Might fiscal policy fail to increase aggregate demand?

Yes, it might fail.

Economists ought not be confident enough in our knowledge of how the economy works to say they are certain that a temporary increase in government spending will definitely increase aggregate demand. We just aren't that good (as if that needed saying).

Here is one reason why it might fail. I think it is the least implausible reason why fiscal policy might fail.

A temporary increase in government spending, financed by borrowing, will increase the future level of the government debt, and increase expected future taxes.

Taxes are typically not lump-sum. Most taxes depend on income; the more income you earn, the more tax you pay. Much of our income comes from investment, in physical and human capital. Higher expected future tax rates will reduce the expected future return to current investment, and will reduce current demand for investment.

(This effect on investment is in addition to any effect that future taxes might have on permanent disposable income and current consumption, which by itself should not fully offset the increased government spending.)

The magnitude of this effect is an empirical question. It depends on the elasticity of investment with respect to future returns, and on the exact nature of the future tax increases that people expect. If investment demand were elastic enough, and the expected future taxes distorting enough, it would be possible for a temporary increase in government spending to cause investment to fall by more than government spending increased, so that aggregate demand would fall. An increase in government spending would cause the IS curve to shift left.

I do not know the answer to that empirical question. Nor does anyone else know the answer to that question with certainty. We can only rely on past experience, hope that we have interpreted past experience correctly, and hope that the lessons of the past apply to the present.

This might or might not be what William Poole was talking about. It is more likely that he was talking about something like this than talking about a vertical LM curve. He did mention higher future taxes and tax incentives for investment; he did not mention interest rates.

I draw three lessons:

1. We need to be careful how we interpret people; especially those with whom we disagree. We might learn more if we apply the Principle of Charity.

2. Our preferred policies might fail for reasons we might not have thought of. Critics might think of something we haven't thought of. "Who could have known?" has been heard too often recently.

3. It would be prudent to try to design fiscal policies to minimise the chances that they might fail for all reasons, just in case the critics are partly right. For example, government spending on investments that increase future income would be especially desirable in the light of this critique, because they would be less likely to require future increases in tax rates.

Comments

[calmo]

That principal of Charity won't get you tenure though (reminds me of G E Moore correcting what's his face (JS Mill?...it's been awhile folks) only to be scorned for this misinterpretation later...but he was laughably lax wrt Wittgenstein's PhD) and half-wits don't want to go half hungry. No.
It B "whocouldanode?" from CR & crew...that's what you get for payin attention: calloused resentment of professionals (not always economists [Stephen Moore and pals] with large conformable (chomsky) audiences whose strong suit is not thinking, but...gliding. Powerful gliders who have substantial cushions...some even substantial enough to weather this descent maybe.

Isn't the reason for the stimulus, failing or succeeding, the last resort measure? Business has not indicated in any way that they are going to unleash their profits of yesterday and stimulate the bejesus out of us. No.
So we (students, following the path clearly trod by Nick, the All too Human) are not expecting latent economic genius performance from this effort. No.
A life boat or two, hopefully not sunk by fatasses, powerful fatasses who still might be able to sinkitall, in the effort to preserve their precious fannies.
For example, government spending on investments that increase future income would be especially desirable... already sounds like a worry about "shovel ready" proposals to me, but that worthwhile spending generating income for those "investors", lessening the tax burden for usall...has not been demonstrated for a decade or mo, yes? The poor, so pesky, keep needing services...and this bread-line stimulus, yes?
I am not even happy with Krugman today...and I feel like biting Nick's hand who just wants to help.
Dangitall.

[Nick Rowe]

calmo: "It B "whocouldanode?" from CR & crew". Yep! That's what I was thinking of. I made two attempts to spell it correctly incorrectly, then gave up, and just spelled it correctly!

I see fiscal policy as one last resort. But unorthodox monetary policy is a second last resort. (Can you have two last resorts?)

[Nick Rowe]

Now, why did that last comment go all italics? Let's see if this works: did that work?

