I just saw Scott Sumner’s latest post. It’s about the zero fiscal multiplier. Scott makes a good and important point, which is that, under almost any conditions, fiscal policy cannot be effective if monetary policy is aiming at a policy objective that is inconsistent with that fiscal policy. Here’s how Scott puts it in his typical understated fashion.
From today’s news:
The marked improvement in the labor market since the U.S. central bank began its third round of quantitative easing, or QE3, has added an edge to calls by some policy hawks to dial down the stimulus. The roughly 50 percent jump in monthly job creation since the program began has even won renewed support from centrists, raising at least some chance the Fed could ratchet back its buying as early as next month.
I hope I don’t have to do any more of these. The fiscal multiplier theory is as dead as John Cleese’s parrot. The growth in jobs didn’t slow with fiscal austerity, it sped up! And the Fed is saying that any job improvement due to fiscal stimulus will be offset with tighter money. They talk like the multiplier is zero, and their actions produce a zero multiplier.
This is classic Sumner, and he deserves credit for rediscovering an argument that Ralph Hawtrey made in 1925, but was ignored and then forgotten until Sumner figured it out for himself. When I went through Hawtrey’s analysis in my recent series of posts on Hawtrey and Keynes, Scott immediately identified the identity between what Hawtrey was saying and what he was saying. So up to this point, I am with Scott all the way. But then he loses me, by asking the following question
Has there ever been a more decisive refutation of a major economic theory?
What’s wrong with that question? Well, it seems to me to fly in the face of another critique by another famous economist whom, I think, Scott actually knows: Robert Lucas. Almost 40 years ago, Lucas published a paper about the Phillips Curve in which he argued that the existence of an empirical relationship between inflation and unemployment, even if empirically well-founded, was not a relationship that policy makers could use as a basis for their policy decisions, because the expectations (of low inflation or stable prices) under which the negative relationship between inflation and unemployment was observed would break down once policy makers used that relationship to try to reduce unemployment by increasing inflation. That simple point, dressed up with just enough mathematical notation to obscure its obviousness, helped Lucas win the Noble Prize, and before long became widely known as the Lucas Critique.
The crux of the Lucas Critique is that economic theory posits deep structural relationships governing economic activity. These structural relationships are necessarily sensitive to the expectations of decision makers, so that no observed empirical relationship between economic variables is invariant to the expectational effects of the policy rules governing policy decisions. Observed relationships between economic variables are useless for policy makers unless they understand those deep structural relationships and how they are affected by expectations.
But now Scott seems to be turning the Lucas Critique on its head by saying that the expectations that result from a particular policy regime — a policy regime that has been subjected to withering criticism by none other than Scott himself – refutes a structural theory (that government spending can increase aggregate spending and income) of how the economy works. I don’t think so. The fact that the Fed has adopted and tenaciously sticks to a perverse reaction function cannot refute a theory in which the Fed’s reaction function is a matter of choice not necessity.
I agree with Scott that monetary policy is usually the best tool for macroeconomic stabilization. But that doesn’t mean that fiscal policy can never ever promote recovery. Even Ralph Hawtrey, originator of the “Treasury view” that fiscal policy is powerless to affect aggregate spending, acknowledged that, in a credit deadlock, when expectations are so pessimistic that the monetary authority is powerless to increase private spending, deficit spending by the government financed by money creation might be the only way to increase aggregate spending. That, to be sure, is a pathological situation. But, with at least some real interest rates, currently below zero, it is not impossible to suppose that we are, or have been, in something like a Hawtreyan credit deadlock. I don’t say that we are in one, just that it’s possible that we are close enough to being there that we can’t confidently exclude the possibility, if only the Fed would listen to Scott and stop targeting 2% inflation, of a positive fiscal multiplier.
With US NGDP not even increasing at a 4% annual rate, and the US economy far below its pre-2008 trendline of 5% annual NGDP growth, I don’t understand why one wouldn’t welcome the aid of fiscal policy in getting NDGP to increase at a faster rate than it has for the last 5 years. Sure the economy has been expanding despite a sharp turn toward contractionary fiscal policy two years ago. If fiscal stimulus had not been withdrawn so rapidly, can we be sure that the economy would not have grown faster? Under conditions such as these, as Hawtrey himself well understood, the prudent course of action is to err on the side of recklessness.
Uneasy Money 
Two years in a row of austerity and the expectations from the pro-spending of the US GDP growth have fail.
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As usual, nice blogging.
I guess the Market Monetarist reaction is, “We have only brought out our monetary pop-guns, and monetary policy is already working a bit. If ever the feeble weaklings at the Fed would bring out some heavy artillery, we wouldn’t need any fiscal stimulus—indeed, monetary-stimulus induced torrent of tax revenues would bury fiscal stimulus.
