How effective is fiscal policy: Guest post from Roger Farmer (crosspost at CT)

Roger Farmer, professor of economics at UCLA, has sent a response to my post on the fiscal multiplier, which is over the fold. I’ll make some substantive points in comments, but I’d like to start by saying that this is a good example of a discussion to which blogs are ideally suited. Contributions from people like Roger who have something important to say, but not the time or inclination for a regular blog, make it even better.

John. You ask for responses from DSGE theorists to the question; how effective is fiscal policy? Let me provide a personal response.

In the opening paragraph of your post you assert that: “The biggest theoretical issue in macroeconomics is ‘what causes unemployment’.” I prefer the following characterization of the state of our subject:

There are two unanswered “big theoretical issues” in macroeconomics. The first is; what causes large sustained shocks to aggregate demand of the kind we saw in 1929 and again in 2007? The second is; why does high unemployment persist?

Distinguishing these two puzzles is central to arriving at an understanding of the crisis that finds most western economies operating with high and apparently sustainable unemployment rates.

There is an active discourse in the blogosphere that characterizes the debate as a battle between a group of classical fiscal policy deniers and a rearguard group of Keynesian realists who carry the truth of the Master. In this characterization of the intellectual discourse the evidence is plain: fiscal policy matters and it matters in a big way. If stubborn government ministers would recognize this simple truth, a large and sustained fiscal boost by leading economies would solve all of the world’s problems.

I consider myself to be equally entitled to the label ‘Keynesian’ as the leading proponents of fiscal expansion, but I do not share the consensus view of self proclaimed Keynesians that a large fiscal expansion is the solution to our dilemma.The slavish devotion to remedies to the Great Depression that were proposed more that eighty years ago smacks of religion; not science. As Keynes himself said on leaving the Bretton Woods convention in 1946, “I was the only non-Keynesian in the room”.

Writing in 1968, Axel Leijonhufvud made the distinction between Keynes and the Keynesians. That distinction is useful because it clarifies the idea that the formulation of the General Theory that was popularized by Samuelson in the third edition of his undergraduate textbook misses the key idea of Keynes’ masterpiece; that high unemployment is an equilibrium phenomenon, not a temporary deviation from a classical ideal state. Samuelson’s interpretation is, to quote Joan Robinson, “bastard Keynesianism”.

In my introductory paragraph, I raised two questions. Let me begin with the second question first: Why does high unemployment persist? Samuelsonian Keynesians see the issue as one of deficient nominal aggregate demand. Unemployment is high because nominal prices and nominal wages are too high. We can wait for nominal wages and prices to adjust, or we can boost demand through monetary or fiscal policies taking existing wages and prices as given. Since the money interest rate is at its lower bound, monetary policy will not work. That leaves fiscal policy to boost demand.

What’s wrong with that analysis? It suffers from the uncomfortable fact that the General Theory does not contain an explanation of unemployment that is consistent with rational behavior by profit seeking firms in the labor market. There is no coherent theory of unemployment in the General Theory; there is simply an assertion that households are not on their labor supply curves. That lacuna pervades all of the new-Keynesian models developed before the 2007 crisis and many of those developed since. In almost all of these models there is no unemployment since households are always on their labor supply schedules. A recession is, to quote James Tobin, “a sudden attack of contagious laziness”.

There is a group of DSGE models that account for unemployment by combining search theoretic models of the labor market with inter-temporal choice by maximizing households. These models are surveyed in a piece I wrote for a special issue of Macroeconomic Dynamics that is available here. In these models there is a coherent account of the idea that there may be a continuum of steady state unemployment rates, and unlike bastard Keynesian analysis, the problem is real not monetary. That is a disturbing thought to those who would boost demand by purely monetary means since it suggests the possibility that we may end up with 8% unemployment and high inflation simultaneously.

Nothing I have said so far is inconsistent with the notion that fiscal policy is the answer to our dilemma. That is where we would be wise to ask ourselves the first question posed in my introductory paragraph.  What causes large sustained shocks to aggregate demand? The answer to that question is contained in a second strand of research that I have been engaged in both individually, here, and jointly here. Competitive unregulated financial markets cannot be expected to find the “right” relative price of capital except by chance, for the reasons expounded more than thirty years ago in a research agenda that was initiated at the University of Pennsylvania.  Demand shifts occur when rational forward looking agents, all of whom have rational expectations of future prices, revise their beliefs of what will occur in the future. Agents are rational. Markets are not.

This brings me back to the correct policy response. Monetary policy has two dimensions. One is the expansion of central bank balance sheets to increase the money supply with the goal of boosting nominal demand. The second is a change in the composition of the balance sheet with the goal of influencing the relative price of assets, with the goal of boosting real aggregate demand.Willem Buiter has called the first policy; quantitative easing and the second; qualitative easing.We need more qualitative easing.We may need a bigger government sector; but that is a logically separate question from the issue of how to cure the unemployment problem.

Will a big fiscal expansion cure the unemployment problem? Probably. But the only time it was unambiguously successful in the US was during WWII when government went from 15% of the economy to 50% in the space of two years.We could put all of the unemployed people into the army. I do not think that is the right response. Alternatively, we could give private companies the incentive to employ more people by moving the economy from a high unemployment equilibrium to a low unemployment equilibrium. That solution would require bloggers, politicians, journalists and policy makers to consider some new ideas.

14 thoughts on “How effective is fiscal policy: Guest post from Roger Farmer (crosspost at CT)

  1. It is ironic that both camps use World War II as evidence that the fiscal policy might work (Farmer) or it does not work (Barro and Ohanian):

    • The nature of the new spending and how it was financed both matter.
    • Whether the new spending was a public good, a private good or a general or contingent income transfer matter, and whether the new spending was tax or bond financed all matter to the income and substitution effects.

    World war two was a temporary increase in government military purchases that will be followed by a long period of primary surpluses and perhaps surprise price inflations to pay down the massive wartime debt.

    • A military build-up financed by debt lowers consumer wealth which induces households to consume less leisure and work more while the temporary nature of the fiscal shock increases labor input through inter-temporal substitution of labour because of lower taxes now.

    • The increase in the supply of labor leads to a fall in productivity and real wages. Inter-temporal substitution also raises the real interest rate and lowers private investment.

    Korean War expenditures were financed mostly by higher taxes resulted in a much lower output and welfare compared to the tax smoothing policy for world war II

    Steve Horwitz has just published a paper showing that the letters, journals, and newspapers indicate continued material deprivation and hardship, rather than rising living standards for the average American.

    Any Dad’s Army fan would know that wartime is a time of much lower personal consumption and leisure. Rationing was less severe in the USA and Oz.

  2. My main objection comes right at the end with the sentence

    But the only time it was unambiguously successful in the US was during WWII when government went from 15% of the economy to 50% in the space of two years.

    Sure, but why confine attention to the US? Australia had great success in 2009 with a stimulus of around 3 per cent of GDP, for which the multiplier was probably close to 1. Moving away from particular cases, the empirical work of the IMF (which could scarcely be accused of a pro-deficit bias) seems pretty convincing.

  3. It seems to me talking about unemployment without considering the relationship between prices and wages (budget feasible consumptions) is not helpful at all. Slavery is a solution to unemployment but most readers of this blog site, I presume, are against this instituion.

    Models with one hypothetical consumer are not interesting on theoretical grounds unless all people can be shown empirically to be identical in all respects, which would imply that there is only 1 type of skill that is used in the production of the 1 ‘output’.

    Models where monetary policy is assumed to be under the control of ‘the government’ (or monetary authority) are not interesting when it is empirically obvious that monetary prices of commodities, empirically labelled physical assets and goods and services’ are influenced by privately created monetary objects that do not fit into the balance sheet of either the government or banks.

