Beware the fair-weather fiscal friend

As I’ve discussed before, a change is in the air for fiscal policy. The FT has done a mea culpa and said “the aim of balancing the budget can, at least temporarily, be dropped.” This is good news for those who have waged the long and lonely war against the fiscal hawks, but I want to urge caution about over-interpreting the new shift in fiscal policy.

There are two ways ideas can shift. First, the assumptions and/or internal logic of an idea can be rejected wholesale; the idea’s core can be negated. Ptolemaic astronomy, which held the Earth was the center of the universe, is gone without reservation, caveat, or condition.

But ideas can also change in a more gentle fashion. The core remains, and where it fails to explain, special caveats, a long list of “buts” “ifs,” and asterisks, are appended. Circumstantial reasons are proposed for why the idea does not work; perhaps the idea only works in “normal times,” and today is not; perhaps it only works when people behave a certain way, and today they are not. At some point, it is presumed, reality will again dance to theory’s tune.

This second type of change is fragile and skin-deep. The special conditions and circumstances can be jettisoned to reveal the original core. If Ptolemaic astronomy were only wrong because we were temporarily passing through a heliocentric phase, we should not be surprised to see its advocates return once they deemed the phase over.

Much of the change in fiscal policy is of this second kind. Exceptionally low interest rates, overextended monetary policy, and a pandemic induced slump are special circumstances that temporarily waive the normal logic, but they do not challenge it. The logic of balanced budgets and restrained fiscal policy still holds in “normal times” (oh those halcyon days!), we are just living through a special period that allows us to temporarily deviate from the optimum.

This colors the attitude of new converts to other parts of the consensus. As the FT’s article makes clear, a temporary shift in circumstances is no reason to change other parts of the consensus, for example changes to central banks are out of the question – “The facts have changed, but not everything else should.”

The danger is these temporary changes can be reversed quickly, at which point the old logic lurking in the background will return in force.

We should not be naïve about these processes being purely fact-based. Facts do not speak for themselves, and interpretation is complex. The US fell below estimates of full employment in 2015, but it took another four years for the Fed to change its approach to unemployment. The FT made much about sensible people changing their minds with the facts, but as Robert Skidelsky’s letter makes clear, the facts haven’t changed, it is only the FT’s interpretation which has.

Low rates, low growth, and low inflation have relaxed many of the distributional and political tensions around macroeconomic policy, and made this entente possible. Subdued inflation has allowed the financial sector to acquiesce to expansionary policy, but do not expect that to last should it pick up again.

Take last week’s fiscal framework from Orszag, Rubin, and Stiglitz (here). While they agreed on what should be done now, they were divided about the post-recovery period – “once we’re at full employment” (never mind that no one knows where it is). Rubin trotted out the warning he has been telling for thirty years, about how out-of-control US debt will cause a crisis of confidence, and a massive currency crisis. Never mind that the opposite has happened. He sounded like the old Marxists, who, when asked why the forces of history had not yet delivered the inevitable revolution, would say “just wait.”

It is a good thing that fiscal policy is experiencing this renaissance, but we should remember that many of its new friends are fair-weather.

Another day, another fiscal policy framework

It’s an exciting time in fiscal policy. A new paper out features three unlikely bedfellows. Financiers cum public servants Peter Orszag and Robert Rubin, advocates of fiscal discipline and balanced budgets in the Clinton and Obama administrations, have published with Nobel Laureate Joseph Stiglitz, of “resigning from the World Bank in protest” fame.

Their core message is simple but profound: the world is uncertain, and policy makers have a poor track record predicting the future. The defining macroeconomic events of the last fifteen years, the GFC, Trump, Brexit, and Covid-19, surprised specialists and laypeople alike. Economists did not predict the years of stagnation across the developed world, or today’s era of low interest rates.

What does that mean for fiscal policy though?

It is as inadvisable to assume we are in a “new normal” of perpetually low interest rates as it was to assume in 2009 that we were on the verge of returning to an “old normal.”