BTW, on Phillips: Those older studies seem to assume that workers have any leverage. Union power. But today, most workers have zero leverage. So if their wages are cut through inflation, they just sit and take it, even if they know it is happening or going to happen. Cutting wages through inflation is socially acceptable behavior on the part of management, btw, and social relations count for a lot. Nominally cutting wages is considered punitive, or sign of sick company.
BTW, Jame Pethokoukis at AEI (!!!!) has a great column on Market Monetarism, and using QE to monetize debt, and cut tax rates.
Finally! The right-wing is learning not to conflate Fed monetary policy with federal spending.
Great quote in the Pethokoukis column about Bernanke telling Japan to do just that: Monetize debt, cut the tax load, and stimulate the economy.
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Sumner already in 2010 correctly predicted no adverse effects from European austerity. Wait…
You are right, it is classical Sumner: ignore data from 12 nations over 30 months and pronounce his theory proven after 2 jobs reports in one country that doesn’t do much of austerity.
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milton friedman wrote many articles on this issue. One example:
Click to access WSJ.01.08.1999.pdf
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I agree completly with you, David. Nothing to Add.
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David, would you describe yourself as a Hawtreyist? How many of you Hawtreyists are out there? :^)
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Where does Japan fit into this discussion? What feeds the pessimistic behavior, a condition for the “Credit Deadlock”? Do people like Plosser and Lacker play a role?
I might have misunderstood, but I understood the Sumner Critique as saying loose fiscal policy doesn’t matter if monetary policy is working at cross-purposes; not that it doesn’t matter if the central bank is willing to play ball. At that point, however. it seems logically worth asking the question if fiscal matters at all when the central bank is conducting more appropriate policy. Why not have monetary policy do the heavy lifting then? Perhaps from an expectational standpoint, doing both might cover all bases, and that is happening to some extent in Japan currently. But think it could be argued that the recent change in the stance of monetary policy has had a larger effect.
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David in saying that monetary policy is usually preferrable but that at times like this fiscal policy might be able to have a productive role you’re actually sounding like vintage Krugman, you realize?
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AldreyM, My apologies, but I can’t figure your comment out.
Benjamin, Thanks, I hope this is not a surprise, but I agree with the Market Monetarist reaction. This post is just a friendly chiding of Scott for going a little overboard in his zero fiscal multiplier kick. He has an excellent point about the Fed’s reaction function to fiscal policy. My only quibble is that point, good as it is, doesn’t all by itself, refute Keynesian economics. I’m not promoting fiscal policy, but I don’t want to discard any tool that might help achieve a recovery.
Sorry, but your theory of the labor market doesn’t sit well with me. If the market is competitive, the equilibrium real wage will adjust to inflation. If it doesn’t adjust to inflation, that means that the real wage was too high. If workers are being paid less than their real marginal product, employers will bid up their wage, not because workers have bargaining power, but because it is profitable for employers to do so. I know the real world is more complicated than that simple story, but that’s where I start from.
Where did Pethokoukis’s column appear?
PeterP, I’m not arguing with Scott about the facts, I’m arguing about logic.
thanos, Thanks for sharing.
Luis, Thanks.
Tom, I greatly admire Hawtrey, and consider him a highly reliable authority on monetary theory and policy, but I would not describe myself as either a Hawtreyist or a Hawtreyan. Despite plastering his portrait all over this blog, I do not believe in personality cults.
dajeeps, Good questions, but, off the top of my head, I have no response for you. You are right about the Sumner critique, and I totally agree with the Sumner critique. My problem was that Scott seems to think that he has thereby refuted Keynesian economics. He hasn’t. That’s all I’m saying. As I put in responding to comments on another thread, in any critical operation or task, it is a good idea to build some redundancy into the system in case something goes wrong. I’m not saying that I prefer fiscal to monetary policy, I just don’t want to discard what might be a useful tool.
Mike, Shocking, simply shocking.
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Not a cultist, eh? How about an MMer? Do you consider yourself one of those, … or are you like Nick Rowe: not into “labels.” ;^)
You’re OK by me, whatever you are. Of course if I could actually understand more of your articles I might not be so generous with my approval. Ha!
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BTW, I’ve described you as an “MM sympathizer” … is that fair, or should I cease and desist?
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Tom, I said that I am not a personality cultist. That doesn’t preclude my being a Market Monetarist or a sympathizer. I support NGDP targeting as a policy regime even though I can think of other policy regimes that in principle at least could be better. I don’t think that there is anything cultish in that. But if I were you, I wouldn’t try to read to much into my response. If you want to call me a MM sympathizer, I won’t complain.
