TL;DR at bottomFigured I'd make one final post--more of a compendium, really--on the issue of monetary policy, and fiscal stimulus vs. austerity. The poll is just to see where most people on the forum lie (note: if you choose the last one, you're bad and you should feel bad).
Full disclosure: I don't really "identify" with any school of thought to a substantial degree. I'm part New Keynesian, part monetarist, part neoclassical.
Deficit Spending and Keynesianism:
It's important to note that I'm talking specifically when we're going through the pains of the business cycle, and in a recession. It isn't good policy to run a deficit during times of prosperity; a 2004
study by Orszag and Gale found that a deficit of 3.5pc leads to rising interest rates and a shrinkage in the economy by 1 or 2pc. The reason for this is that it crowds out private investment by competing in the pool of available savings (speaking strictly domestically) and driving up interest rates.
An
earlier study in 1999 by Blanchard and Perotti supports this; they demonstrate a very small long-run multiplier for increased government expenditure, as well as a similar crowding out effect. It's important to note that, at least in terms of the business cycle, Keynesian economics has been thoroughly discredited. Keynes was simply mostly wrong; investment isn't driven by animal spirits, and a combination of fiscal policy + regulation probably isn't the best way to deal with the business cycle (there are other errors, but they're somewhat more technical and not really worth mentioning, although I will elaborate if anybody wishes).
In fairness to Keynes, however, he got one very important thing absolutely correct. Parts of the business cycle are not optimal, and there is space for the government to act in its mitigation. This cannot be understated as a massive improvement upon the neoclassical economics which dominated at the time.
Fiscal Stimulus:
It's important to note that the existence of automatic stabilisers--which are essentially automatic deficits as tax receipts fall and social welfare spending rises during a bust--are useful for at least the partial mitigation of the business cycle. It's for this reason that I feel the Conservatives' pursuance of austerity in the midst of the Recession was probably sub-optimal (shocker), although the existence of a prior structural deficit muddies the issue.
However, where the issue get's really interesting is when short-term interest rates hit zero. The current view of monetary policy--not unjustifiably--is Wicksellian, in that it views monetary policy through a lens of manipulating interest rates. This is essentially why everybody freaked out when central banks started pursuing quantitative easing. Monetary policy works through open market operations, wherein the central bank buys or sells assets (usually short-term treasury bills in the US) in order to influence the supply of money and push the short-term interest rate under their influence up or down.
The conventional, New Keynesian perspective is that we enter a liquidity trap when those short-term interest rates hit zero. And thus monetary policy can't do any more. Thus, we must resort to the oh-so controversial fiscal stimulus to get the economy moving again. Make no mistake, fiscal stimulus works, it's just a question of whether it works better than monetary policy in a liquidity trap. During a liquidity trap, a 2011
paper by Christiano, Eichenbaum and Rebelo found a fiscal multiplier of 1.5 (meaning that fiscal stimulus is essentially worthwhile, under such circumstances).
Fiscal Austerity:
On the flip-side, we have fiscal austerity. There's no doubt that austerity is good form during a growing economy, but evidence suggests that in a liquidity trap the multiplier works in reverse, making austerity painful as the central bank cannot offset it. For some countries, like Greece, they don't really have a choice in austerity; they don't have the historical grounding as a reliable country for debt repayments, and they don't have the freedom that comes with having debt denominated in its own currency like the US. In an incredibly messy financial system, creditors may worry that larger deficits mean increased likelihood of default and so they raise interest rates; but the fact of the matter is that the UK simply wasn't in that position and probably never will be. The claims of the Conservatives on the need to avoid a Greek-like debt crisis were, essentially, false.
Monetary Policy in a liquidity trap:
Now, this is where I become more monetarist than the mainstream. I don't think the New Keynesian argument that liquidity traps kills off the central bank's effectiveness are all that good, and I think there is superior evidence that monetary policy can be effective during a liquidity trap. Just to take Paul Krugman during the 1990s, he argued vehemently (along with Ben Bernanke (the real one)) for more aggressive monetary stimulus in Japan even though they were in a liquidity trap.