Policy makers should eliminate normal from their vocabularies, or in their words: a cogent fiscal policy framework should account for this deep uncertainty and provide fiscal policymakers tools to manage it and its fiscal consequences

What does it mean in practice, what are the ‘tools’?

The familiar: expand automatic stabilisers, make infrastructure spending more automatic and less pro-cyclical, increase debt maturities, and index long-term entitlement spending.

The novelty is their call for fiscal discretion. Hard fiscal anchors like the 3% deficit limit, or the 60% debt/GDP ratio need to go. Alongside automatic stabilisers, governments need discretion to respond to the unique challenges thrown up by an uncertain world.

This is a big shift. As I’ve written about before, the goal for many decades was to limit government discretion as much as possible, whether by legislating spending limits, or policing from independent central banks. The closer government was to an algorithm, the better.

In practice, their proposals do not differ much from Summers and Furman’s recent policy paper, however, their caution against taking today’s low-interest rate environment as given is a good one.

Most importantly, placing true uncertainty – Knightian uncertainty – at the centre of their framework is a positive step forward.

As you might expect from such unlikely bedfellows, there were some interesting tensions on display which I’ll get into tomorrow.

Fiscal policy – automatic stabilisers and government as the risk taker of last resort

In last week’s posts on fiscal policy (1, 2, and 3), I focused on discretionary policy. Today I want to talk about automatic stabilisers.

Automatic stabilisers are fiscal policy on autopilot. Unlike one-off spending bills, automatic stabilisers work through changes in spending and taxation triggered by economic changes. In a recession, tax receipts with incomes, while welfare payments increase with unemployment. This automatic expansion of the government’s budget helps cushion a recession. The opposite occurs in a boom, with tax receipts increasing while welfare payments fall.

Automatic stabilisers can be a significant part of a country’s response to a recession.


Automatic stabilizers are very popular with economists. They tend to take effect very quickly, in part because they avoid the political battles that often surround discretionary fiscal stimulus. They are also usually targeted at those that need the help most.

Automatic stabilisers are usually confined to tax or welfare payments, but why not be more ambitious? In chapter 6 of this Brookings book on fiscal policy, the authors argue that infrastructure spending should have a more ‘automatic’ quality too.

Put simply, governments should have pre-ready infrastructure agendas that receive progressively larger sums of investment as economic conditions worsen.

Why stop there? State development bank investment or R&D spending could be counter-cyclical too (although you’d want to avoid spending dropping below certain levels given how important it is for economic growth).

In fact, maybe we should think about government as a counter-cyclical risk taker. Private sector risk appetites fall in a recession, and private investment pulls back from uncertain or longer-term investments. As the private sector de-risks, governments could step in to ensure important investment continues. Perhaps, like the pre-ready infrastructure agenda, governments could maintain lists of important investment priorities (think China’s commitment around AI) for which funding was scaled up during downturns.

(Traces of this are already visible in existing programs. The ECB’s TLTRO provides cheap long-term loans to banks on the condition they lend to the non-housing/non-financial sector. The problem is banks sometimes prefer to just shrink their balance sheets, or sit on the cash.)

Fiscal policy and industrial policy – new bedfellows?

In the north of Sweden, the EU is part-funding a new battery ‘gigafactory.’ When finished, it will be larger than Tesla’s factory in Nevada. The project is part of the EU’s investment in a new battery industry, its answer to competition from the US and China in the industries of the future.

Across the West, this kind of industrial policy has been making a comeback in the last decade. Industrial policy is a big tent that includes everything from coordinating private actors and funding basic research, to subsidies, long-term investments or public guarantees.

Does the rehabilitation of fiscal policy strengthen the case for it?

One of the factors driving the rehabilitation of fiscal policy has been the reduced risk of crowding out private investment. Low interest rates and slack supply for the foreseeable future mean crowding out through higher interest rates is unlikely. The low productivity of capital means the productivity differential between public and private investment might be diminished. Then there is the list seemingly worthwhile public investments like decarbonisation.

To date, advocates have focused on the classic areas for government spending like infrastructure, health, and education, areas which are often underfunded by the private sector, but are also likely to increase the nation’s long-term productive capacity.

