Hope springs eternal
[Before beginning, let me emphasize that this post is not discussing the use of government policy to provide income assistance for the unemployed. My focus is on the use of fiscal policy to boost aggregate demand.]
During the current epidemic, we are seeing an avalanche of articles advocating the use of fiscal stimulus. At times the media/twitter/blogosphere gives the impression that only a fool would fail to see the rationale for giving every American $1000. In fact, the evidence favoring fiscal stimulus is almost non-existent. I’ve discussed these issues before, but there is obviously a need to remind people of why fiscal stimulus is unlikely to work. Like Sisyphus, I have to keep making the same points, over and over again.
As recently as 2007, the consensus among macroeconomists was that monetary policy should be used to control inflation, and that fiscal stimulus was ineffective for all sorts of reasons. That consensus changed after 2007, but there isn’t any new evidence that would justify a change.
We’ve had 4 major fiscal policy shifts since 2007, and all four completely failed to have the impact predicted by Keynesian economists. Let’s examine each one of them.
1. In early 2008, the economy had fallen into a very mild recession. During the spring, President Bush got Congress to agree to a program of sending $300 checks to each person (excluding people earning less than $3000, and also excluding those who were upper middle class or rich.) Very soon after the checks were sent out, the economy fell off a cliff.
Now it’s true that the rebates probably boosted consumption and GDP slightly in 2008:Q2, but the Fed responded by tightening policy and hence by the second half of 2008 any beneficial impact was more than neutralized by monetary offset.
2. In early 2009, Congress passed President Obama’s $800 billion ARRA program. It was claimed that this would prevent unemployment from rising above roughly 8%, and that unemployment would rise to 9% without the program. Actually unemployment rose to 10%, with the program.
Obviously I cannot prove that the program had no impact, ceteris paribus; but does anyone seriously believe that the Fed would not have been more aggressive in the absence of the ARRA program?
3. At the very end of 2012, Congress sharply tightened fiscal policy. The deficit fell from $1050 billion in calendar 2012 to $550 billion in calendar (not fiscal) 2013. Roughly 350 Keynesian economists signed a letter suggesting that the fiscal austerity would slow the economy, and risked pushing us into recession. In fact, both NGDP and RGDP growth increased, and by 2013:Q4, the 12-month growth rate was considerably higher than in 2012:Q4, right before the austerity.
The explanation is simple. The Fed saw the fiscal austerity coming and rolled out some new monetary stimulus programs, including QE3 and a more aggressive form of forward guidance. The Fed successfully offset the fiscal austerity.
4. Between 2015 and 2019, the fiscal deficit exploded from $442 billion to $984 billion. This is not supposed to happen during a period when unemployment is falling to low levels. Keynesian models predict that all this unneeded fiscal stimulus during a period of low unemployment would push the inflation rate above 2%, and thus the Fed used “Phillips curve models” as a rationale to boost interest rates and prevent a rise in inflation. But the inflation never came, as fiscal policy doesn’t determine the rate of inflation, monetary policy does. Inflation actually undershot the 2% target.
And this leads to an important point that people miss. If fiscal policy doesn’t determine inflation, then it does not have a significant impact on aggregate demand (NGDP.) That doesn’t mean fiscal actions cannot affect RGDP; they can. But they do so by boosting aggregate supply, not demand.
If the fiscal authorities give every American $1000 it will be like throwing a stone in the ocean. It doesn’t create any new money, it just moves money around. (It doesn’t boost the supply side either.) The fiscal authorities borrow $1000 from John and give the $1000 to Jack. The Fed determines the rate of inflation through monetary policy, the creation of new money.
Just to be clear, I’m not saying it is impossible that fiscal policy could have some impact. You can conceive of a case where fiscal actions cause the central bank to adopt a different monetary policy, cause it to produce a different inflation rate. Central banks are often incompetent.
But the last 12 years gives us little reason for hope. We’ve done four major fiscal operations, and each one had an impact that was quite different from what was expected by Keynesian policymakers.
It’s time to focus on monetary stimulus, which is an order of magnitude more powerful than fiscal, is far less costly, and can be deployed much more quickly. Start by switching to level targeting (of prices, or better yet NGDP), and then adopt a “whatever it takes” approach to asset purchases. That’s the only way to meaningfully boost aggregate demand.
Speaking of Sisyphus, here’s Titian’s magnificent version: