Tuesday, 21 July 2009

Monetary versus fiscal policy

The debate between proponents of monetary and fiscal policy remains surprisingly interesting all these months later.

Not so much at Robert Peston's blog, unfortunately, where the question is more or less ignored; instead it is reduced to a question - without an answer - about how expensive it will be for the government to finance its debt.

But have a look at some of the comments on this Worthwhile Canadian Initiative posting. Adam P in particular makes an intriguing point:
Moreover, this really goes to a distinction that people are often not careful about (I was trying to make this point in the discussion of your 'why fiscal policy won't work competition'). We need to decide on what we mean for fiscal stimulus to "work". There are two distinct questions:

1) Can fiscal policy increase output in a liquidity trapped economy? Clearly yes.
2) Can fiscal policy end the recession, break the trap? Only by increasing expected inflation which could also be done by monetary policy (and doing it with monetary policy is clearly the better way).
Now I don't think Adam has quite demonstrated this point. It's a standard assertion among monetary theorists that monetary actions are "clearly" better than fiscal ones. Paul Krugman and others would presumably say that:
  1. Monetary policy has run out now anyway
  2. Fiscal policy can achieve economic adjustment in a different way, by creating investment in public goods and increasing expectations of future aggregate demand
The debate on Peston's article should therefore take into account not just whether the government "can finance its debt" - after all it can, always. It should consider whether financing it by printing money is a good thing. Monetary economists, such as many of those on the right wing who are concerned about public debt, would say yes. And after all there is really no issue about paying the Bank of England "its" money back - the impact of not doing so is only to create a bit of inflation. Which is exactly what we want now.

Two more points on this.

First, Peston's £220 billion figure for new gilt issuance. He claims that this will be the same again next year because the government won't cut spending or raise taxes. Wrong! The reason it got so high this year is not because of increased spending or reduced taxes: it is because of the automatic impact of the recession, mainly on tax receipts. The British public deficit is highly sensitive to recessions for various reasons. In fact, most economists think an economic recovery is either already underway, or is about to be, and so the deficit will automatically shrink. I would expect next year's borrowing figure to be at least a third less than this year's even with no policy changes.

Second, and more interesting from a theoretical point of view. How much does this automatic fiscal stimulus contribute towards recovery? Recovery from a recession can come from various sources:
  1. Adjustment of prices to a new full employment equilibrium (more or less the monetarist viewpoint - inflation makes this adjustment much easier because most individual prices and wages will not adjust downwards, so instead you adjust the general price level upwards to compensate)
  2. Satisfying the demand for excess saving by increasing the money supply (printing money) and thus forestalling the paradox of thrift
  3. Getting out of a 'sunspot' or a low-output equilibrium by raising expectations of future demand, therefore encouraging people to spend more (the Keynesian multiplier effect)
  4. Directly increasing aggregate demand, creating investment opportunities which absorb the desired savings of the private sector (either because the public sector invests directly - the US fiscal stimulus case - or because the private sector finds more opportunities to invest)
Most of these routes are complementary - with a partial exception in the last case, if "crowding out" happens - that is, the demand for government borrowing makes private borrowing for investment more expensive. But crowding out does not appear to be a worry, at least in the short term: the reason for low private investment is not high interest rates, but a perception that there are few profitable investment opportunities available.

Thus we may never know which of the above was the "real" cause of recovery - because the economy will simultaneously adjust in response to all of them.

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