Monetary Alchemy, Fiscal Science

The year 2013 marks the 100th anniversaries of two separate major institutional innovations in American economic policy:  the Constitutional Amendment enacting the federal income tax, ratified on February 3, 1913, and the law establishing the Federal Reserve, passed in December 1913.

It took some time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy, respectively.   It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macro-economy.  John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression.   Milton Friedmanblamed the Depression on the Fed for allowing the money supply to fall.    [Tools of fiscal policy used by governments, in addition to tax rates and tax deductions, are spending and transfers.  Tools of monetary policy used by central banks include interest rates, quantities of money and credit, and instruments such as reserve requirements and foreign exchange intervention used in various (non-US) countries.]

In subsequent debate, Keynes was associated with support for activist or discretionary policy.  The aim was counter-cyclical response to economic fluctuations: expansion in recessions, discipline in booms.  (It is a myth that he favored big government generally.  He said “the boom is the time for austerity.”)      Friedman opposed activist or discretionary policy, believing that government institutions, whether monetary or fiscal, lacked the ability to get the timing right.   But both great economists were opposed to pro-cyclical policy moves, such as the misguided US tightening of 1937 at a time when the economy had not yet fully recovered.

After World War II, the lessons of the 1930s were incorporated into all the macroeconomic textbooks and, to some extent, into the beliefs and actions of policy-makers.  But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by experiences such as the high-inflation 1970s.  As a result, many politicians in advanced countries are repeating the mistakes of 1937 today.  This despite conditions that are qualitatively similar to those that determined Keynes’ policy recommendations in the 1930s: high unemployment, low inflation, and rock-bottom interest rates.

The austerity-versus-stimulus debate has been thoroughly hashed out.   On the one hand, proponents of austerity correctly point out that the long-term consequences of permanently expansionary macroeconomic policy [both fiscal and monetary] are unsustainable deficits, debts, and inflation.    On the other hand, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt/GDP ratios that go up rather than down.  Procyclicalists, both in the US and Europe, represent the worst of both worlds:  they push in the direction of expansion during booms such as 2003-07 and in the direction of contraction during recessions such as 2008-2012, thereby exacerbating both the upswings and downswings.  Countercyclicalists have it right:  working in the direction of fiscal and monetary discipline during booms and ease during recessions.

Less thoroughly aired recently is the question whether — given recent conditions – monetary or fiscal expansion is the more effective instrument.   This question was addressed clearly in 1937 by Sir John Hicks in a once-famous article titled “Mr. Keynes and the Classics.”  The graphical model is known to many generations of undergraduate students in macroeconomics under the label “IS-LM.”

The answer to the question which form of policy is more effective:  under the circumstances that held in the 1930s and that hold again now – which are conditions not just of high unemployment and low inflation, but also near-zero interest rates — stimulus in the specific form of fiscal expansion is much more likely to be effective in the short-term than stimulus in the form of monetary expansion.   Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero.  (Flat LM curve.)  This situation, labeled by Keynes a liquidity trap, is today called the Zero Lower Bound.  In addition, firms are less likely to react to easy money by investing in new plant and equipment if they can’t sell the goods they are producing in the factories they already have.  (Flat IS curve.)  The hoary — but still evocative — metaphor is “pushing on a string.”  Meanwhile, fiscal expansion is rendered relatively more effective, in that it doesn’t push up those rock-bottom interest rates and thereby crowd out private-sector demand.

Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries.  It is worth trying all sorts of things:  quantitative easing, forward guidance, nominal targets.   Even if the short-term interest rate channel is inoperative, such steps may work through other channels:  long-term interest rates, credit channel, risk premia, expected inflation, asset prices, commodity prices or exchange rates.  But the effects of each are highly uncertain.

That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position.  But many economists have forgotten much of what they knew and politicians may not have even heard the proposition.

Introductory economics textbooks have long talked about the Keynesian multiplier effect:  the recipients of federal spending (or of consumer spending stimulated by tax cuts or transfers) respond to the increase in their incomes by spending more as well, as do the recipients of that spending, and so on.  Again, the multiplier is much more relevant under current conditions than in the normal situation where the expansion goes partly into inflation and interest rates and thus crowds out private spending.  By the time of the 2008-09 global recession even those who believed that fiscal stimulus works had marked down their estimates of the fiscal multiplier — intimidated, perhaps, by newer theories of policy ineffectiveness.  The subsequent continuing severity of recessions in the United Kingdom and other countries pursuing contractionary fiscal policies, apparently to the surprise of the politicians enacting them, suggested that multipliers are not just positive, but greater than one, as the old wisdom had it.   The IMF Research Department has now reacted to this recent evidence and bravely confessed that official forecasts, including even its own, had been operating with under-estimates of multiplier magnitudes.