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The point i’m trying to make is why the keynesians get it so wrong in their forecasts when america start doing austerity.
The fiscal multiplier seems overrated to me.
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David–
I think what are called “institutional imperfections” define much of the modern labor market.
There is another idea also: A worker may receive unique OTJ training, valuable only to his employer. This makes it hard for the employee to leave and make as much anywhere else, but also allows the employer to sit on wages, even in inflationary periods. Where is the employee going to go?
Suppose this situation defines most of the labor force?
I agree we must consult models, based upon assumptions, such as competition, or the EMT for stock markets. But there are times when the models vary so far from the reality…
Consider this: For centuries, people would not work on Sundays (Saturdays). A social or religious convention. Some still follow this social rule, and such a rule is enshrined in law in some places.
Social norms, such as cutting wages through inflation, explain a lot too.
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David-
link to the James P. blog at AEI.
Even AEI calling for monetary stimulus? !
http://www.aei-ideas.org/2013/05/how-about-a-massive-tax-cut-financed-by-the-fed/
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Richard Fisher, everyone’s fave and Dalla fed president, has your back, working Americans:
Richard Fisher, president of the Federal Reserve Bank of Dallas, was back on CNBC this morning – the second time in as many weeks – talking about everything from too-big-to-fail banks and monetary policy to the jobless rate and the national employment participation rate.
Fisher reiterated his stance that the Federal Reserve should dial back its monthly bond-buying program because it’s no longer effective in stimulating the economy.
“We have made rich people richer,” Fisher told CNBC today. “The question is, what have we done for the working men and women of America?”
Yes, I see no irony in a Texan GOP money manager standing up for working Americans. That is his real agenda, after all—a better life for working Americans.
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My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt–so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent. …
Isn’t it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ’s purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan’s fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.
That is not me speaking.
It is Bernanke, in Japan, 2003.
This is how we do it.
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David,
“when expectations are so pessimistic”
I seem to be fond of pointing out that expectations are anything but pessimistic in stock, commodity, high yield, commercial real estate, CLO, and many other markets.
What would be helpful is some kind of benchmark or reference point by which you might reverse your “deadlock” view of credit. A market P/E of 20? Junk spreads at 2007 lows? C&I lending growth of 5%+?
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Didn’t other people say essentially the same thing when talking about these things in the late 1960s and early 1970s — it seems to me there is more than a family resemblance between this and what a number of others were saying at the time:
“The existence of an empirical relationship between inflation and unemployment, even if empirically well-founded, was not a relationship that policy makers could use as a basis for their policy decisions, because the expectations (of low inflation or stable prices) under which the negative relationship between inflation and unemployment was observed would break down once policy makers used that relationship to try to reduce unemployment by increasing inflation.”
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Why does this “Critique” get the ‘Lucas’ label when others before Lucas pointed out essentially the same point?
“The crux of the Lucas Critique is that economic theory posits deep structural relationships governing economic activity. These structural relationships are necessarily sensitive to the expectations of decision makers, so that no observed empirical relationship between economic variables is invariant to the expectational effects of the policy rules governing policy decisions.”
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Yes, there was a bit of hyperbole in my “refutation” comment, but I’m pushing back against Keynesians who say that recent events support the Keynesian model, whereas they actually undercut the model. The economy was supposed to slow in early 2013, and it didn’t. And all you have to do is focus on today’s stock market headlines to know that it’s all about what the Fed will or will not do. I’m trying to get everyone to focus on monetary policy, which drives NGDP. One reason we are in this mess is that pundits have focused far too much attention on fiscal policy, and far too little on monetary policy. I’m trying to change the conversation, in the hope that a new conversation will boost the economy. As long as we focus on fiscal austerity, policy will remain ineffective.
Someone mentioned the ECB. I’ve always maintained that fiscal stimulus can help individual ECB countries (if they can afford it, which many cannot), but that the ECB drives aggregate NGDP. And sure enough the short term interest rate increases of 2011 drove Europe into recession. Even Krugman admits that the fiscal stimulus argument goes away when not at the zero bound, and Europe wasn’t at the zero bound in 2012. So Krugman and I should agree on Europe. If he doesn’t, then someone will have to ask him why not.
And finally, I don’t deserve any credit for rediscovering Hawtrey’s ideas, as monetary offset was pretty much standard NK theory in the 1990s and early 2000s.
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More educative columns and reasoned responses.
I am running out of adjectives however
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AldreyM, I don’t disagree, but I also don’t think that we should assume that fiscal austerity is irrelevant to macroeconomic performance.