[Stephen Gordon]

calmo's post left an italics tag open; I just closed it.

[JKH]

Nick,

I think I understand roughly the nature of the multiplier effect and I think I understand roughly the nature of Ricardian equivalence.

Can you explain in a succinct way the nature of the potential interaction between these ideas?

E.g.

Multiplier scenarios of .75, 1.0, and 1.25

bonds versus taxes

Wasn't this sort of thing part of the whole debate around Fama et al?

[JKH]

Off-topic,

Good article on the Canadian banks in the NY times, cross posted to Naked Capitalism

http://www.nakedcapitalism.com/2009/03/in-praise-of-primitive-banking.html

[Leigh Caldwell]

JKH: I'll have a go at that (no doubt Nick will add more insight too).

The multiplier effect depends on the extent to which Ricardian equivalence holds. If it holds perfectly - i.e. people expect all increase in income to be eaten up by future tax increases - then the multiplier effect should in theory be zero.

However, the truth of Ricardian equivalence also depends on the multiplier effect! Full Ricardian equivalence is based on the idea that national income will not be affected by a stimulus. If instead the stimulus does increase income, then future tax revenues will be increased automatically, partly offsetting the marginal tax rises that are expected. And does the stimulus increase income? Well, that depends on the multiplier effect!

Although I haven't worked out the mathematics, I expect there would be at least two stable equilibria: one where Ricardian equivalence is complete and self-fulfilling, and another where it is not complete and also self-fulfilling.

My choice between them is to throw in the fact that at least some people do not rationally optimise their lifetime predicted income, and therefore a stimulus will have at least some effect for those people. This is enough to give a non-zero multiplier, which in turn means Ricardian equivalence in its traditional sense will not hold, and thus the rational expectation of the investor should be for increasing income.

Cross-posted to Circular Ricardian equivalence at Knowing and Making. Will update later if I have worked out the mathematical implications

[bob]

yes, I think that ultimately it comes down to the multiplier.

If it is above one (+ interest on government debt), we should be ok. say we get a multiplier of 1.1, then the growth in employment will more than make up for the tax burden, and tax rates wouldn't have to go up. If we got a great multiplier of 2 then maybe tax rates could fall in the long run because of the increased revenue base (although the larger economy would require more services, so the tax rate wouldn't fall very drastically).

I think that designing stimulus carefully, and not counting on a great multiplier is the best course of action.

I'm a keynesian, but not a keynesian fundamentalist (neither was Keynes himself really). If I were a Keynesian fundamentalist, I would be advocating a plan to bury money in mineshafts for people to dig up. I don't have that unshakable faith in the multiplier effect, so I think it is important that stimulus projects raise long term productivity, as an insurance policy against a low multiplier.

[JKH]

Something says to me that a multiplier of 1 should logically represent some sort of neutrality with respect to a relationship between the multiplier and Ricardian equivalence. Does that make any sense? I haven't thought it through at all. Or is a multiplier of 0 some sort of inflection point? Or neither? I'm really just guessing at this point.

[Don the libertarian Democrat]

Nick,

Doesn't Buiter's proposal work without borrowing?

Leigh and Nick,

Is Ricardian Equivalence a tautology, akin to "Robbing Peter to pay Paul"? If you take, it must be from someone, etc. After all, it sounds as if no one has empirical evidence for this view one way or the other. I can see that it would have some theoretical use, since it focuses on the correlation of a few terms, but it seems dubious empirically. In fact, I'm not sure that it can be shown empirically at all, since it assumes a certain view of human behavior in order to be valid. If that view of human behavior is invalid, then, at best, this is a tautology, or simply, a model construct, useful heuristically, if not empirically. I go on like this when anyone mentions Moore and Wittgenstein. Please excuse me.

[bob]

"Is Ricardian Equivalence a tautology, akin to "Robbing Peter to pay Paul"?"

Seems to me that that is kind of the point of stimulus, no? We induce an increase in the velocity of money by robbing Peter (our future self), to pay Paul (our current self). It's the velocity of money that should induce growth, the flow of the transfer, not the sum that is transfered.

