All posts tagged Fiscal multiplier

Sunday notes – Three working papers and three prediction markets

It is Sunday morning and I really shouldn’t be blogging, but I just have time to share a couple of working papers with you.

First on the list yet another great paper from my friend Bob Hetzel at the Richmond Fed – “A Comparison of Greece and Germany: Lessons for the Eurozone?”

Here is the abstract:

During the Great Recession and its aftermath, the economic performance of Greece and Germany diverged sharply with persistent high unemployment in Greece and low unemployment in Germany. A common explanation for this divergence is the assumption of an unsustainable level of debt in Greece in the years after the formation of the Eurozone while Germany maintained fiscal discipline. This paper reviews the experience of Greece and Germany since the creation of the Eurozone. The review points to the importance of monetary factors, especially the intensification of the recession in Greece starting in 2011 derived from the price-specie flow mechanism described by David Hume.

It is incredible that Bob continues to write great and insightful papers on monetary matters and this paper is no exception. By the way Bob is celebrating 40 years at the Richmond Fed this year.

Second (and third) are two papers by Andrew Jalil. First a paper he has co-authored with Gisela Rua – “Inflation Expectations and Recovery from the Depression in 1933: Evidence from the Narrative Record”.

Here is the abstract:

This paper uses the historical narrative record to determine whether inflation expectations shifted during the second quarter of 1933, precisely as the recovery from the Great Depression took hold. First, by examining the historical news record and the forecasts of contemporary business analysts, we show that inflation expectations increased dramatically. Second, using an event-studies approach, we identify the impact on financial markets of the key events that shifted inflation expectations. Third, we gather new evidence—both quantitative and narrative—that indicates that the shift in inflation expectations played a causal role in stimulating the recovery.

It is clear to see both the influence of Christina Romer and Barry Eichengreen in the paper, but mostly I am reminded of Scott Sumner‘s unpublished book on the Great Depression.

I very much like the narrative approach to analysis of “monetary events” where you combine news from for example newspapers or magazines (or these days Google Trends) with the financial market reaction to such news – an approach utilized both in this great paper and in Scott’s Great Depression book.

Such approach captures the impact of expectations in the monetary transmission mechanism much better than traditional econometric studies of monetary policy shocks. As Scott Sumner often has argued – monetary policy works with longer and variable leads – as a consequence it might not make sense to look at present money base and money supply growth or interest rates. Instead we should be looking at expectations of changes in monetary policy. By combining newsflow from the media with information from financial markets we can do that.

The conclusion from the Jalil-Rua paper by the way very much is that monetary policy can be highly potent and that expectations are key for the transmission of monetary shocks.

Marcus Nunes, David Glasner and Mark Thoma also comment on the Jalil-Rua paper.

The other Jalil paper is a paper – Comparing tax and spending multipliers: It is all about controlling for monetary policy – from 2012 that I discovered when Googling Jalil. It is at least as interesting as his paper with Rua and it is on the topic of fiscal austerity and the importance of the monetary policy regime for the size of fiscal multipliers.

Here is the abstract:

This paper derives empirical estimates for tax and spending multipliers. To deal with endogeneity concerns, I employ a large sample of fiscal consolidations identified through the narrative approach. To control for monetary policy, I study the output effects of fiscal consolidations in countries where monetary authorities are constrained in their ability to counteract shocks because they are in either a monetary union (and hence, lack an independent central bank) or a liquidity trap. My results suggest that for fiscal consolidations, the tax multiplier is larger than the spending multiplier. My estimates indicate that whereas the tax multiplier is roughly 3—similar to the recent estimates derived by Romer and Romer (2010), the spending multiplier is close to zero. A number of caveats accompany these results, however.

You really shouldn’t be surprised by these empirical results if you have been reading market monetarist blogs as we – the market monetarists – have for a long time been arguing that if the central bank is targeting either inflation or nominal GDP (essentially aggregate demand) then there will be full monetary offset of fiscal austerity.The so-called fiscal cliff in the US in 2013 is a good example. Here fiscal austerity was fully offset by the expectation of monetary easing from the Federal Reserve.