A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others.   Baum, Poplawski-Riberio and Weber (2012) allow the estimate to change when crossing a threshold measure of the output gap.  Batini, Callegari and Melina (2012) allow regime-switching, across recessions versus booms.  Others that similarly distinguish between multipliers in periods of excess capacity versus normal times include Auerbach and Gorodnichenko (2012a, 2012b), Baum and Koester (2011), and Fazzari, Morley and Panovska (2012).  Most of this research finds high multipliers under conditions of excess capacity and low interest rates.  (Few of them have the courage to mention that this is what one would have expected from the elementary textbooks of 50 years ago, perhaps due to fear of sounding old-fashioned.)   Related studies confirm other conditions that matter for the size of the fiscal multiplier in precisely the way the traditional textbooks say, for example that they are lower in small open economies because of crowding out of net exports.

Needless to say, the effects of fiscal policy are subject to substantial uncertainty.   One never knows, for example, when rising debt levels might suddenly alarm global investors who then start demanding abruptly higher interest rates, as happened to countries on the European periphery in 2010.    (For this reason, the United States would be well-advised to lock in a long-term path toward debt sustainability, even while undertaking a little short-term stimulus.)   In the case of stimulus in the form of tax cuts, one never knows how much of the boost to disposable income will be saved by households rather than spent. We are also uncertain as to the magnitude of negative effects of high tax rates, via incentives, on long-term growth.   And it is true that monetary policy is much better understood than it was in the past.

Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter.  One might even dramatize the contrast by speaking of “monetary alchemy and fiscal science.”

A much-admired 2010 paper by Eric Leeper had it the other way around: it characterized monetary policy as science and fiscal policy as alchemy.   It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to the best that modern society has to offer.    It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state of economic knowledge and motivated largely by politicians’ desire to be re-elected.  These political realities may be what the author of “Monetary Science, Fiscal Alchemy” had in mind.

But the ancient alchemists were not in fact stupid or selfish people in general, notwithstanding their search for the “philosopher’s stone” that was to turn lead into gold (of which modern proponents of returning monetary policy to the pre-1914 gold standard are reminiscent).  Nor was the alchemists’ problem that the monarchs of their day refused to listen to them.  It was rather that the state of knowledge fell far short of what the modern science of chemistry can tell us.
The term alchemy could be applied to pre-Keynesians like US Treasury Secretary Andrew Mellon (whose Depression prescription was that President Herbert Hoover should “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system”).  It could also be applied to the “Treasury view” in the UK of 1929. (Churchill:  ”The orthodox Treasury view … is that when the Government borrow[s] in the money market it becomes a new competitor with industry and engrosses to itself resources which would otherwise have been employed by private enterprise, and in the process raises the rent of money to all who have need of it.” ).  But in light of all that was learned in the 1930s, it would be misleading to characterize the current state of fiscal policy knowledge as alchemy.


Miguel Almunia, Agustín Bénétrix, Barry Eichengreen, Kevin O’Rourke, and Gisela Rua, 2010, “From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons,” Economic Policy, 25 (62), pp. 219-65.

Alan Auerbach and Yuriy Gorodnichenko, 2012a, “Measuring the Output Responses to Fiscal Policy,” American Economic Journal: Economic Policy, vol. 4(2), pp. 1-27, May.

Alan Auerbach and Yuriy Gorodnichenko, 2012b, “Fiscal Multipliers in Recession and Expansion,” NBER Chapters, in Fiscal Policy after the Financial Crisis, edited by AlbertoAlesina and Francesco Giavazzi (University of Chicago Press).

Nicoletta Batini, Giovanni Callegari and Giovanni Melina, 2012. “Successful Austerity in the United States, Europe and Japan,” IMF Working Papers 12/190, International Monetary Fund.

Anja Baum and Gerritt Koester, 2011, “The Impact of Fiscal Policy on Economic Activity Over the Business Cycle – Evidence from a Threshold VAR Analysis” Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies  number 2011,03.

Anja Baum, Marcos Poplawski-Riberio and Anke Weber, 2012, “Fiscal Multipliers and the State of the Economy,” IMF Working Paper 12/286, International Monetary Fund, December.