[bob]

just to clarify the comment above:

It seems like the Ricardian Equivalence crowd like Barro don't really believe in a multiplier effect, or just ignore it when it involves government expenditure? When it comes to tax cuts, they seem to grasp it just fine, although tax cuts tend to benefit the wealthy who save more and neutralize the multiplier (the failure of trickle-down).

I think that this is why Krugman and DeLong are so livid about these "dark ages" economists. They don't seem be believe in the multiplier effect, the power of exchange whereby through the course of trading goods and services amongst each other we all become wealthier on a net basis. You know, the market mojo. The fact that deflation and lower economic activity begets more of the same, and prosperity begets prosperity. By avoiding a deflationary spiral now, we will provide a better future for our children, and if the multiplier is good, we will be able to pay them back with interest without high tax rates. So to me it is not obvious that it would discourage investment. If the government is stimulating, and I were thinking of setting up a factory, I might be worried about having to foot part of the bill when it becomes due, but what if the multiplier is good and the stimulus works? Growth and increased productivity over time should make it a worthwhile investment and keep tax rates low. If it the multiplier is good and the stimulus is successful, it would be good to invest at the beginning. If the stimulus fails spectacularly then you would want to avoid investing because the profits would be less than the future tax burden. So I would say that future tax rates and therefore investment depend on the multiplier.

To my mind, the chief problem is leakage if other countries don't coordinate their stimulus and don't have free floating exchange rates. This would reduce the multiplier effect because a portion of the money sent abroad would just end up in foreign countries' forex reserves, pushing up our dollar, not being spent on our exports and not circulating in the global economy. I think this is why Krugman and Duy have been stressing the need for global coordination in pursuing stimulus, and are worried about leakage. No one country can stimulate the whole global economy without ruining its balance sheet, especially when there is a bloc of central banks in Asia determined to save.

[Nick Rowe]

OK. Let's see if I can answer all this at once.

In very simple Keynesian models, a $100 increase in Government spending will cause aggregate demand to rise by more than $100. For example, if an extra $1 of income causes private demand to rise by %0.50 (a marginal propensity to spend of 0.5), then a $100 increase in G will cause AD to rise by $200. Hence the name "multiplier", because the ultimate effects are a "multiple" of the original increase. In this example the multiplier is 2.

But language changed over time, and we began to use the word "multiplier" as a sorthand for "the derivative of AD with respect to G". So we could talk about a multiplier of 2, as in the above example, but we could also talk about a multiplier of 1 (if a $100 increase in G caused AD to rise by the same $100), or even (oxymoronically, but that never stopped economists) a multiplier of 0.5 (if a $100 increase in G caused private spending to fall, so the ultimate effect on AD was a rise of only $50).

And sometimes we define multiplier as the effect not on AD, but on real income, Y. (Whether an increase in AD causes an equal increase in Y depends on the slope of the Aggregate Supply curve).

Strict Ricardian Equivalence says that an increase in G financed by bonds is equivalent to an increase in G financed by current taxes. A logical corollary is that a cut in taxes financed by bonds will have zero effect.

Ricardian Equivalence thus says that the tax cut multipler is zero. And that the (bond-financed) government expenditure multiplier is equal to the "balanced budget" (tax-financed) government expenditure multipliers. In very simple Keynesian models, the balanced budget multiplier is 1. So if we add Ricardian Equivalence to a very simple Keynesian model we get a bond-financed government expenditure multiplier of 1 as well. In more complicated keynesian models (add imports, or an effect of income on interest rates) and the multiplier gets smaller still, but still positive for an increase in government expenditure, even under Ricardian Equivalence.

Ricardian Equivalence is not a tautology. It is almost certainly false (or at least, not exactly true). We can think of good theoretical reasons why it will not be exactly true. It is very hard to test Ricardian Equivalence in isolation. We can only test it in combination with other hypotheses.