This of course is really not different from the results in a standard New Keynesian model even though self-styled “Keynesians” often fails to recognise this. But don’t just blame Keynesians – often self-styled anti-Keynesians also fail to appreciate the importance of the monetary regime for the impact of fiscal policy.

More challenging of standard Keynesian thinking is in fact that Jalil shows that even when we don’t have monetary offset the public spending multiplier appears to be close to zero, while there is a strongly negative tax multiplier. That means that governments should rely on spending cuts rather than on tax hikes when doing austerity.

And finally I should note this Sunday that Hypermind has launched a couple of new prediction markets that should be of interest to most people in the finanial markets. The new markets are a U.S. presidential election prediction market and one on whether we will see Grexit in 2015 and one on whether EUR/USD will hit parity.

Enjoy the reminder of the weekend – tomorrow I am heading to Poland for a couple speaking engagements. I think I will be spreading a rather upbeat message on the Polish economy.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

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by Lars Christensen on May 17, 2015  •  Permalink
Posted in Andrew Jalil, Gisela Rua, Scott Sumner
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Posted by Lars Christensen on May 17, 2015

https://marketmonetarist.com/2015/05/17/sunday-notes-three-working-papers-and-three-prediction-markets/

Brad DeLong on the Sumner Critique and why the fiscal multiplier is zero

This is Brad DeLong:

An optimizing central bank that cares only about inflation and unemployment because it does not find itself at the zero nominal lower bound and does not fear engaging in nonstandard monetary policy will engage in full fiscal offset: it will take care to make sure that if fiscal policy becomes more stimulative then it will make monetary policy less stimulative by the same amount.

What Brad of course here is expressing is the so-called Sumner Critique – that is the fiscal multiplier will always be zero if the central bank directly or indirectly targets aggregate demand either as a result of an inflation target, an NGDP level target or for that matter a Bernanke-Evans style monetary rule.

Brad has a nice little model to illustrate his point. In some ways Brad’s model is similar to Nick Rowe’s game theoretical discussion of what Brad calls “full fiscal offset” (see my earlier post on the topic here). My simpler IS/LM+ model illustrates the same point (have a look at the model here).

Brad, however, thinks that the fiscal multiplier is positive at the Zero Lower Bound (ZLB):

… this argument breaks down at the zero nominal lower bound. At the zero lower bound the central bank does care only about inflation and unemployment. It cares as well about the magnitude of the non-standard monetary policy measures it must take in order to achieve its net monetary policy impetus value m.

This argument is somewhat harder for me to get. The Zero Lower Bound only exists as a mental construction in the heads of central bankers. Central banks can always ease monetary policy – even if interest rates are close to zero. That is exactly what the Fed and the Bank of Japan are doing at the moment.

Furthermore, it might of course be right that “real world” central banks prefer not to use other instruments rather than interest rates and therefore prefer the government to “push” aggregate demand (hence that is why Brad argues that the “instrument” should enter into the utility function of the central  bank). However, that would still be monetary policy (rather than fiscal policy) as government spending would only impact aggregate demand/NGDP because the central bank chose not to offset the increase in government spending. If the central bank on the other hand used for example a money base rule or McCallum’s MC rule where the policy instrument is a combination of the exchange rate and interest rates then the central bank would not pay any attention to the ZLB.

PS I find it “interesting” to read the comment section on Brad’s blog. It is clear that some of the more ideologically inclined Keynesians have a very hard time accepting the fact that the fiscal multiplier might be zero. (yes, I similarly have a very hard time accepting arguments that it might be positive so I am no saint…)

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This one is pretty funny (HT Daniel Brackins)

krugman astroid

14 Comments
by Lars Christensen on February 18, 2013  •  Permalink
Posted in Brad DeLong, Fiscal multiplier, Fiscal policy, IS/LM model, Sumner Critique
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Posted by Lars Christensen on February 18, 2013

https://marketmonetarist.com/2013/02/18/brad-delong-on-the-sumner-critique-and-why-the-fiscal-multiplier-is-zero/

The Bundesbank demonstrated the Sumner critique in 1991-92

I have recently written a number of posts (here and here) in which I have been critical about Arthur Laffer’s attempt to argue against fiscal stimulus. As I have stressed in these posts I do not disagree with his skepticism about fiscal stimulus, but with his arguments (and particularly his math). It is therefore only fair that I try to illustrate my view on fiscal stimulus and why fiscal stimulus (on it own) is unlikely to work.

