The optimal speed of fiscal adjustment: How rapidly should governments correct their fiscal deficits, which in the long run are unsustainable in the US, UK, Japan and many countries in the eurozone?… [O]ccasionally a piece of research comes along which changes the “dial” on the debate, and I believe that applies to the important Brookings Paper published last week by Brad DeLong and Larry Summers. This paper… essentially implies that the trade-off between near-term GDP growth and the probability of fiscal crisis can be irrelevant, because temporary fiscal expansions, at a time when interest rates are at the zero bound, are eventually self-financing…. [A] fiscal expansion today raises GDP today; higher GDP today permanently raises the path for GDP; and a permanently higher path for GDP results in permanently higher tax receipts. Eventually, these higher tax receipts might fully finance the original cost of today’s budgetary injection.
All of this has been in the public debate for quite a while (see Paul Krugman for example), but the important additional contribution of DeLong and Summers is that we can now quantify the parameters involved…. The authors, for example, suggest a case in which the multiplier is 1, and the hysteresis parameter is 0.05. Their equation then suggests that a temporary fiscal expansion will be self-financing unless the real yield on treasuries exceeds the long-term growth of GDP by more than 2.5 per cent per annum, which has hardly ever happened in recent US history.
How robust should we take this result to be?
A fiscal multiplier of around 1 in present circumstances seems reasonable…. Much less is known about the hysteresis coefficient….
But I would pose one more question to Brad and Larry, concerning policy credibility. They take this seriously, but make the assumption that a temporary easing in fiscal policy would have no effect on the risk premium which the market expects on US treasuries…. [T]hey would argue that it is not rational for investors to expect a higher risk premium if a temporary fiscal injection is actually likely to be self-financing.
These are valid points, but investors are not always rational, and they would be sceptical about any government which takes the “make me chaste, but not yet” approach to policy. Easier fiscal policy today might well be taken as a signal that the political will to tighten policy tomorrow simply will never exist. Rational or not, that remains a serious problem.
I would agree that in a world in which the Republican presidential candidate-presumptive attacks President Obama for (a) running large deficits, (b) raising your taxes, and (c ) cutting social-insurance benefits, that a rational investor would conclude that the Republican Party at least has absolutely no political will to tighten policy, ever. Thus whether the political will to tighten policy tomorrow exists rests on whether the current Republican Party becomes the natural party of government--or whether it loses persistently and repeatedly to the Democrats, or else undergoes a 180-degree change in its policy preferences.
But, from my perspective, whether the U.S. political system is capable of providing even semi-competent governance is a question that has very little to do with what policies we adopt to speed recovery over the next three years.