To what degree should this logic be applied to industrial policy?

It seems to me there is no in principle reason not to make industrial policy part of fiscal expansion – whether through tax credits or even direct spending funneled through state investment banks. We can all agree that “wasteful and poorly designed spending programs” must be avoided, but what constitutes that is an empirical question which should be examined.

To date, much of the research has focused on industrial policy in the context of developing countries. For the developed world, a 2014 report by the OECD was cautiously optimistic, but said more research is required.

The simultaneous rehabilitation of fiscal spending and industrial policy offers left-wing politicians a way to resolve tensions between their socially liberal and working class supporters by encouraging job creation in a renewed and sustainable industrial base.

Fiscal policy part 2 – some theory

I want to do a bit of theoretical situating today to give context for Sunday’s post on fiscal policy.

One way to understand Sunday’s post is as part of a broader debate about the effectiveness of stimulus policy – the use of monetary or fiscal policy to boost demand. Let’s start with an oversimplified summary of the existing consensus. The maximum levels of output and employment an economy can achieve are determined by the total supply of land, labour and capital. Left by itself, an economy would tend to these “potential” levels over the long-run, however random shocks cause actual economic performance to fluctuate above or below this long-run average.

Accordingly, the goal for policy makers is to keep actual economic performance as close to “potential” as possible. Where a negative shock, like a recession, causes the actual economy to be below its “potential,” stimulus can boost short-run demand and nudge an economy back to its “potential” levels. Alternately, if the economy is running above its potential, policy makers can withdraw stimulus or even contract the economy.

I want to pause here and ask the obvious question for non-economists. Why would policy makers not keep stimulus running? If you can turn on the growth tap, why not keep it on?

This question hinges on the assumption that supply is relatively fixed in the short/medium term. If supply is fixed, then so is the economy’s potential. Attempting to stimulate an economy past its “potential” will create inflation, but no extra output or employment. In simplified form, more and more demand chases a fixed supply, leading to price increases but no corresponding increase in supply.

It follows then that monetary or fiscal stimulus policy cannot grow the economy long-term, nor push it to new productive heights. Instead, they should keep it finely balanced on its apriori “potential” level with periodic nudges.

For a variety of reasons, theory held that governments and discretionary fiscal policy were undesirable for this nudging role. Politicians were unreliable and might short-sightedly try to boost an economy beyond its potential. Fiscal policy came with lags, complicated politics, and the sneaking suspicion that governments were wasteful and inefficient. On the other hand, monetary policy could be changed quickly, and independent central bankers were immune to electoral pressure.

There were lots of other reasons to be skeptical about fiscal policy. Some thought far sighted consumers would realise that government spending today would eventually require tax hikes, and offset any stimulus, maybe with precautionary savings. If governments financed spending through debt it would cause interest rates to increase and choke off any growth. Government spending would crowd out private investment. The multiplier – the extra dollars each dollar of government spending might generate – was argued to be below 1. Theoretically, there was always the possibility that fiscal spending could increase long-run output, for example with infrastructure spending. In practice, there were doubts about its reliability.

Given all these problems, and with monetary policy a reliable alternative, best practice was to avoid discretionary fiscal policy as much as possible. Instead, politicians should focus on supply side reforms like deregulation and more efficient taxes.

The deep assumption at work here is that “real” growth is the product of the (long) past. There is a bias against the possibility of activity in the short-run changing the long-run potential of an economy. The long-run is king.

The result was very little room for politics or politicians in short-run macroeconomic policy.  

Fast forward to the present, the Furman and Summers paper is part of an effort to reclaim theoretical and practical space for fiscal policy. This effort tends to rely on two related arguments:

The first is the presence of ‘hysteresis,’ better thought of as scarring. According to the standard view, the short-run drop in output and employment in a recession is made up symmetrically in the boom and there are no persistent effects. Hysteresis disagrees, arguing that various forms of scarring can cause long-run potential to shrink in a recession. Imagine someone who loses their job, is unemployed for years, loses their skills, and becomes less employable. If hysteresis exists, then stimulus policy can affect long-run potential by acting quickly to end a recession, get people back into work, and stop long-term ‘scarring.’

