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.

James Tobin on Business Cycles

In 1994 the Federal Reserve Bank of Boston hosted a conference on monetary policy. Today it is mostly remembered for Debelle and Fischer’s paper on goal vs. instrument independence, but it has proved full of gems.

This was a time when the modern central bank was still emerging and so lacked today’s (somewhat diminished) aura of certainty and inevitability. New Zealand had made history five years earlier by giving their central bank independence, and it would not be for another three years that the UK would follow suit. Throughout the proceedings, traces of uncertainty at the incipient consensus are visible; these comments from Nobel Laureate James Tobin in particular.

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.

September FOMC meeting

The Federal Reserve had its September Board meeting yesterday (Australian time). Apart from the time difference, the most frustrating thing is the Fed appears to host the press conference video themselves, and there is no button to adjust playback speed.

The press conference and statement offered some useful clarifications on the big announcements made last month at Jackson Hole (see forthcoming piece – hopefully this week!)

There were a lot of questions about how the Fed’s new average inflation targeting approach would work, how far above 2% would inflation be allowed to go and for how long?

With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent

So what will policy be like in the meantime?

The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time

Low for loooooooong baby! Remember inflation has barely touched 2% over the last decade. The projections of Board members show no one thinks inflation will reach 2% before 2022/3. The median projection for unemployment is 4% in 2023, but the range goes all the way up to 7.5%. The Fed has already issued a mea culpa for raising rates in 2018 when unemployment dropped below 4%, so it is unlikely they will do so again. All this adds up to low rates for the next few years, barring something extraordinary.

Preemptive tightening in the face of unemployment is officially dead and buried.

We view maximum employment as a broad-based and inclusive goal and do not see a high level of employment as posing a policy concern unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals

Powell acknowledged the new normal; low interest rates are now part of the furniture.

In turn, well-anchored inflation expectations enhance our ability to meet both our employment and inflation objectives, particularly in the new normal in which interest rates are closer to their effective lower bound even in good times

Aside from all the technical announcements, two short sections caught my eye:

As I have emphasized before, these are lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. We can only create programs or facilities with broad-based eligibility to make loans to solvent entities with the expectation that the loans will be repaid

Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources. (is monetary policy not?)

Firstly, it is simply not true that the Fed cannot grant money to particular beneficiaries. Legality aside, it is certainly possible operationally. It would be politically momentous, sure, but lets not kid ourselves about what Central Banks can and cannot do.

Secondly, the second paragraph implies that monetary policy, unlike fiscal policy, is not one of society’s collective resources. Again, I disagree. The money supply is a collective resource, and even if its creation and control currently sits outside day-to-day political control, that is a choice. It is neither inevitable nor eternal and we do ourselves a disservice when we blithely reify the specific institutional arrangements we happen to have today.