I am not up to date with empirical tests of Ricardian Equivalence. I can remember one test by Greg Mankiw, many years ago, where he tested the combined hypothesis of permanent income theory+rational expectations against the current income theory. (Ricardian Equivalence assumes permanent income+rational expectations, while the simplest Kenyesian model assumes the current income theory of consumption.) He found that the facts seemed to be roughly halfway between the two theories. That seemed plausible to me, and even though it was not a direct test of Ricardian Equivalence, I tend to think of Ricardian Equivalence as being about half true, unless someone convinces me otherwise.

I think of it this way: "Ricardian effect" will tend to reduce the size of multipliers, but only full Ricardian Equivalence can reduce a multiplier to zero, and then only the tax-cut multiplier, not the government spending multiplier.

The theory I sketched above, of a negative multiplier, is very different from Ricardian Equivalence (though Ricardian Equivalence would make it easier for my effects to get a negative multiplier). Ricardian Equivalence is about the effect of future levels of taxation on permanent disposable income and hence on current consumption. I am talking about the effect of future marginal tax rates (not the same as tax revenue) on current investment. Ricardian Equivalence is about wealth effects on consumption. I am talking about incentive effects on investment.

Leigh: if you take a standard simple Keynesian model, you will never get the result that increases in G are self-financing. Or rather, you would only get it with a mpc>1, which makes the equilibrium unstable, if it exists.

But it is possible to take a fairly standard ISLM, plus liquidity trap, plus Phillips Curve, plus adaptive expectations, plus a Taylor-rule type monetary policy, and get a temporary increase in G to be self-financing. I sketched it in a post a month or two back. (Damn, but I can't remember the post title). The trick is that the above model has two equilibria, each locally stable. And you can use a temporary increase in G to jump you from the low equilibrium to the high equilibrium. But nobody paid any attention to my radically exciting post, boo hoo!

May respond to other points later.

[calmo]

I could be wrong (imagine that!) but my view is that philosphers have been replaced by economists in the business of Nogginhood. Decades ago. When I was misled by mere curiosity. [somewhat continuing plight] And not remuneration. Leaving me with not only antiquated references. But beans and rice. Not petite Angus (something to eat, you vegetarians, not some little Scottish Bagpiper).
So my HCL is spectacular, yours?
Me too Don the libertarian Democrat Who is Not about to Confuse you with Descriptors...apologies allround.
For those less antiquated, Moore refereeing Wittgenstein's PhD thesis, admits that he doesn't understand a word of the Tractatus, but asserts that it is far beyond the requirements needed...an action that damaged more than his over-sold reputation, but possibly the English tradition of Philosphy now housed in Romance Studies...depending on the economic priorities of the institution...staffed with very few philosophers and many economists or administrators steeped in economics (not poverty stricken tautological tautologies, you know?)
So, that ancient reference not totally without context.
Unlike this comment so far.
But bob rescues me: thank you for noting the time scale behind the Peter and Paul robbery.
Annow the velocity bit...the mislead, I make it, or perhaps merely a distraction. In our efforts to get the entire picture (seriously, this is it, right? we need to weed out the inconsistent bits that collide with our basic requirement for a coherent picture, yes? I have no use for those who get the 'velocity' picture in perfect focus at the cost of discarding nearly everything else...I am revisable) we skip the observation that few have gadzooks of money...it's so political, too political...for any forward movement.
Anso the reluctance to pass the US stimulus bill, comes from the party closer to money...as Menzie puts it: from those households less liquidity constrained, that will be paying higher taxes for goods and services going to the "so underprivileged" (Mrs Bush).

[Nick Rowe]

Don:
"Doesn't Buiter's proposal work without borrowing?"

You mean helicopter money? Yes, it works without borrowing. Just print money and give it to people as a transfer, or tax cut.

OK, the government "borrows" the money from the central bank, and gives it bonds in return. But since the government owns the central bank, it's a wash.

