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.

Source

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.)

Merry Christmas at the Federal Reserve

The US Federal Reserve held their December FOMC meeting yesterday. They voted unanimously to continue the current accommmodative stance, keeping interest rates at zero and asset purchases at $120 billion a month.

The decision is unsurprising given the impact of Covid in the US, and the ongoing fight in Congress over more fiscal stimulus.

The FOMC meets eight times a year, but every second meeting they release a Summary of Economic Projections. Each member of the committee forecasts the path of GDP, unemployment, and inflation and they are aggregated. The public gets to see the median, central tendency, and range, but not the projections of individual members.

The figures reveal the diversity of opinion on the FOMC, especially when it comes to the path of unemployment. Since September, forecasts have improved, but there is still quite a gap between the optimists and pessimists. Of particular interest is the longer run estimate, which likely reflects participant’s views on the “natural rate of unemployment.”

Source

Where the FOMC thinks the “natural rate” is matters because, up until this year, the Fed would tighten policy preemptively when unemployment neared the “natural rate.” If the estimate was wrong, and there was still slack, the effect would be to unnecessarily throw people out of work.

The experience after 2015, where unemployment dropped below estimates of the natural rate (at that time, ~5%), down to the unprecedented level of 3%, without stoking any inflation, led the Fed to change tact. Under the Fed’s new strategy, policy will not be tightened preemptively, it will instead wait for inflation to pick up sustainably.

Still, estimates of the “natural rate” continue to be an important guide for central bankers around the world. They have real consequences for the stance of monetary and fiscal policy, and are important to keep track of.