Despite unemployment beginning to fall, labor force participation does not rebound.

The second is that that post-GFC conditions – interest rates stuck at zero and lots of idle supply – make fiscal spending more effective. With monetary policy constrained, fiscal policy is more useful and complementary. Public debt is not as bad in a world with low interest rates and lackluster private investment; fiscal policy may even pay for itself if it can boost growth in anemic economy.

Combined, this raises the theoretical possibility that fiscal demand stimulus can increase long-run output; a kind of supply expanding demand spending. From the Furman and Summers paper:

One of the interesting parts of this effort to rehabilitate fiscal policy is the way it rests, to varying degrees, on a distinction between “normal” and “abnormal.” Even these new advocates are in agreement that under normal conditions, the classical position about fiscal policy still holds. It is only our unusual post-crisis world that has created the special conditions for fiscal policy effectiveness.

I am personally uncomfortable with the notion of normality. It requires looking at economies as trans historical abstractions and then inserting reality as a series of ‘frictions’ or ‘rigidities.’ This is a useful and clarifying intellectual exercise, but I remain unconvinced about where the standard for normality has been pitched. Economies are made up of constantly evolving institutions. The rules which describe them are contingent on those changing arrangements. This does not mean there are no rules or tendencies, no consistencies or inclinations to discover, only that they are always contingent.

I’m especially skeptical when the basis for “normality” is the experience of a few developed countries between the 1980s and 2007. On either side, whether the post-war boom or the post-crisis slump, we find rather different institutions, tendencies, and experiences. I’m unconvinced about the analytical value in labeling one set normal over others.

Fiscal policy series – debt, government spending, and the future of the state

There is a new paper on fiscal policy out by Larry Summers and Jason Furman (There is also a video presentation of their paper along with a star-studded discussion panel including Ben Bernanke, Olivier Blanchard and Ken Rogoff here. It begins at 49 minutes).

The paper argues that the drastic fall in real-interest rates over the last thirty years has made regular fiscal stimulus by government both necessary and sustainable.

The assumption that low interest rates are here to stay leads to three conclusions:

  • Fiscal policy is needed: There have been persistent shortfalls of demand since the crisis. Monetary policy is increasingly constrained in dealing with this. Interest rates have been zero (or below) zero for years. QE and perpetually loose monetary policy also comes with financial stability risks. More tools are needed.
  • Fiscal policy is affordable: With interest rates so low, debt servicing costs are low. In fact, real interest payments as a % of GDP have been falling in the US since 2000.
  • Fiscal policy is effective: There are lots of threads to this, but there are two broad points. First, it builds off research arguing that the cost of debt may not be as significant as once thought in an environment of low interest rates. Second, it builds off research that shows fiscal spending might be more effective than once thought. Governments can make productive investments which pay for themselves by increasing future output by a larger amount.

This kind of argument is increasingly the norm, and it sounds so obvious that it is worth reminding ourselves of the consensus they are critiquing. From the 1980s/90s, up until even the early/mid 2010s, it was believed that the best contribution government could make to macroeconomic growth was a balanced budget. There was a role for some moderate automatic stabilisers (e.g. unemployment benefits), but not much beyond that. If any macroeconomic stimulus was required in a crisis, it should be left to monetary policy and independent central banks.

Their contribution joins the broader reform conversation going on in macroeconomics today. Earlier this year, Anna Stansbury and Larry Summers co-authored a piece blaming the economic doldrums on declining worker power. Olivier Blanchard used his 2019 address to the AEA to discuss why public debt may not be as bad as once thought. If you would like an overview of the contemporary debates in macro, I highly recommend Blanchard and Summers’s introduction to the edited book: “Evolution or Revolution? Rethinking Macroeconomic Policy after the Great Recession.”

I’m going to be following up on this paper and fiscal policy more broadly over the next week. Stay tuned!