The tricky thing is: what if you print a lot of money now, to get the ball rolling, but once it does start rolling you need to reduce the quantity of money, because you realise you've overdone it, and it's starting to cause hyperinflation? The the Central bank needs to buy it back, by selling the bonds it got from the government. And now the government's debt really does go up.

That's what Buiter of the blog, as opposed to Buiter of that paper, was so concerned about.

[Don the libertarian Democrat]

I know I'm alone in this, but I think that's a more solvable problem than Debt-Deflation, which is a kind of economic vertigo. But if Buiter doesn't even recommend it, I guess it won't be going anywhere.

Since I'm for:
1) Buiter's QE
2) The Swedish Plan
3) Narrow Banking
4) A sales tax cut as stimulus
I'm not doing very well in this crisis.

[Mark]

Is it fair to say that your above post is just another way to approach the same conclusion Fama and Cochrane reach that the government multiplier most likely does not exceed zero (nevermind one)?

[Nick Rowe]

Mark: Hmmmm. Yes, no, maybe, sort of.

I think Cochrane and Fama were saying the multiplier is zero, but I couldn't figure out their reasoning on that point.

I am saying, in this post, that it is theoretically possible for the multiplier to be positive, zero, or even negative. It all depends on the actual numbers (the parameters). And I am explaining the reasons.

[jp]

I enjoyed this article and the other ones you've written on the subject of fiscal policy's effectiveness.

I was reminded of a paper I read a few days ago called "Crowding Out and It's Critics" published by the St Louis Fed (free!)

http://research.stlouisfed.org/publications/review/75/12/Crowding_Dec1975.pdf

The authours show how fiscal policy may not be effective. They illustrate several examples in which the IS curve shifts to the right and then back to the left such that aggregate demand is not stimulated. Anyone interested in seeing Nick's ideas illustrated using ISLM may find this interesting. Nick, is the particular case you were describing on the bottom of page 5?

Also, what does an ISLM diagram showing increased bond financed gov't spending subject to Ricardian Equivalence look like? Is it also a movement to the left of the IS curve, or is there some movement in the LM curve? Does it require a vertical LM curve?

[Nick Rowe]

Thanks jp!

Oh my God, that article brings back memories, from grad school! I think it was on David Laidler's reading list, Fall 1977. It was a very good article in it's day, and still reads well. Did someone just post it again recently? How did you find it?

The one I'm talking about here has the IS curve move left, so it's not quite like the bottom of page 5 case, which also talks about the LM curve moving left, because of an increase in money demand. (Money demand is not so relevant currently, since the central bank will adjust supply endogenously, setting a horizontal LM curve). Also, I have tried to explain why the IS curve would shift left, rather than just talk about "business confidence".

Ricardian Equivalence does not rely on a vertical LM curve, or any shift in the LM curve. Instead, RE says the IS does not shift when you cut taxes (or the fall in consumption causes it to shift back to where it began). The "ultra-rationality" case they describe comes very close to Ricardian Equivalence, though you would need to assume both Ricardian Equivalence plus assume that government expenditure is a perfect substitute for private expenditure to get full crowding out of changes in government spending (as well as tax cuts).

[hartal]

My concern is that the anticipated profitability from new investments is so weak that whatever demand support government spending provides in hopes of encouraging new investment will be neutralized by the discouragement of investment due to expectations of future higher tax rates cutting into profits. In other words, the problem of extant overcapacity can't be solved without a new source of "Malthusian" demand, i.e. demand that does not create new supply and compound the problem of overcapacity; but such a new source of demand (debt financed government spending) cannot be generated without compounding the supply problem, that is underinvestment.
There does not seem to be any way out of the crisis by means of Keynesian macro-management. The question is how private investment will be revived. Fixing the banks will not be the solution;and the fixation on fixing the banks only speaks to the objective illusion that the interruption of circulation seems to be caused by a shortage of money. The resumption of private investment will depend on raising profitability by cutting capital costs (perhaps through a wave of employment destroying mergers and acquisitions) and raising the rate of exploitation (as a result of renegotiating wage contracts in a weak labor market).
There will be groping attempts by business to rationalize costs as society staggers along in a depressed state for the next few years. Policy will be powerless to reduce the misery.
Brad DeLong attacks this as nihilism with an ulterior motive. But it could also be the truth of the situation, and its unpleasantness does not make it any less true.

