Mr. Hollande the fiscal multiplier is zero if Mario says so

 The newly elected French president Hollande’s rallying cry has been “Yes to growth and no to austerity”.

While I am certainly is no Keynesian (I my readers know that very well…) and my gut instincts are (very!) fiscally conservative I have some sympathy with what Hollande is saying. While I strongly believe that Europe needs massive structural reforms to bust productivity growth in the longer run I also believe that the present crisis has very little – if anything – to do with the lack of structural reforms. The crisis in Europe has nothing to do with tax evasion in Greece, rigid Italian and Spanish firing and hiring rules or an overly generous French pension system. These are all massive problems that need to be addressed, but they are not the causes of the crisis. The crisis is primarily a result of the massive drop in nominal GDP, which we have seen in the euro zone since 2008. And that problem can only be solved by the ECB moving towards a much easier monetary policy stance. There is no way around this.

While I have sympathy for Mr. Hollande’s concerns about the direction of economic policy in Europe I nonetheless think that his analysis of the situation is seriously flawed. Mr. Hollande fully well knows that no government, company or household in the long run can spend more money that it earns. This is simple mamanomics – my mom always used to tell not to spend more money than I earn. This is not economic Calvinism, but simple economic law. That said, how much revenue the French government brings in is crucially dependent on the level and growth of nominal GDP.

Mr. Holland understands this, but he is wrong when he seems to believe that you can increase nominal GDP by boosting public spending. Said in another way the fiscal multiplier is zero.

Lets imagine that we get a Hollande style European “growth pact” which dictates that fiscal policy will have to be eased by 5% GDP in all euro zone countries. Imagine then that this miraculously does not have any negative impact on market sentiment and that increases NGDP by lets say 2% across the euro zone. Hollande would be happy, but would the ECB also be happy?

We most assume that the ECB thinks that nominal GDP in the euro zone is exactly where it should be right now – neither too high nor too low – otherwise the ECB would have done more to boost NGDP. Hence, if Mr. Hollande is able to able to increase the euro zone NGDP by 2% then the ECB would be in a situation where it would face an level of NGDP which would be too high for its liking and as a consequence it would have to move towards a tightening of monetary policy. Hence, the ECB will always have the final word on the level of NGDP – no matter what Mr. Hollande thinks. This is why I have earlier argued that there really is no such thing as fiscal policy – at least in way Keynesians traditionally think about fiscal policy. Fiscal policy cannot on its own increase NGDP. Only the central bank can do this.

You might object and say that ECB does not think that the NGDP level is where it should be. Well, if that is the case then the ECB tomorrow can increase NGDP to exactly the level it want. There are numerous ways to increase NGDP and if you think that the central bank cannot do it then you might want to consult Gideon Gono.

So yes, Mr. Hollande is right when he says that we desperately needs growth (in NGDP) in the euro zone, but he is wrong if he think that it can be achieved by increasing the budget deficit in France or anywhere else in Europe. Only Mario Draghi and his colleagues in the ECB can increase euro zone NGDP.

At the core of Mr. Hollande’s failed analysis is that he is doing “national accounting economics”. He starts out with a national accounting identity: Y=C+I+G+NX. As a consequence he think he by increasing government spending (G) can increase GDP (Y). Had he instead started out with the equation of exchange (MV=PY) then he would have realised that recessions are always and everywhere a monetary phenomenon and that the fiscal multiplier is zero.

I am sorry for sounding like a broken record, but it is saddening and frustrating that nearly no European policy makers realise that at the core of our problems is an overly tight monetary policy and the crisis cannot be solved by more austerity nor can it be solved by a more expansionary fiscal policy. Neither the Keynesian nor the Calvinists are right. It’s not about fiscal policy. It is about monetary policy and if Ralph Hawtry, Gustav Cassel or Milton Friedman were alive they would scream it at you!

PS Maybe British Prime Minister David Cameron is the European leader who comes closest to understanding the need for monetary easing to solve the European crisis. See Britmouse’s excellent comment on Cameron’s recent speech on the UK economy.

Leave a comment


  1. Bill Ramsay

     /  May 17, 2012

    It does seem reasonable to assume that monetary policy can essentially always counter fiscal policy, but do you not think there are times when monetary policy gets “stuck” in which case a fiscal boost can get the monetary engine going? Or perhaps another way to put it is that monetary authorities might be unwilling to pull the trigger on loosening, but would be willing to avoid tightening in the face of a fiscal boost?

  2. Bill, No I don’t think monetary policy gets “stuck” in the sense that we would be in an liquidity trap. That said, do think that what would be hugely irresponsible fiscal easing could increase expectations that the public debt could be monetized in the future and as such spur expectations of higher NGDP growth in the future. However, the central bank will always be able to counteract this.

    A possibility is of course that the central react passively – and that fiscal easing “triggers” monetary easing, but I don’t that. Especially with the über hawkish ECB leadership.

  3. “no government, company or household in the long run can spend more money that it earns”

    Then central banks, Mario’s especially, better start running optimal ‘deficits’ of net financial assets (assets unencumbered by offsetting credit liabilities), rather than just targeting interest rates and purchasing govt securities. I believe a CB could target NGDP indefinitely with QE1-style operations, or close-to-optimal interest payments on reserves. But QE2 or rate targeting, even if they are supportive of NGDP for a time, will lead inevitably to financial fragility. Perhaps some market monetarists are already aware of this (apologies for my ignorance)?

    And in any case, what you’ve said here is untrue for a govt that is monetarily sovereign. With an ‘inconvertible’ currency and modern central bank and sovereign budget operations, fiscal and monetary operations are two sides of the same coin (see Scott Fullwiler’s work, for example). Granted, they can work at cross-purposes, but so can fiscal actions alone (or CB operations alone, which happens all the time). But under conventional CB policy operations, and in a world of positive nominal rates, a sovereign govt must spend into existence at least some of the money that companies and households earn, save, and pay taxes with…no?

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