiscal policy part 2 – some theory

    1. I just looked through the paper. Its interesting that they see TFP as endogenous to demand. Have you read the Lucas 2003 AEA address?


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