[Nick Rowe]

hartal: I did a double-take when I saw you use the word "Malthusian" in this context! But your use was correct. (For those that don't know, Malthus didn't just write about population; Ricardo agreed with Malthus on population, but the two disagreed on Say's Law [supply creates its own demand] with Malthus arguing for the possibility of deficient aggregate demand).

The alternative (or complement) to fiscal policy is unorthodox monetary policy. We have the central banks just keep on increasing the supply of money (or money+bonds) by whatever means necessary, to whatever extent necessary, until we create an excess supply that people don't want to hold, and want to spend/lend/invest. Helicopter money creates a Malthusian source of demand. The problem is to find some way to create the expectation that the new money (or the money finance of fiscal deficits, if we see them as complements) is permanent, and so does not imply future tax liabilities.

"Inconvenient truth" maybe? But I don't think it's a "truth". More of a "might be", or a risk, and one that can be ameliorated. But yes, attacking motives wouldn't help.

[bob]

"My concern is that the anticipated profitability from new investments is so weak that whatever demand support government spending provides in hopes of encouraging new investment will be neutralized by the discouragement of investment due to expectations of future higher tax rates cutting into profits."

Well, if we assume that all stimulus will fail, of course that will discourage investment. It's called a deflationary depression. That's what some of us are trying to avoid. Right now, investors are dumping their money in treasuries because they can't find good uses for it, not because they are worried about future taxes. Successful stimulus creates investment opportunities that are profitable, even when the tax costs are taken into account, inducing investors to take their money out of treasuries and invest it in the private market. THAT'S THE WHOLE POINT. Ricardian Equivalence is just a way of assuming the failure of stimulus, without proving that it will fail. Circular reasoning, bad economics and bad public policy.

I can't believe that we are even having these discussions really. Nick, if you don't believe that the Ricardian Equivalence crowd really are in the Dark Ages, just take a look at hartal's comment. discredited fallacy upon discredited fallacy, with a sprinkle of Malthus for good measure. I wouldn't be surprised if hartal trepans when he gets a headache. The sad truth is that DeLong and Krugman are actually 100% right about these guys.

[bob]

"The problem is to find some way to create the expectation that the new money (or the money finance of fiscal deficits, if we see them as complements) is permanent, and so does not imply future tax liabilities."

Growth. The way to create that expectation is to create a good stimulus plan that protects and raises long term growth. If the multiplier is high, then it is a good time to invest, if it is low than it would discourage investment. Ricardian Equivalence depends entirely on the multiplier, not vice-versa as something that pushes down the multiplier. As an investor, investing right now is a bet on the multiplier, a bet that the stimulus will work, and that profits will be greater than the ultimate tax burden.

If I thought that the Obama plan was big enough, and had a good enough multiplier, I would be up to my eyes in stock right now, but the plan is weak both in terms of size and multipliers, so I'm still shorting the SPY.

Leigh Caldwell nailed it in his comment above.

[Nick Rowe]

bob: you are conflating a number of quite different arguments about why fiscal policy arguments might fail. Some of those arguments are obviously bad theoretically, some obviously bad empirically, and some are not obviously bad (and might be at least partly right). Let me list the ones you are conflating:

1. The loanable funds savings=investment as an (unacknowledged) identity. Theoretically bad. Definitely "Dark Age"

2. Vertical LM. "Interest rates will rise by whatever it takes to get 100% crowding out". Under current circumstances (but not in normal times) obviously empirically bad. Definitely "Dark Age".

3. Ricardian Equivalence. "The effect of expected future taxes on current consumption". Theoretically OK. Empirically probably a half-truth. And even if fully true, would not prevent an increase in G (rather than a cut in T) from having some effect (just a smaller one than if it were 100% false).