My view of fiscal policy is similar to that view Scott Sumner as articulated in what has been called the “Sumner critique”. According to the Sumner critique if the central bank for example targets inflation or nominal GDP any action by the government to “stimulate” aggregate demand will only work if it does not go counter to the central bank’s nominal target.

Imagine that the central bank is targeting 2% inflation and inflation and expected inflation is at exactly 2%. Now the government in an attempt to spur growth increases the government spending by 10%. In a normal AS-AD model that would shift the AD-curve to the right from AD to AD’ as illustrated in the graph below.

The increase in government spending will initially increase real GDP (output) from Y to Y’, but also push up the price level from P to P’ and hence increase inflation.

However, as the central bank is a strict ECB type inflation targeter it will have to act to the increase in inflation by tightening monetary policy to push back the price level to P (yes, yes I am “confusing” the level of prices and growth in prices, but bare with me – I might just have written the whole thing in growth rates or argued that the central bank targets the price level).

Hence, once the government announces an increase in government spending the central bank would announce that it would reduce the money base (or the growth rate in the money base) to counteract any impact on inflation from the “fiscal stimulus”. The reduction in the money base would push the AD curve back to AD.

This is the Sumner critique – the government can not beat the central bank when it comes to aggregate demand. The central bank will ultimately determine aggregate demand and if the central bank targets for example inflation, the price level or nominal GDP then fiscal policy will have no impact on aggregate demand and note that this is even the case in a situation where unemployment is above the natural rate of unemployment. Hence, we have full crowding out even in a model with sticky prices and wages and underutilization of production factors (involuntary keynesian unemployment).

Furthermore, if the inflation target is credible then investors will realise that any fiscal expansion will be counteracted by a monetary contraction. Therefore, once the fiscal expansion is announce the markets would react by starting to price in a monetary contraction – leading to a strengthening of the country’s currency, falling stock markets and lower inflation expectations – this on its own would counteract the increase in aggregate demand. This is the Chuck Norris effect in fiscal policy.

Obviously in the real world neither monetary policy nor fiscal policy is ever 100% credible and there will always be some uncertainty about the scale and commitment to fiscal expansion and uncertainty about the central bank’s reaction to the fiscal stimulus. However, anybody who have follow developments in the euro zone over the past two years will realise that “promises” of fiscal austerity have been led to a rally in the stock markets (and fixed income markets in the PIIGS countries) as the markets have priced in the impact on aggregate demand of the expected monetary easing from the ECB. This is the reverse Sumner critique – fiscal tightening will not lead to a drop in aggregate demand if the markets expect the central bank to “cover” the short-fall in aggregate demand.

Hence, I think that the Sumner critique is highly relevant for the discussion of fiscal policy today both in Europe and the US. Below I will try to illustrate the Sumner critique with an episode from recent economic history – the German reunification.

The Bundesbank took all the fun out of German reunification 

After the fall of the Berlin wall in 1989 West Germany and East Germany was reunified. Due to the nature of the collapse of communism in East Germany the reunification of Germany happened extremely fast. Hence, most economic-political decisions were highly influenced by political expediency and geo-political and electoral concerns rather than by rational economic considerations.

One such decisions was the imitate political unification of the two Germanys. In fact East Germany was “absorbed” into West Germany. That for example mend that all social benefits and pensions etc., which were available to West German immediately (or more or less so) became available to East Germans and more or less from day one the benefit levels became the same in the entire unified Germany. This obviously led to a rather sharp increase in German government spending. The unification obviously also led to other forms of increases in public spending – for example the Capital was moved from Bonn to Berlin.