    The proposal that “we could give private companies the incentive to employ more people by moving the economy from a high unemployment equilibrium to a low unemployment equilibrium” is a mystery to me. Who is ‘we’? What ‘incentive’? Why do private companies need an incentive to employ more people if ‘we’ (or who?) have moved the economy from a high unemployment equilibrium to a ‘low unemployment equilibrium’? Is ‘low unemployment’ the only caracteristic of ‘an equilibrium’ or are other ideas worth while representing (eg resource feasibility, including the environment and people’s preferences)?

    It seems to me, a plausible interpretation of the above proposal to get low ‘unemployment’ is to say ‘we’, the people, demand from democratically elected governments to change the rules of the game such that the instituionally (legal) entity of a ‘private’ company is abolished and it is the government’s job to employ everybody. A less convincing version of this interpretation is to introduce the notion of a threat: unless you hire more people at reasonable wages, the laws will be changed. I presume most readers of this blog site would not like this idea.

    Soon the host of this blog site may become bored or annoyed with my grievances about macroeconomics. I am asking for a bit more patience because I take Economics, concerned with the welfare of people and resource constraints seriously.

    Consider an alternative approach, one where the micro-foundation is not imposed on a macromodel but where the distinction between micro and macroeconomics is meaningless. Consider Radner’s mid-1970s model of a sequence of commodity and securities markets in an otherwise private ownership economy (and leave open the problem of how it should be classified). (neoclassical or otherwise). Roy Radner introduced two changes to the Arrow-Debreu model (prsumably classified as neo-classical), namely a sequence of markets (finte number) and securities issued by private agents. He found the introduction of financial markets is non-trivial because negative quantities of securities (short sales) can be held. This means the lower bound on the economy is lost. Physical assets are taken care of via the concept of a commodity in these models (1 physical asset such as a house, is represented by a set of commodities – physical objects that are time and state contingent). Radner introduced a arbitrary lower bound for the sequence of securities markets. Under otherwise ‘standard assumptions’ (relative to the Arrow-Debreu model) he proved existence of a pseudo-equilibrium (a series of states of ‘the economy) with the property that the value of excess supply is minimised.

    So, ‘we’ note, in Radner’s otherwise neo-classical general equilibrium model, positive excess supply is possible (and we know why). This means unemployment is possible too. Why don’t unemployed people die from starvation? This question hasn’t been asked explicitly in Radner’s model. But, given that he retained the minimum wealth assumption, the problem does not acutely arise. To the best of my knowledge, the analytical models are not prescriptive.

    The question I’d like to ask is: What happens to people in a private ownership economy who empirically have a negative wealth and are unemployed (ie many people in the USA and elsewhere)? I see a reason for fiscal policy (wealth redistribution) in this area.

    Another question: Empirically there are examples of imposed limits on negative security holdings (eg the debt limit in the USA). Should there be limits on short selling or on the types of securities that can be issued by private agents? There is an insight from Radner’s model. The debt limit concerns privately issued securities (not government debt; there is no government in the model). To blame governments for everything is apparently not a water tight argument. (Nor is the opposite).

    I really would like to have educated guesses as to whether or not the GFC would have happened had the USA a prudential regulatory framework for the private financial sector? I don’t know of any macroeconomic model which allows this question to be asked.

    Giving incentives to ‘private companies’ to hire more people has been tried long enough on Wall Street – IMHO.

  4. Oh well, I guess I am ready for my definitive “proclamation”… at least until I change my mind again. (That’s self-depracating irony folks.)

    In my previous simplistic naiveity (and I mean that literally and without irony), I thought that Marx and Keynes had pretty well summed it up (and Adam Smith working from antecedents had laid the basic groundwork from which the two paths could be taken). Marx made logical and defensible sense if you accepted one set of premises and Keynes made logical and defensible sense if you accepted another set of premises.

    Clearly, I was wrong. Intriguingly, that does not necessarily mean Marx and Keynes were wrong. I still tend to think that from their respective premises and congruent with their respective times each got a substantial amount right. However, they both appear to be getting “wronger” and “wronger” now.