4. The unnamed effect that I and hartal are talking about. "The effect of future tax RATES (not revenues) on INVESTMENT (not consumption)". This is NOT Ricardian Equivalence, for both those reasons. Empirically: dunno. Not obviously empirically bad.

Ignore 1 and 2.

Anyone who invokes 3 or 4 does not ASSUME that fiscal policy will fail. Instead, it is a conclusion derived from theory plus assumed parameter values.

(It is true, however, than in working out whether fiscal policy will succeed or fail, an economist will sometimes initially SUPPOSE it succeeds, or suppose it fails, and try to derive a contradiction. For example, if I initially suppose it fails, and then find that, under that supposition, demand exceeds output, then I know my initial supposition was wrong, and the policy must succeed. But if instead I find that demand=output, then I confirm my initial supposition [unless there are multiple equilibria, in which case failure is one possibility, but not the only possibility].)

Now. You (I think) implicitly invoke the "accelerator" model of investment (investment depends on expected future demand for output). Accelerator effects are important. They are like multiplier effects. (Except that multiplier effects have demand depend on the level of output, while accelerator effects depend on the rate of change of output). But these "amplification" effects need a signal to amplify. If the fiscal stimulus will succeed anyway, even without amplification, they will make it succeed by a bigger amount. But by the same token, they will also amplify failure. If the fiscal stimulus will fail (cause output to fall) anyway, even without amplification, they will make it fail by an even bigger amount.

So, if your defence of the success of fiscal policy rests purely on the accelerator/multiplier, or other amplifications, then it is you who is assuming what you need to prove.

Just to make it more complicated still, I believe, like Leigh (though for perhaps different reasons) that there are multiple equilibria. But then I am unhappy about simply assuming that fiscal policy can automatically jump us to the good equilibrium. (If I thought it could, I would recommend a fiscal policy of sacrificing a goat.) I would prefer to find a temporary fiscal policy which could eliminate the bad equilibria as an equilibrium, and force the economy onto the good equilibrium.

What's SPY?

[JKH]

Securities Issuer Type Symbol

SPDRS (Standard & Poor's Depositary Receipts) AMEX ETF SPY

[Nick Rowe]

Thanks JKH! So "shorting the SPY" means betting that the S&P500 will fall, I suppose.

Just to add to my comment above: if there are multiple equilibria, and I believe there are, then IF fiscal policy succeeds in getting us from the bad to the good equilibria, then it IS entirely possible (though not certain, it depends) that the fiscal policy could be self-financing, or even MORE than self-financing. In other words, a successful deficit-financed fiscal policy could even reduce the future debt/GDP ratio, and mean that future tax rates would be LOWER than they would otherwise be. Which would, of course, be great on all counts, both because we don't like high tax rates in the future, plus because the Ricardian and 4-effect would actually go in reverse, and would amplify the effectiveness of the fiscal stimulus. It wouldn't just be a free lunch. It would be a lunch we would be paid to eat!

[hartal]

Nick, what the American conservatives should give to have someone of your analytical power on their side, though of course you are not on their side: you are only showing that with certain assumptions fiscal policy could fail, not that it will, or is even likely to, fail, and that if it were to fail, monetary policy could then be radicalized. Bravo. Ultimately I take your analysis as a reminder that the Keynesian system is not mechanical in its operation. Bob, I am interested in this possibility of failure not because I want Obama's plan to fail. I am a die hard Obama supporter. I want him to succeed, but because I have two young children and a renewable contract, I want to make sure that we have some alternative strategy if fiscal policy does not work as Christina Romer thinks it will.

[bob]

yep, that's what I'm saying.

It's still a big if. I think the "IF" of fiscal policy is the multiplier versus the tax burden. That's how the CBO has their stimulus summary table set up:

http://economistsview.typepad.com/economistsview/2009/03/estimated-macroeconomic-impacts-of-the-american-recovery-and-reinvestment-act-of-2009.html

Some people definitely will respond like in 3 or 4 (put their stimulus rebate in a savings account or treasuries), but if a critical mass of the consumers and investors start spending, it's better to be in equities than treasuries or a savings account, so 3 or 4 becomes illogical. The multiplier is the tricky part where design comes in. It seems like it's more of an art than a science at this point, as a stimulus designer you are kind of in the business of fooling people into spending money that they will have to pay back later.