It seems that most of the problems associated with monetary policy in liquidity traps are conceptual issues. Like I said, people freak out when the Fed/BoE performs quantitative easing. . . Despite the fact there is no real distinction between short-term treasury bills and long-term treasury bills, or indeed any other kind of asset. The only real liquidity trap would be one in which the central bank has driven the interest rates of every single asset on the planet down to zero (but more on this shortly).
To back this up with some empirical evidence:
Lars Svensson (2003) argues for a mixture of clear communication and forward guidance, sticking to the monetary guns and a clear exit strategy (the latter being a significant failing of the Fed's rounds of QE).
Eggertson and Woodford (2003) note that liquidity traps can indeed happen, but note alongside Svensson that forward guidance can help to mitigate this. It's also important to note that the degree of leverage (debt) held in an economy can have significant influence on whether or not short-term rates do hit zero.
My recommendations for policy:
I think one of the most important things is to sort out financial regulation. Nobody really knows just how much financial crises affect the business cycle, and I personally don't believe it's very much besides a depression of real GDP growth which can be offset. But, all the same, the uncertainty makes it not worth the risk. We should cut back on excessive, intricate regulation and follow Canada's example: institute broad capital and liquidity requirements to make sure banks can weather crises, and maybe also help counter-party surveillance by mandating public plans of "winding down" should a bank become insolvent (which will also help to combat too-big-to-fail).
In terms of monetary policy, I think the ideal is a nGDP level target wherein the central bank essentially commits to stabilise aggregate demand instead of inflation. However, I'm sceptical of whether or not this is reasonably possible (although evidence does suggest that Alan Greenspan successfully pulled it off from 1992 onwards). If an nGDP level target isn't possible, then maybe Paul Krugman's proposal of a 4pc rate of inflation is worth looking at. Make no mistake, the goal is to make fiscal stimulus unneeded.
If, however, we still hit a liquidity trap then I don't think monetary policy can hold out forever. I mentioned earlier that a "true" liquidity trap would require the central bank to push the interest rates of every single asset on the planet down to zero. While this is true, pursuing such a policy would result in significant capital risk that I'm not sure I can abide. I'm optimistic about the potential of monetary policy to manage the business cycle, but if we have a situation where it begins to fall down I don't think it should be pursued forever. And so we end up with the Larry Summers solution; the central bank pursues quantitative easing to a certain limit of GDP and then automatic fiscal stimulus takes over, mainly through tax cuts. I'm not having none of this politicised fiscal stimulus though.
In terms of austerity: I don't believe austerity should be pursued in times of recession. Automatic stabilisers should remain in place to make sure the contraction isn't excessive, and austerity should be pursued in times of recovery. With a pre-existing deficit, however, it's a lot harder to tell.
TL;DR for the lazy:
- Deficit spending crowds out private investment and hurts growth over the long-term.
- Keynes was wrong about the business cycle.
- Keynes was right that the government has a role.
- Automatic deficits occur when an economy goes into recession, and these are useful.
- Tories kind of fucked up by pursuing austerity when they did, although Labour's over-spending complicates it.
- When short-term interest rates reach zero, conventional wisdom says monetary policy can't do much more.
- Fiscal stimulus works, the question is whether it works better than monetary stimulus.
- Austerity may be necessary to avoid a credit crisis, although the UK wasn't in this position.
- I personally think monetary policy is effective even when rates approach zero.
- We need to make fiscal stimulus unnecessary.
- Monetary policy can probably control the business cycle (it definitely does if we never hit zero rates), but if it can't then some kind of fiscal stimulus could be warranted.
Ultimately, off the poll choices, I'm closest to "monetary stimulus, with delayed austerity".
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