Olivier Blanchard and Daniel Leigh, 2013, “Growth Forecast Errors and Fiscal Multipliers,” IMF Working Paper No. 13/1, January.  Forthcoming, American Economic Review, May.

Steven Fazzari, James Morley, and Irina Panovksa, 2012, “State-Dependent Effects of Fiscal Policy,”  UNSW Australian School of Business Research Paper No. 2012-27, April.

Milton Friedman and Anna Schwartz, 1963,  A Monetary History of the United States, 1867-1960 (Princeton University Press).

John Hicks, 1937, Mr. Keynes and the Classics: A Suggested Reinterpretation,” Econometrica, pp. 147-59.

Ethan Ilzetzki, Enrique Mendoza & Carlos Vegh, 2011. “How Big (Small?) are Fiscal Multipliers?,” IMF Working Papers 11/52 (International Monetary Fund.)  Forthcoming, Journal of Monetary Economics.

Eric Leeper, 2010, “Monetary Science, Fiscal Alchemy,” NBER Working Paper No. 16510.

Christina Romer and David Romer, 2013, “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter,” UC Berkeley, January.

Antonio Spilimbergo, Steven Symansky, and Martin Schindler, “Fiscal Multipliers,Staff Position Note No. 2009/11, International Monetary Fund.

[This post also appears at Econbrowser. Comments may be posted there.]

Debt Ceilings, Bombs, Cliffs and the Trillion Dollar Coin

Needless to say, the US has a long-term debt problem.  The problem is long-term both in the sense that it pertains to the next several decades rather than to this year.  (Indeed, the deficit/GDP ratio has been falling since 2009, despite the weakness of the economy.)   The problem is also long-term in the sense that we have known about it for a long time; it was clear in 1991 and should still have been clear in 2001.

It should be almost as needless-to-say that the approaching debt ceiling bomb is not helpful in solving our fiscal situation, any more so than were previous standoffs:  the January 1, 2013, fiscal cliff; before that, the August 2011 debt ceiling standoff, which led Standard and Poor’s to downgrade the credit rating of US debt for the first time in history; and before that, the 1995 shutdown of the government, which largely discredited Republican House Speaker Newt Gingrich.

The current debt ceiling bomb is, of course, another attempt to hold the country hostage under threat of blowing us all up.  The conflict is usually phrased as a question of ideological polarization, a battle between fiscal conservatives and their opponents.  This familiar frame does not seem right to me.  There is in fact no correlation or consistency between the practice of federal fiscal discipline and the political rhetoric, either across states or across time.

What are the demands of the hostage-takers?   Even if there existed an explicit ransom letter detailing specific severe spending cuts, in exchange for which it credibly offered to raise the debt ceiling, President Obama’s refusal to negotiate under such conditions would be fully justified.  But the situation is worse than that.  There is no specific set of demands, and never has been.  I truly believe there does not exist any set of spending cuts that the blackmailers would accept if they came from Obama.

Remember the occasions in the past when he has announced that he will accept the Republican position on some issue, only to have his opponents switch places, saying “if you are in favor of it, we are against it”?    One example was the idea of Obamacare itself, which originally came from conservative think tanks and Mitt Romney.   Another example was the proposal for an automatic version of what in February 2010 became the Simpson-Bowles Commission.

There are only so many dollars that can be cut out of PBS and foreign aid.   If, hypothetically, Obama were to come out in support of severe cuts in agricultural supports, oil and gas subsidies, Medicare benefits and other programs, Republicans would attack him for proposing hurtful cuts. (Remember attacks on Obama’s health plan for non-existent “death panels” and fictional cuts to Medicare benefits?)  Simultaneously, Republicans would say that the cuts were not big enough.

What would be enough?   Some debt crazies have said they think it would be fine if we failed to raise the debt ceiling.  Some are crazy enough to think it is not a problem if the US government were to default on its legal obligations.  (They may not realize that defaulting on the bill for office supplies that you ordered from Staples is as bad as  missing interest payments on your debt.)  But some want to enforce a balanced budget immediately:  the refusal to allow the government to borrow any more is not just a negotiating tactic, but is the outcome they want.  This is crazy in light of the adverse economic and financial impact (which would be much worse than that of the fiscal cliff that we just dodged two weeks ago).

But the prize for ultimate insanity must go to those who want to eliminate the budget deficit rapidly and insist on doing it without raising taxes, cutting defense, or cutting programs for seniors.  These people deserve the label “deranged” because what they are demanding is for a literally false proposition to be true.  It is arithmetically impossible to eliminate the budget deficit if the cuts are to come primarily in non-defense discretionary spending.