[Nick Rowe]

Yep. You get where I'm coming from. But I would rather see unorthodox monetary and fiscal policy working together, rather than trying fiscal and then using unorthodox money of it doesn't work. I really wish my head were clearer on this, but maybe they are complements rather than substitutes. In other words, they are multiplicative rather than additive in their effects. If fiscal deficits were money-financed, rather than bond-financed, we wouldn't have to worry about 3 and 4 at all (I think, not 100% sure). A (permanently) money-financed temporary deficit is helicopter money. It brings a (desirable) increase in expected inflation to the table, reinforcing the direct effects from fiscal policy. And if money-financed, the inflation tax would not kick in to trigger 3 and 4 UNLESS the policy were actually successful. So we could not use 3 and 4 to argue that the policy would fail. Because if it did fail then there wouldn't be an inflation tax.

But, how to make sure it will be money-financed. That's what I still can't get my head around.

[hartal]

Yet I still think there are grounds for worrying that even a coupled program of unorthodox monetary and fiscal policy will not improve anticipated profitability such that private investment will go in a downward spiral until capital and labor costs have been cut. The other side of Bernacke's savings glut after all is a dearth of profitable opportunities.

[bob]

I think that helicopter drops do have attractive features, in terms of how they are financed (by printing money, minimizes 3 & 4), but that fiscal policy is attractive in how it is administered.

In a pure helicoptor drop of freshly printed money, many people will spend, but many will save regardless, neutralizing part of the multiplier effect.

With government spending, the sum is guaranteed to be spent in the first instance, and people may be even less inclined to save it when it comes to them in the form of a government salary or contract, rather than a windfall.

I think that this is why the minimum multiplier for government spending in the CBO estimates bottoms out at 1, while their estimates for "helicopter drop" type payments (tax rebates) can fall below 1:

http://economistsview.typepad.com/economistsview/2009/03/estimated-macroeconomic-impacts-of-the-american-recovery-and-reinvestment-act-of-2009.html

I think that monetizing government spending could incorporate the best of both, so I think I'm with you on that. I guess the simplest way for the government to do it would be to secretly print up cash, and use it to spend on infrastructure etc. although this is not possible with the current system. I guess the government would still have to issue bonds and the bank of canada would print the money to buy them, so even though the net debt of the country does not increase, the nominal debt of the government would. I have to think this through a bit more, as I'm not certain as to what all the effects would be, but it seems attractive. Almost like a Social Credit idea?

I've been reading a post by Andy Harless, and your post here:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2008/11/will-deficit-spending-in-fact-be-moneyfinanced.html

Very interesting. Seems that if stimulus can tilt the economy back into a good equilibrium (up the icy hill, as Mark Thoma put it) the stimulus could be self-financing, either fiscally, or monetarily. I think it was Bill Vickrey who said that inflation was the consequence of a failed monetary stimulus, one that is too small to shift the equilibrium, not monetary stimulus itself. Makes a lot of sense to me. You only pay for stimulus if it doesn't work, either fiscally via high tax rates or monetarily via high inflation rates.

[hartal]

Helicopter money or not and Krugman's babysitting coop or not, the most important and volatile motivation to spend in a capitalist economy
is the making of profit by the production of commodities. That is, not all spending is for services as in Krugman's coop. And even
if the money will lose value due to a regime of inflation expectations business won't necessarily invest as long as anticipated profits
are weak. Fiscal policy can solve the demand side for business but only at the expense of creating the threat of underinvestment in the long
run especially if the economy is not expected to grow, for then tax rates will have to be raised and investment possibly discouraged in the here and now.
And I submit that this is the principal problem: there is no long term driver of growth, and the age of bubbles is now over.