Jonathan Portes at lunch at Details on Harwood St. directs me to:
Paul Krugman: Deleveraging Shocks and the Multiplier:
[P]olicy makers in many places were working with the assumption of a multiplier on fiscal contraction much less than 1, whereas experience now suggests that it’s actually more than 1. What I thought might be worth pointing out is that the logic for a biggish multiplier and the logic of the crisis itself are very closely linked: times like these, the aftermath of a credit bubble, are precisely when you expect fiscal multipliers to be large…. [F]atalism — or worse yet, demands for fiscal retrenchment — in the aftermath of such a bubble are deeply destructive….
[T]he simple but surely broadly correct story… is… excessive complacency about leverage… came to a sudden end…. [L]everaging and deleveraging are not symmetric…. Leveraging… leads to high aggregate demand — but this can be and is in practice offset by the central bank…. Deleveraging… can’t be offset equally easily; the central bank can cut rates, but only to zero, and unconventional monetary policy is both controversial and… iffy… (which doesn’t mean that it shouldn’t be tried). So a large leveraging/deleveraging cycle is likely to be followed by a persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy… depression economics.
Now, the same thing that makes deleveraging so hard to handle also makes the fiscal multiplier larger than it is in normal times. Normally, expansionary fiscal policy is offset by monetary tightening, contractionary policy by monetary loosening. Hence the lowish multiplier estimates based on recent history. But if deleveraging has pushed you into a liquidity trap, there are no offsets. So how big would you expect the multiplier to be under these conditions? Bigger than one….
[In] a frictionless world in which consumers have perfect foresight and perfect access to capital markets… the multiplier should be exactly 1, with consumer demand neither rising nor falling in the face of a change in government purchases…. [A]dd in… households that are liquidity-constrained and/or use rules of thumb… a rise or fall in current income due to fiscal policy will lead to at least some movement of consumption in the same direction. So we get a multiplier bigger than 1.
But, you say, confidence! OK, if people believe that a movement in government spending now presages even bigger moves in the future, you could reverse this conclusion. But there is no reason at all to believe this when it comes to fiscal stimulus, which has proved completely temporary; and it’s a highly dubious proposition for austerity imposed in response to a fiscal panic, too.
So there really was no good reason to be surprised by large fiscal multipliers. They were a predictable consequence of the kind of crisis we’re in; and the unjustified assumption of small multipliers has helped make the crisis worse.