    How do we account for this? Let us for a moment consider a field like human anatomy. In the course of a couple of hundred years or several hundred years at most, modern scientific anatomy moved from its nascent beginnings to its current comprehensive, dependable and verifiable state of knowledge. (Of course if you want to go down to the levels of human cellular biology and biochemistry then much remains to be discovered.)

    But we note that anatomists essentially had a fixed target to hit. Human anatomy has evolved negligibly, if at all, over a mere few hundred years. Of course, you already know where I am going and knew it before I knew it. (At least Prof J.Q. and Ernestine did.)

    The “economy” and society, along with science, technology, financial instruments, institutions, insitutional arrangements, ideology, public discourse etc. etc., have evolved (if that is roughly the right word) enormously even since Keynes’s time let alone since Marx’s time.

    In addition, every piece of political economy discourse, economic discourse and economic theory and praxis enter into the real situation and change it as soon as they enter it. In this field, even a merely descriptive piece of research once it enters the system it describes changes that system both quantitatively and qualitatively. In all social and economic life, imaginative and opportunistic changes, tweaks, tricks, subterfuges, exploits, artifices, devices, obfuscations, avoidances, circumlocutions, gaming behaviours, lies, half-truths and so on almost ad infinitum further transform, transmute, transmogrify etc. etc.

    What must be our final conclusion? I think it must be this. The disciplines of political economy and economics, though interesting and engrossing intellectual exercises, are fundamentally and profoundly hopeless enterprises and admit of no conclusive solutions.

  5. Oh and that’s it, I’m done. J.Q. please ban me forever in case I break my second, belated New Year’s resolution.Thank you for being an excellent and tolerant blog host, one of the best around in this or any field. Cherrio to all!

  6. “Will a big fiscal expansion cure the unemployment problem? Probably.”

    That’s it? That’s the whole answer to your question, “what do DSGE theorists have to say about the effectiveness of fiscal policy”?

  7. Macro economics fills a role not dissimilar to that of a medical general practitioner, except the patient is the economy of a state body. And like GP’s the macro economist seeks to resolve ailments of the patient with a very limited number of remedies and advice.

    The GP copes with macro ailments such as high blood pressure, high cholesterol, low iron, low calcium, poor diet, infections, and epidemics such as colds and flue. The Macro economist deals with inflation, unemployment, trade, investment, monetary policy and fiscal policy.

    And just as GP’s have their antibiotic silver bullet macro economists have their interest rate fixall silver bullet. The problem is that just as antibiotics become less effective over time so also does the interest rate instrument.

    Interest rate control works in two ways. It is very effective at influencing the construction industry, while at the same time serves to at a lesser rate stimulate manufacturing, and indirectly affect inflation. The problem with it is that while lower interest rates promote property development, they also cause property price inflation (banks can lend more with lower interest rates to the fixed income of the buyer and so the buyer tends to pay more for the same property). Ultimately property values over reach the ability of the economy to sustain them and the economic stress of this leads to unemployment and the interest rate instrument collapses as interest rates fall towards zero while attempting to stimulate the economy to reduce unemployment.

    So once the Interest Rate economotic has been rendered ineffective and unemployment is still high, what else is there? Now it falls to fiscal policy to take up the baton and there are a number of ways that this can be done. The most common methods voiced is that of a stimulus injection of cash directly to the consumer, or the building of government funded infrastructure. Other methods are stimulus spending through the social welfare system, of handing funds to industry to invest in capital equipment. And there are 2 methods for funding this, borrowing and printing money. Well actually there is a third.

    But the most significant role that a GP plays is in understanding the function of the body so that ailments can be detected and specialist treatment sought. So also must the Macro economist understand the base cause of an economy’s most crippling ailment, unemployment.

    After having a long think about this I believe that unemployment arises from an insufficient level of broad spectrum entrepreneurialism within an economy, and the real challenge is to understand how this state has come about. Entrepreneurs pop up at all ages but they have a better chance of occurring in the young adult and the post family adult. People in their 20’s have the best chance to experiment in business as they have fresh energy fresh ideas and have the resilience to make fail and restart without major consequence. People in their 40’s to 60’s have the benefit of knowledge, experience and financial resources.

    But there are many road blocks for entrepreneurs in a developed economy, the principle one being establishment. Mature businesses do not like fresh competition (despite lip service to the contrary) and have many methods to frustrate new enterprise. Australia has a healthy level of young entrepreneurialism but it is very much directly connected to the construction industry and therefore suffers in concert with macro ailments such as the GFC and topped out property values. The other road block for a broad focused entrepreneurialism is that modern industry requires a relatively high level of capital in order to be competitive in our highly automated economy. In other words it is very hard to earn a living with a box full of hand tools (the construction industry being the exception). The current entrepreneurial flashpoint is with computing, and this very much plays to the strengths of the young. But we need more, much more.

    The role here for the macro economist is to recognise the problem and refer the economy for specialist treatment, and then be entrepreneurial itself and develop a macro economic environment that sustains that level of healthy micro economic energy. This may involve macro economists rethinking some of its mantras of the past. Global Free Trade for instance might become managed open trade, there might be a global transaction tax to discourage capital flight, fund the elimination of poverty and fund global climate emergency relief. Macro Economists might seek out more economic instruments to provide better balance to economies with auto correction devices such as unemployment linked uniform trade levies.

    Macro economics is not a dead duck, it is just a relatively lame duck. But with just a little bit of greatness of mind it will be the economic stabilising influence that it was conceived to be.

  8. @Ernestine Gross

    I might look a bit rude in this reply, if so, please forgive me.

    It seems to me that you have not thought much about what you’ve posted sometimes on economics.

    “What happens to people in a private ownership economy who empirically have a negative wealth and are unemployed (ie many people in the USA and elsewhere)?”

    Because of the safety net of the economy (e.g. unemployment benefit) and the financial market, even if they are unemployed, they can hang on. Even if they keep incurring debt (expenditure higher than income received from social security or other methods) as long as the financial market is willing to lend them money, they should not die from starvation. You may ask why does the financial market willing to lend them money? The answer is predatory lending practice without the fear of consequences because of too big to fail. Have you hear of products such as 100% mortgage or negative amortisation loans in the US (the value of debt actually goes up as time goes by)? They are the consequences of unregulated predatory lending, flawed unregulated incentive structure of the market and they know that they are too big to fail (the repeal of Glass-Stegall Act is a major contributor to this). There are solutions to this, either strictly regulate the market so the flawed incentives breaks down, let the government take over the role as a lender to the market, or nationalise the banks. None of those can ever be applied in the current financial market controlled US political environment, and that is not even taking into account of the “anti-socialist” sentiment of the US population. If you want to know more about how the financial market really work in the unregulated environment prior to the GFC read Joseph Stiglitz’s “Freefall: America, Free Markets, and the Sinking of the World Economy”. Everything you learn in finance or economic course are useless.

    “I see a reason for fiscal policy (wealth redistribution) in this area.”

    “Anti-Socialist” sentiment, even the people who benefit from this will reject the proposal (I’m not saying that it is a bad proposal). Other than this, you have to apply strict capital flow control to prevent large sum funds going to overseas bank account. The only proposal which “may” work is intentionally create high inflation and index wage (make it look like you’re not doing it).

    “Empirically there are examples of imposed limits on negative security holdings (eg the debt limit in the USA)”

    Like Bruce Barlett said on one of his columns, the US of A is the only country to his knowledge that has a debt ceiling on government. Even he, as one of the major contributor to supply-side economics and a conservative intellectuals see this is the most stupid thing. My opinion on why this exist is to prevent the government from doing the thing that I said might work in the above.

    “Should there be limits on short selling or on the types of securities that can be issued by private agents?”

    Political problems, the financial market benefit from the more debt the private holds, the more they can charge for risk premium, and they are not scared of the consequences like I’ve said above. However, economically, using the National Account (I’m not a MMTer to be clear), as long as an economy have a trade deficit, either the government sector or the private sector would have to be in deficit otherwise GDP (thus living standard) simply falls.

