Martin Wolf Talks Sense: The Case for Austerity in Credit-Worthy Core Countries Is Bankrupt: Fiscal Policy, Monetary Policy, and the Long-Run Debt Burden in a Liqudity Trap
Martin Wolf's Exchange | Economic commentary from the Financial Times – FT.com: What is the correct approach to fiscal and monetary policy when an economy is depressed and the central bank’s rate of interest is close to zero?… I can identify three macroeconomic viewpoints…. The first is the pre-1930 belief in balanced budgets and the gold standard…. The second is the religion of balanced budgets and managed money, with Milton Friedman’s monetarism at the rules-governed end of the spectrum and independent inflation-targeting central banks at the discretionary end. The third demands a return to Keynesian ways of thinking, with “modern monetary theory” (in which monetary policy and central banks are permanently subservient to fiscal policy) at one end of the policy spectrum, and temporary resort to active fiscal policy at the other.
In this note, I do not intend to address the first view…. I also do not intend to address Friedman’s monetarism… [or] “modern monetary theory”…. This leaves us with the respectable contemporary view that the best way to respond to contemporary conditions is via fiscal consolidation and aggressive monetary policy, and the somewhat less respectable view that aggressive fiscal policy is essential when official interest rates are close to zero.
Two new papers bring light from the second of these perspectives…. McCulley… and… Pozsar… [and] J. Bradford DeLong… and Lawrence Summers….
McCulley and Mr Pozsar puts the case for aggressive fiscal policy. The US, they argue, is in a “liquidity trap”: even with official interest rates near zero, the incentive for extra borrowing, lending and spending in the private sector is inadequate…. [L]arge swathes of the private sector became over-indebted. Once asset prices fell, erstwhile borrowers were forced to reduce their debts… “debt deflation”… “balance-sheet recession”, coined by Richard Koo of Nomura. That is what Japan had to manage in the 1990s. This is how the McCulley-Pozsar paper makes the point:
deleveraging is a beast of burden that capitalism cannot bear alone. At the macroeconomic level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction . . . by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole. Fiscal austerity does not work in a liquidity trap and makes as much sense as putting an anorexic on a diet. Yet ‘diets’ are the very prescriptions that fiscal ‘austerians’ have imposed (or plan to impose) in the US, UK and eurozone. Austerians fail to realise, however, that everyone cannot save at the same time and that, in liquidity traps, the paradox of thrift and depression are fellow travellers that are functionally intertwined.
Confronted by this line of argument, austerians (a term coined by Rob Parenteau, a research associate at the Levy Economics Institute of Bard College), make three arguments:
- additional borrowing will add heavily to future debt and so be an unreasonable burden on future generations;
- increased borrowing will crowd out private borrowing;
- bond investors will stop buying and push yields up.
In a liquidity trap, none of these arguments hold….
McCulley and Pozsar:
held back by concerns borne out of these orthodoxies, . . . governments are not spending with passionate purpose. They are victims of intellectual paralysis borne out of inertia of dogma . . . As a result, their acting responsibly, relative to orthodoxy, and going forth with austerity may drag economies down the vortex of deflation and depression….
The conclusion of the McCulley-Pozsar paper is, in brief, that aggressive fiscal policy does work in the unusual circumstances of a liquidity trap, particularly if combined with monetisation. But conventional wisdom blocks full use of the unorthodox tool kit. Historically, political pressure has destroyed such resistance. Political pressure drove the UK off gold in 1931. But it also brought Hitler to power in Germany in 1933. The eurozone should take note.
Remarkably, in the circumstances of a liquidity trap, enlarged fiscal deficits are likely to reduce future levels of privately held public debt rather than raise them. The view that fiscal deficits might provide such a free lunch is the core argument of the paper by DeLong and Summers….
In normal times, with resources close to being fully utilised, the multiplier will end up very close to zero; in unusual times, such as the present, it could be large enough and the economic benefits of such expansion significant enough to pay for itself. In a liquidity trap fiscal retrenchment is penny wise, pound foolish. Indeed, relying on monetary policy alone is the foolish policy: if it worked, which it probably will not, it does so largely by expanding stretched private balance sheets even further…. [T]he absence of supply constraints means that the multiplier is likely to be large. It is likely to be made even bigger by the fact that fiscal expansion may well raise expected inflation and so lower the real rate of interest, when the nominal rate is close to zero…. [M]oderate hysteresis effects of such fiscal expansion, via increases in the likely level of future output, have big effects on the future debt burden…. [T]oday’s ultra-low real interest rates… suggest that monetary policy is relatively ineffective….
This is a very powerful result. It rests on the three features of the present situation: high multipliers; low real interest rates; and the plausibility of hysteresis effects…. [T]he expansion would continue to pay for itself even if the real interest rate were to rise far above the prospective growth rate, provided there were significantly positive multiplier and hysteresis effects…. Are such numbers implausible? The answer is: not at all. Multipliers above one are quite plausible in a depressed economy, though not in normal circumstances. This is particularly true when real interest rates are more likely to fall, than rise, as a result of expansion. Similarly, we know that recessions cause long-term economic costs. They lower investment dramatically…. Again, we know that high unemployment has a permanent impact on workers, both young and old. The US, in particular, seems to have slipped into European levels of separation from the labour force…. Indeed, we can see hysteresis effects at work in the way in which forecasters, including official forecasters, mark down potential output in line with actual output: a self-fulfilling prophecy if ever there was one. This procedure has been particularly marked in the UK, where the Office for Budget Responsibility has more or less eliminated the notion that the UK is in a recession. Yet such effects are not God-given; they are man-chosen. They are the product of fundamentally misguided policies.
This is an important paper. It challenges complacent “do-nothingism” of policymakers, let alone the “austerians” who dominate policy almost everywhere. Policy-makers have allowed a huge financial crisis to impose a permanent blight on economies, with devastating social effects. It makes one wonder why the Obama administration, in which prof Summers was an influential adviser, did not do more, or at least argue for more, as many outsiders argued.
The private sector needs to deleverage. The government can help by holding up the economy. It should do so. People who reject free lunches are fools.