It is always hard to estimate how large a fiscal expansion is as the budget situation is not only influenced by discretionary changes in fiscal policy, but also by so-called automatic stabilizers. However, judging from calculation made by the Bundesbank (in the 1990s) the fiscal expansion due to reunification was substantial. In 1989 the cyclical adjusted budget surplus was around 1% of GDP. However, after unification the budget swung into a deficit. In 1990 the cyclical adjusted budget deficit was 2.5% GDP and in 19991 it had increased to 4.2% of GDP. Hence, the fiscal expansion from 1989 to 1991 amounted to more than 5% of GDP. This by any measure is a substantial fiscal easing.

It is very hard to assess what impact this strong fiscal easing had on the German economy – among other things because the Germany of 1989 was not the same country as the Germany of 1990 and 1991. Furthermore, this fiscal easing coincided with significant monetary easing as it controversially was decided to exchange one East Mark for one West Mark. That led to a rather substantial initial increase in the unified Germany’s money supply. However, while it can be hard to assess the direct impact on growth from the fiscal expansion it is much easier to assess the German Bundesbank’s reaction to it.

The Bundesbank was horrified by the scale of fiscal expansion and the potential inflationary consequences and the Bundesbank did not led anybody doubt that it would have to tighten monetary policy to counteract any inflationary consequences of the unification. Secondly, it also pushed strongly for the German government to fast tighten fiscal policy to reduce the budget deficit. Hence, market participants from an early stage would have had to expect that the Bundesbank would tighten monetary policy and that it would “force” the government to tighten fiscal policy. This in many ways is the exact same thing we see in the eurozone today, where the Bundesbank dominated ECB is telling policy makers if you don’t tighten fiscal policy then we will effectively allow monetary conditions to become tighter.

Already in 1991 the Bundesbank moved to counteract perceived inflationary risks and started tightening monetary policy. In a series of aggressive interest rate hikes the Bundesbank increased its key policy rate to nearly 10% in 1992. In that regard it should be noted that the Bundesbank hiked interest rates at a time when global growth was weak due among other things a spike in global oil prices in connection with the first Gulf war. Furthermore, the Bundesbank also put significant pressure on the German government to tighten fiscal policy, which it did in 1992.

There is no doubt that the Bundesbank wanted to demonstrate its independence to the government and probably for exactly that reason chose to be even more aggressive in its monetary tightening that was warranted even according to its own thinking. As a consequence of disagreement between the German government and the Bundesbank the governor of the Bundesbank at the time Karl Otto Pöhl resigned in October 1991 after having initiated monetary tightening.

The monetary tightening in 1991-92 not only sent Germany into a deep and prolonged recession it also was the direct cause of the so-called EMS crisis in 1992-93.

This particular episode in German (and European) monetary history is a powerful illustration of the Sumner critique. It is pretty clear that even substantial fiscal easing (around 5% of GDP) did not have long lasting impact on growth in Germany due to the Bundesbank’s counteractions to curb the perceived (!) inflationary risks.  I do not claim to have proven that the fiscal multiplier is zero, but I hope I have demonstrated that it is that it is unlikely to be positive if the central bank does not play along.

In the case of Germany in the early 1990s the fiscal multiplier was probably even negative as the Bundesbank decided to punish the German government for what it perceived as irresponsible policies. Anybody who is following the political struggle among European governments and European central bankers would have to acknowledge that it is very similar to the situation in Germany after the reunification.

Consequently I think it can be concluded that monetary policy will never be able to lift aggregate demand if the central bank refuse to do so – and that will often be the case if the central bank is worried about its credibility and independence.

I am no Calvinist and I tend to think that some of the calls from certain economists for austerity is rather hysterical given our problems particular in Europe primarily are monetary, however, I do think that the Sumner critique is highly relevant and we under normal circumstances (that is circumstances where the central bank for example pursues an inflation target) should expect the fiscal multiplier to be close to zero.

We all of course also know there are numerous other problems with fiscal easing – for example any temporary increase in public spending seem to become permanent and that is hard good for long-term growth in any economy, but that discussion is more or less irrelevant for the present crisis, which in my view mostly a result of misguided monetary policies rather than failed fiscal policies.