To be very clear, I don’t think most Republicans believe all of this.  Certainly my many economist friends who are Republicans do not.  The truly “deranged” people are just a subset of the “crazy” people, who are in turn a subset of those who are unwise enough to favor the debt ceiling threat as a tactic, who are in turn a subset of the Republican Party.   The problem is that it is this minority of a minority that is holding the whole country hostage.  The size of the minority evidently shrunk after the August 2011 debt ceiling debacle, after the November 2012 election, and after the January 1 cliff.   But it still has its finger on the grenade pin.

So that leads us to the question of tactics.  A variety of stratagems have been proposed for the White House to use to defuse the bomb, if it comes to that.  These are all designed as ways that the federal government can continue to meet its legal obligations beyond March, even if the Congress doesn’t raise the debt ceiling.   While these unconventional proposals are beyond anything that would have been contemplated under normal conditions, they must be considered, in light of the correspondingly absurd situation in which the country would find itself.  If the Congress refuses to act, the White House would have to choose between two contradictory laws: the one that Congress passed to authorize spending and taxes versus the debt ceiling law that apparently prohibits the government from borrowing to make up the difference between spending and taxes.  Following the implication of the latter law would have disastrous impacts on the country and the world if obeyed.

  • Given the contradiction between the two laws, President Obama could just ignore the debt ceiling and follow the direct implications of the spending and taxation laws. I am not qualified to judge the legality of this course of action. The courts would eventually have to sort it out. The hope is that by then the Congress would have come to its senses and raised the debt limit.
  • In the meantime, the White House might try invoking the 14th Amendment, as Bill Clinton suggested at the time of the last debt ceiling standoff, in 2011.  The Amendment includes the passage “The validity of the public debt of the United States…shall not be questioned.” Again the Supreme Court would eventually have to decide the issue.
  • The Treasury could issue “IOUs” to the office supply stores, soldiers, Social Security recipients, etc. The IOUs would just be written acknowledgements of a legal fact: that the government owes these people money. Maybe the Federal Reserve could let it be known that it will honor these IOUs. (There must be something wrong with this, or somebody besides me would have proposed it already.)
  • The government writes an option to buy all its property and buildings for $1, and then sells that very valuable option to the Federal Reserve for something like its true value. This proposal has been made by the Yale constitutional expert Jack Balkin last time around, from which I infer that it is not obviously contrary to the law.
  • And finally, the most colorful of the proposals: the trillion dollar coin. The Treasury would exercise its legal authority to mint a commemorative coin made out of platinum, with a face value of $1 trillion. The Federal Reserve would then buy the coin for $ 1 trillion, allowing the Treasury to pay its obligations by drawing down its checking account at the Fed up to that amount. This proposal originated in the blogosphere and was one of those anointed by Balkin in July 2011. Paul Krugman greatly elevated its prominence by declaring his support earlier this month.

Contrary to some fears, none of these proposals need result in the money supply being any larger than it would otherwise be.  The Federal Reserve determines the money supply.  If it creates a new component of money by buying a platinum coin, a property option or IOUs, it can offset it by shrinking other components of the money supply by the same amount, leaving the total unchanged.

The Obama Administration so far is eschewing gimmicks, and is calling on the Congress to do its job in a responsible manner.  This is the right approach.

But in the event that the minority does succeed in blocking a debt increase, it may be worth turning to some legal gimmick to avert the financial and economic catastrophe.   Of the five proposals bulleted above, the platinum coin is the one that seems to have the most experts currently expressing belief in its legality.  It is certainly clever.  Unfortunately, it would probably be the worst from a political standpoint.  The reason is – I am guessing here – there is a fairly high overlap between the debt crazies (defined above) and people who have paranoid conspiracy theories that relate to the Fed, money and precious metals (especially gold, but platinum is too close for comfort). For all I know, some of these people are the same who believe that Obama was born outside the U.S.  (That would fall into the category of deranged propositions, also defined above; but there is no need for us to go there.)  When you are dealing with a crazy person, it is best to avoid anything that would pour gasoline on the flames of his paranoia.  We actually want to win back some of those people who are merely misguided but not really insane.  After all, just getting past the current debt cliff wouldn’t solve the problem, with sequester and shutdown deadlines also looming.   So I’d go for some other legal gimmick, one that would be less likely to feed the paranoia and more likely to continuing chipping away at popular support for the extremists.

[I have been interviewed this week on the trillion dollar coin by Boston magazine and radio station WGBH.]