    Macroeconomists are not as simple nor stupid as you might think they are. The official macroeconomic textbook, models or undergraduate course are hopeless, but I hope you know that macroeconomist’s thinking are not confined to these models. If you do happen to read Joseph Stiglitz’s book, please tell me how would you model these chaos in the financial market and put it in a textbook.

  9. @BilB Friedman’s case for policy rules such as constant annual monetary growth of 4% per year without any variation in the rate of increase to meet cyclical needs was based on the microeconomics of information and the many limitations and complexities of macroeconomic stabilisation policy.

    First do no harm was his watchword on macroeconomic policy.

    Friedman spent his career explain what monetary policy could not do. He argued that stabilisation policies destabilise the economy. The leads and lag on monetary policy was one reason. The much under-discussed leads and lags on fiscal policy are even longer.

  10. @Tom

    No precautionary apology for rudeness required, Tom. I don’t consider your post rude.

    I believe there are two points I need to clarify.

    1. In reply to my sentence “What happens to people in a private ownership economy who empirically have a negative wealth and are unemployed (ie many people in the USA and elsewhere)?” you refer to a safety net (eg unemployment benefit) and the financial markets.

    My sentence is a question motivated by empirical observations and I addressed to the Radner model (and I gave the answer one obtains from the same model; negative wealth is excluded by the minimum wealth condition). I appreciate this method of gaining insights from theoretial models is not often practised and I apologise for not having explained what I am doing.

    Your observation of a safety net is an empirical observation (which is a reply to my question motivated by empirical observations). I assume you refer to a safety net which is provided via ‘the government’ (various layers – states, local, …). Now the interaction between empirical observations and Radner’s theoretical model needs to be completed. (I suppose I could have done this in my post but it was already very long). Your empirical observation confirms that the countries to which your observation pertains are not ‘private ownership economies’ but ‘mixed economies’. Unemployment benefit is not necessarily the same as satisfying a minimum wealth constraint (the latter ensures each individual can chose at least a little bit of everything on offer while unemployment benefits in Australia, Germany and elsewhere have fallen so low that people can at most live of specials and home brands).

    Your reference to financial markets is weak, if I may say, both in relation to the theoretical conditions in the model in question and to empirical data. Negative wealth for any individual is excluded in the multiperiod model. The empirical fact that there are beggars and people who depend on charities, even in the USA, is sufficent to reject your statement “as long as the financial market is willing to lend them money, they should not die from starvation” as a solution to the problem.

    2. Limits on government debt. The particular form of the government debt limit in the USA may well be unique to the USA. However, the EU[Euro] countries have effectively limits on government debt.

    The Radner model is only one in a series of theoretical models. The purpose of me referring to this model is to a) highlight relevant theoretical knowledge available before the deregulation of the financial markets having been ignored, b) the belief in ‘general equilibrium’ (or not) doesn’t correspond to the theoretical knowledge, c) limiting government debt is of no use without limiting private debt creation, d) the wealth distribution matters.

  11. @Tom

    Like Bruce Barlett said on one of his columns, the US of A is the only country to his knowledge that has a debt ceiling on government. Even he, as one of the major contributor to supply-side economics and a conservative intellectuals see this is the most stupid thing. My opinion on why this exist is to prevent the government from doing the thing that I said might work in the above.

    Historically the US debt ceiling came into existence in 1917 when the Congress relinquished authority to issue bonds to finance government debt. As recompense, Congress retained the right to declare the maximum magnitude of the debt, though not the right to decide on the issuance of that debt within those limits.

    As such the Debt ceiling represents a surrender of authority from the legislature to the executive. As such, the circumstances of the creation of the debt ceiling represents an eclipse of democracy.

    It’s no coincidence that this augmentation of executive power came into existence in the context of total war. This surrender of legislative authority in 1917 was one of the most important wellsprings of the security state and the Military Industrial complex.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s