I was off at the cottage when Simon Wren-Lewis and Paul Krugman responded to my post on neo-fiscalism. Amusingly, given Simon's metaphor, the handbrake on the MX6 seized on as I was driving, slowing me down and creating a nasty smell. I did a fiscal bodge-job with a screwdriver to free it, and did a proper monetary repair with allen key and synthetic grease when I got back home.
We are arguing about the second- and third-best policies. We agree that actual monetary policy is not optimal. The question is whether or not a second-best fiscal policy response to the original monetary non-optimality would or would not lead to an even less optimal monetary policy counter-response. If one passenger has the screwdriver, and another has the allen key and synthetic grease, solve for the game's equilibrium. We need to know their preferences. (If the synthetic grease is back home in the garage, the equilibrium is simpler, and the fiscal screwdriver will get used.)
But something important is being left out of this debate. I have blogged about this in the past, and I want to raise it again now.
Let me grant all of Simon's and Paul's assumptions, including in particular their preferred New Keynesian framework. The monetary authority refuses to move the actual rate of interest to equal the natural rate of interest, so the fiscal authority must move the natural rate of interest to equal the actual rate of interest. Otherwise, if the actual rate is above the natural rate, we get a recession.
If, at time t, you want to increase the natural rate of interest r*(t), in a New Keynesian model, what do you do with the time-path of government spending G(t)?
The simplest New Keynesian model, with no investment or foreigners, and a consumption-Euler equation IS curve, provides a very clear answer to that question:
The natural rate of interest r*(t) is a negative function of dG(t)/dt. If you want to increase the natural rate of interest, you must announce a slower growth rate of government spending. The current level of government spending G(t), holding constant the growth rate dG(t)/dt, does not affect the current natural rate r*(t).
Any good New Keynesian macroeconomist will be able to understand why that is true, but may not have thought about it that way before. In a simple model where C(t)+G(t)=Y(t), where Cdot(t) is a positive function of r(t) by the consumption-Euler equation, and r*(t) is defined as the time path for r(t) such that Y(t) equals potential output Y*(t) for all t, so Cdot(r*(t))+Gdot(t)=Y*dot(t), that's what you get. But they can do the math much better than I can.
In other words, if you want to increase the natural rate of interest, starting now, for the next 3 years, it does not matter what you do to the level of government spending right now. The only thing that matters is that you get people to believe that the growth rate of government spending will be lower than they would otherwise expect it would be.
Suppose people had previously expected that G would be 100 every month. You could make G jump to 136 instantly now, and announce it will be 135 next month, then 134 the following month,...and so on, until you got back to 100. That would work. Or you could leave it at 100 this month, and announce it will be 99 next month, then 98 the following month,...and so on, until it got down to 64. That would work too. Both policies would work equally well at raising the natural rate of interest for the next 3 years and preventing a recession.
According to the simple New Keynesian model, it does not matter, for the natural rate of interest, whether you do an unexpected instantaneous jump up, jump down, or no jump at all. The only thing that matters is what people expect to happen from now on to the rate of change of government spending. And in the real world, if it takes time for the new government workers to find their shovels, and if you can't give secret orders that lead to unexpected jumps in spending, the only feasible policy to increase the natural rate of interest and prevent a recession is to announce that government spending will be falling from now on, until the threat of recession is past.
Is such a fiscal policy first-best, or even second-best? Probably not (unless government spending was too high to begin with). But, according to the New Keynesian model, and assuming the central bank is sitting on its hands, that policy will increase the natural rate of interest as desired and prevent a recession. The New Keynesian model says that announced increasing austerity will be expansionary. If we see governments announce that they will be cutting spending from now on, and if we see output and employment then rise, that is empirical evidence in favour of the New Keynesian model.
Does that result survive if we include investment and net exports in the model? I'm not 100% sure, because I haven't done the math, but I think it does. The investment-Euler equation looks similar to the consumption-Euler equation.
Does that result survive if we include some hand-to-mouth agents in the model, who consume their current disposable income every period regardless of the future? I have done the math, and I think it does, but my math might be wrong. And it says that announced increasing taxes would work too.
Do I believe that result? ..............................................God only knows. As I have said before, those results creep me out. But I can't see what is wrong with them. Unless it's the New Keynesian indeterminacy problem? (And if it is, the fiscal policy that will work best is to increase government spending on sacrificing goats.)
I would feel much more comfortable giving second-best fiscal policy advice if I thought I actually knew what advice to give. I know how to use a screwdriver to do a bodge-job on the E-brake of an MX6, because I can actually see the levers move, so I know I need to push the screwdriver, not pull it, or twist it.
The average reader of the New York Times probably thinks he knows about fiscal policy. "We know that Y=C+I+G+NX, so we can see that higher G increases Y. And monetary policy works because lower interest rates increase I, if we can cut interest rates. And Nick Rowe is just obfuscating, no doubt for political reasons, by ignoring that simple obvious mechanism."
We also know that Y=C+S+T. And we can equally well "see" that higher taxes will increase Y. And higher interest rates, if it encourages more saving, will work too.
We also know that Y=gG, where G is goats sacrificed, and g is real output per goat sacrificed. That will work too.
Those are all just accounting identities; all three are equally true, and equally useless.
I'm a very amateur auto mechanic, and a professional macroeconomist. I wish I knew as much about fixing macroeconomies as I know about fixing cars.