In a recession it is easy to motivate some form of discretionary fiscal policy. Let us rehearse the arguments: aggregate demand is shocked downwards as real and financial wealth falls; under heightened uncertainty, consumption and investment plans are delayed; and the ongoing difficulties in obtaining (bank and other financial) credit seem likely to amplify the impact of these effects on the economy. Furthermore we can point to a co-ordinated international downturn, which not only is likely to increase the size of the initial shock but also limit individual country responses with no individual option available to increase external demand. Furthermore it has become clear that monetary policy has reached its limits, with the zero bound and resort to quantitative easing, which means that there is an "interest rate gap" to be mopped up by fiscal policy expansion.
So if we can agree that there is a demand gap going forward and fiscal policy is part of the answer, what form should the fiscal stimulus take? One background point first - there has been an upward shock to the level of public debt in all economies with substitution of private claims for public claims on banks and this means that all economies are nearer some notion of the threshold of public solvency than they were prior to the crisis. And implies that the overall room for manoeuvre is somewhat limited. The IMF use a number of key phrases in thinking about the fiscal response. That it should be timely (now); large (expensive); contingent (could be end up being even larger); collective (all join hands) and diversified (to deal with the uncertainty of multipliers in any one sector). What really worries me is that large is no substitute for well directed and that for any discretionary fiscal policy to work what it must put spending into the economy in exactly those areas where demand has been weakest during contraction, which implies to my mind that it is temporary in nature and well targeted rather than scattergun. For example, a scheme to help the recently unemployed maintain consumption or for idle construction projects to go ahead is preferable to one that raises the wages of public sector workers, even academics.
The temporary nature of the fiscal expansion is also key. If treated as permanent, the fiscal expansion is more likely to lead to higher nominal interest rates at term and hence crowd out private sector investment or expenditure as it will be perceived to reflect more probability of default or inflation risk. Obviously this kind of concern will limit the accommodative stance of monetary policy at zero nominal rates. Think flat LM curve with IS shocks and upward sloping LM curve with the same shocks - in the latter case with higher interest rates, output (and the multiplier) is lower. In this respect funding choices also matter - a government that raises discretionary expenditure with index-linked bonds may be treated as more credible than one that does so with nominal bonds and hence may be able to reduce the crowding out. It also likely to be the case that a more permanent increase in expenditure is one which people will save against. The Ricardian equivalence hypothesis may not work when there are liquidity constraints and when the government can borrow more cheaply than the private sector but if government behavior more clearly starts to resemble the private sector and of more equal risk, any advantage will be watered down.
So how should fiscal policy state what is does during a deep recession in order to maximise its effectiveness? It helps to start with monetary policy as an example. The solution to the zero bound problem for monetary policy involves some kind of commitment to inflate. Which is a long run commitment to do what is necessary to drive inflation up. This is possible because monetary policy ultimately controls the price level. But fiscal policy cannot promise to spend, spend and spend again to save the country it loves (passim Gaitskell) because that raises the spectre of fiscal solvency and increases the present value of the burden on tax payers, reducing their marginal propensity to consume. Ultimately we believe that income is supply side determined. In this sense fiscal policy is more like a one-off expansion of a deflated tyre - some air should go into the gap but not too much. The expansion should be just enough to offset deflation and leakages ought be minimised. And when the tyre gets back to the correct pressure all expansion must be turned off immediately.
So how can we answer the key question on fiscal policy? How vocal should fiscal authorities be about the exit strategy, by which we mean the relaxation of high levels of discretionary expenditure? The key is to ensure some belief in the government's present value budget constraint. That spending will be undertaken to the extent that it does not threaten fiscal solvency. But who should judge whether a government's spending is solvent? Certainly not the government itself or the(ir) IMF (representatives) and probably the financial markets should play a role, which they will do in the pricing of nominal and real government liabilities at term. But while QE continues it will be very hard to treat market prices as telling as much about the financial markets' views. And so under uncertainty about the preferences or ability of the government to cut back on fiscal expenditure, there needs to be some conditional plans about the path of real expenditure and revenue which are measurable. Which sounds very complicated and rather difficult to convey and so what so the danger is that we might end up with is something more of a random walk, which seems to increase uncertainty.
If we want to keep the public sector as large as it is now, there will have to be increases in expenditure and tax increases over the longer run. But some serious discussion about the appropriate size and role of the public sector is also required, which does seem somewhat bloated. So as well as plotting a course out of the current sequences of deficits, responsible government would also call for a debate on the appropriate size and government involvement in the economy, as well as the magnitude of both public and private indebtedness.
No comments:
Post a Comment