Benjamin, I was commenting on the way you explained why inflation would not drive up nominal wages, as if employers are free to pay workers as little as they want now that labor unions are no longer powerful. You obviously have a more sophisticated understanding of how labor markets operate than I was giving you credit for, so my comment was should be understood as a clarification not a criticism.
Thanks for the link and for the (priceless!) Bernanke quote.
About Fisher, somebody told me recently that in the previous millennium he ran unsuccessfully in Texas for the US Senate as . . . a Democrat!
Diego, Lots of opportunities for astute traders and speculators, aren’t there? Good luck!
I don’t believe in historical benchmarks. Obviously, we are in a unique historical situation, so why would you expect historical benchmarks to be informative? But if implicit market expectations in some markets are very different from the expectations implicit in other markets, there should be a trading strategy that will exploit those inconsistencies.
Greg, Actually, to be fair to Lucas, in his article he actually acknowledged that others (specifically I remember that he cited Tinbergen) had made the basic point previously. Obviously others had made the point with varying degrees of generality before him, but his explication of the point in a very general context, of which the Phillips Curve was just one example, became the definitive citation for that proposition. It is not always the original discoverer who gets most of the credit.
Scott, Thanks for your response and clarification. You’re the strategic thinker, big picture guy. I’m just pedantically commenting on the strict meaning of what you said. That’s the risk in writing for the blogosphere, we write with implicit assumptions that are not always clear to our readers or even fully to ourselves. And, obviously, Bernanke caused major heartburn with his Congressional testimony yesterday, which certainly confirms your point. My point is that understanding that there is a Fed reaction function is not incompatible with believing in a Keynesian model of how the economy operates. I guess I wasn’t paying attention to NK models in the 1990s and early 2000s, so I didn’t notice, or at least forgot about, the monetary offset idea before I saw you make the point on your blog. In any case, credit withdrawn.:)
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David, in reply to Scott Sumner, you write, “My point is that understanding that there is a Fed reaction function is not incompatible with believing in a Keynesian model of how the economy operates.”
Yes, precisely. Leaving the contemporary “Keynesian” models aside, Keynes himself envisioned an arrangement in which, lo and behold, the Bank of England, her Majesty’s Government, and Local Governments would act in concert to put people back to work building useful projects. It’s hard to imagine anyone thinking that more debt-financed public expenditure would be successful if the central bank declined to facilitate this expansion.
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Greg Hill,
Early on after the GT, Keynes thought you could have debt-financed stimulus with a fixed money stock (and an implicit assumption of low-interest rate sensitivity of the demand for money) but he very soon switched off this idea.
More recently, there are Post-Keynesians who think that interest rates are either ineffectual or even inflationary if raised. In fact, a cost-push endogenous money model could lead quite logically to the conclusion that a central bank that tried to tighten money in response to fiscal stimulus by raising interest rates would simply raise costs and thereby encourage inflation. I don’t recommend such a model.
The biggest problem, as I see it, lies in debates about fiscal policy that just ignore the central bank, rather than take it into account and dismiss it.
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Yep, the Lucas Critique is an example of Stigler’s Law, and so is Stigler’s Law.
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W. Peden,
Here’s what Keynes said about debt-financed public works in the GT, “The method of financing the policy . . . may have the effect of increasing the rate of interest and so retarding [private] investment. . . unless the monetary authority takes steps to the contrary” (Ch.10, part III).
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Scott Sumner,
It’s still early days but one reason federal austerity might not have as much bite is that many states have balanced their budgets, most notably California, so state level austerity is far less of a drag on the economy.
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David, I agree, but I suppose the model I was criticizing was the variant of the Keynesian model that ignores monetary offset. Surely that’s been refuted?
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Greg, The strict Keynesian model (Keynesian cross/liquidity trap) requires no monetary policy intervention. It works with a fixed money supply. The effectiveness of pure fiscal policy can be rationalized as a form of redistributing cash balances from those with an infinite demand for cash to those who are income constrained and will therefore spend any cash receipts. In the intermediate case both fiscal stimulus and monetary stimulus can independently increase GDP.
W. Peden, It’s never a good idea to ignore the central bank.
What’s Stigler’s Law?
B. Park, But to get their budgets into balance, they were raising taxes and cutting expenditure, so that was a drag on the economy until now.
Scott, Yes I agree. But you made it sound as if that assumption is an essential feature of the Keynesian model. That’s what I was objecting to.
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David, I’m not sure what you mean by “the strict Keynesian model.” The passage from the GT I cited says that debt-financed public investment will displace private investment “unless the monetary authority takes steps to the contrary.” By “pure fiscal policy,” do you mean 100% tax-financed gov’t. expenditures, which can certainly redistribute cash balances, giving rise to a balanced budget multiplier or something like it?
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