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My discussion above was among other things inspired by Jürg Bibow paper “On the ‘burden’ of German unification” (2003) and a discussion with chief economist in the Danish think tank CEPOS Mads Lundby Hansen

Related posts:

“Meantime people wrangle about fiscal remedies”
Please keep “politics” out of the monetary reaction function
Is Matthew Yglesias now fully converted to Market Monetarism?
Mr. Hollande the fiscal multiplier is zero if Mario says so
Maybe Jens Weidmann and Francios Hollande should switch jobs
There is no such thing as fiscal policy

18 Comments
by Lars Christensen on August 18, 2012  •  Permalink
Posted in Bundesbank, Fiscal policy, Germany, Karl Otto Pöhl, Scott Sumner, Sumner Critique
Tagged , , , , , ,

Posted by Lars Christensen on August 18, 2012

https://marketmonetarist.com/2012/08/18/the-bundesbank-demonstrated-the-sumner-critique-in-1991-92/

Is Matthew Yglesias now fully converted to Market Monetarism?

The always interesting Matthew Yglesias comments on my point that we should stop talking about national accounting standards. In the process Matt is having a bit of fun with two identities.

The national account standard:

(1) Y=C+I+G+NX

And the equation of exchange:

(2) MV=PY

As Matt rightly notes that we can combine the two:

MV=C+I+G+NX

Matt uses the notation X for net exports – I use NX. P is assumed to be 1.

This is of course completely correct – both are identities. They do not tell us anything about causality. However, the point I have been making is that when people think of (1) they also tend to think that causality runs from right to left in the equation. However, that is only the case if you ignore (2).

This is of course is also why the fiscal multiplier is zero. Hence, public spending (G) can only increase nominal GDP (PY) if the central bank plays along (and increases MV) or as Matt express it:

“If monetary stimulus increases MV then what you’ll get is more spending across a wide variety of categories. Since in today’s economy some things are scarce (gasoline, apartments in San Francisco) and other things are not (unskilled labor, mall space near Phoenix) that will mean some increase in real output and some increase in prices. Similarly on the fiscal policy side, there’s no such thing as an inflation-adjusted tax cut or appropriation. You’re pulling on nominal levers, so if crowding out doesn’t occur that has to be because the central bank is tolerating an increase in the price level.”

This is of course also why the idea that we could use fiscal stimulus to get us out of the European crisis makes no sense at all unless the ECB plays along. You can not increase PY without increasing MV.

Matt has been calling for fiscal stimulus in the US, but his fun with the identities could indicate that he is changing his mind or as David Wright comments on Matt’s article:

“The contrapositive of an assertion is logically equivilent to the original assertion, and the contrapositive of this statement is “if the central bank is enforcing an inflation target, fiscal policy will be ineffective because of crowding out”. This is precisely the claim that Scott Sumner has been shouting from the rooftops from the last couple of years, but in that same time you have been advocating fiscal stimulus and the fed has been consistently enforcing an inflation target. Have you changed your tune?” 

I will leave it to Matt to answer, but I agree with David that it surely looks like Matt is now fully converted from the New Keynesian view to Market Monetarism. Not that it really matters – Matt has long been advocating NGDP level targeting and that is what is really important…

UPDATE: Scott Sumner today comments on an other of Matt’s articles in which he also seems to endorse what he calls the Sumner Critique (the fiscal multiplier is zero).

– and unsurprisingly reaches the same conclusion as me (and a bit more).

9 Comments
by Lars Christensen on May 20, 2012  •  Permalink
Posted in ECB, euro crisis, Matthew Yglesias, MM Research agenda, Sumner Critique
Tagged , , , , ,

Posted by Lars Christensen on May 20, 2012

https://marketmonetarist.com/2012/05/20/matthew-yglesias-is-having-fun-with-mvpy-and-another-other-identity/

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.

9 Comments
by Lars Christensen on May 17, 2012  •  Permalink
Posted in Britmouse, Fiscal policy
Tagged , , ,

Posted by Lars Christensen on May 17, 2012

https://marketmonetarist.com/2012/05/17/mr-hollande-the-fiscal-multiplier-is-zero-if-mario-says-so/

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