On Twitter recently, Eric Brynjolfsson took an interesting poll, asking those who self-identify as economists if they view the current state of fiscal policy in the United States as expansionary or contractionary. Only slightly more than half of the economists who answered the question viewed fiscal policy as expansionary, which seems surprising given the rise in inflation in recent months.
Divergence of views among economists about the impacts of fiscal policy should not surprise us, as they are nothing new. In the 1930s, disagreements played out as a famous debate between John Maynard Keynes of Cambridge and Friedrich Hayek and Lionel Robbins of the London School of Economics. By the latter part of the 20th century, the debate had morphed into one between “freshwater” schools like the University of Chicago and the University of Minnesota and “saltwater” schools like Harvard and MIT.
One explanation for the divide is that there are some obvious political implications that follow from debates about fiscal policy. Those on the left tend to like more government spending, and therefore see it as beneficial, while those on the right tend to be more skeptical. There are also genuine economic disagreements, for example between Keynesians who see interest rates as vitally central to the economy’s workings, and Monetarists who see the quantity of money as more important.
I thought I would use this post to offer some of my own views about how fiscal policy “works” in the economy. Perhaps others will find this information useful for clarifying their own thoughts. I would also love to hear from people who might disagree with anything I’ve said here.
Aggregate Demand Problems
First off, it is undoubtedly true that aggregate demand failures occur. By this I mean that the value of total spending in the economy (aggregate demand) can either exceed or fall short of the value of total production (aggregate supply) at the current price level. In the case of the former we get inflation, and in the case of the latter we see unemployment and recession.
During most ordinary times, including times of recession, increases in government spending typically do not add a lot to total spending, and therefore changing the amount of government spending is not a very effective way of combatting recession or influencing aggregate demand. This explains why government spending multipliers are typically found to be fairly low in the empirical literature.
The reason for the low observed multipliers is probably something like the following: Government has to get money from somewhere. Taxing or borrowing it pulls money out of the private sector, thereby reducing aggregate demand elsewhere and counteracting the impacts of fiscal policy. It’s the classic case of taking a dollar out of one pocket and putting it into another. In some cases, increases in government spending can even end up lowering total spending below what it would be if the private sector kept the money (the multiplier is less than one) or resulting in a negative multiplier (the economy shrinks relative to no new spending from either the public or private sectors), due to the distortionary effects of government policies.
Money is What Matters
One of the lessons the great economist Milton Friedman taught us is that monetary policy is a much better tool to ameliorate aggregate demand problems than is fiscal policy. The fiscal authority tends to be slow to react to changes in the state of the economy, and the monetary authority has more influence over the quantity of money.
Friedman taught us (and his views largely come from Irving Fisher) that total spending in the economy is determined by two factors: the amount of money in the economy and the rate at which money is spent. Influencing the latter, known as velocity, is the primary channel through which fiscal policy operates. But velocity is a complicated variable that is hard to control. It’s a bit like pushing on a string.[1] Far easier is influencing the total quantity of money, since the government can simply print more or less of it—something near costless in a fiat money regime.
The Liquidity Trap Bogey
Some economists have concerns about the “zero lower bound” causing a “liquidity trap.” This is the idea that monetary policy becomes ineffective when interest rates hit zero, since the central bank has no more room to reduce interest rates to stimulate the economy.
This view is misguided for several reasons. First of all, the government doesn’t run out of the ability to print money when interest rates hit zero—it can keep printing away. Second, confusion about the role interest rates play in the economy seems to underlie the liquidity trap idea.
“New Keynesian” economic models, as well as simpler Keynesian models like the IS-LM model, tend to view “the” interest rate as the primary price that simultaneously clears the money and loanable funds markets. It’s as if there is a single, natural rate that exists, and the central bank just needs to find it with monetary policy to achieve macroeconomic equilibrium. When the natural rate is negative, however, the central bank can’t reach the equilibrium rate, and so aggregate demand will be chronically insufficient to meet aggregate supply.
I have problems with this view for at least two reasons. First of all, the central bank can set negative interest rates. It can tax bank reserves held in central bank accounts, which is the equivalent of setting negative rates. In fact, a number of countries have had negative interest rate policies in recent years, so this is not merely a theoretical proposal.
Additionally, if the supply of money is insufficient to the meet the public’s demand for money, the “price” of money that adjusts to bring about an equilibrium is the price level, not the interest rate. The price level falls (or rises more slowly) such that the purchasing power of money rises. (Inversely, when people hold money balances in excess of what they wish to hold at current prices, they spend off excess cash balances bringing about higher inflation.)
In this sense, the “liquidity preference theory of interest” of John Maynard Keynes is not correct. Interest rates can be influenced by the public’s demand for money, and interest rates can be one contributing factor in determining the public’s demand for money, but they are not the price of money that adjusts to bring about a static equilibrium. The relevant price is the price level, and policy that affects the quantity of money is much more impactful at influencing the price level than is policy that affects interest rates.
When Fiscal Policy Is Monetary Policy
There are times when fiscal policy is more effective at stimulating aggregate demand, and it turns out that interest rates hitting zero is one of those times—it’s just not for the reasons the liquidity preference theorists posit. Short term government debt and money become near perfect substitutes when interest rates are zero, so during these times fiscal policy becomes a form of monetary policy through its influence on deficits and is therefore more effective at stimulating aggregate demand thab otherwise.
A Treasury bill that pays zero interest is almost identical to a Treasury-issued dollar, which also pays zero interest. During times of economic uncertainty and stress, the public tends to demand more safe assets and this demand can be satiated by issuing more currency or more Treasury bills. Increases in the deficit increase the supply of Treasury bills, and therefore can have a palliative effect on the economy by satisfying the public’s increased demand to hold money during aggregate demand shortfalls.
One complication that arises in this kind of situation is that if the central bank is targeting inflation, it can counteract some of the beneficial effects of more spending by the fiscal authority. In other words, if fiscal policy pushes up the inflation rate, the central bank might respond by reducing money growth in order to keep inflation in check, thereby offsetting the beneficial effects of fiscal policy.
This could be a reason why the Biden economic stimulus package of 2021 seems to have spurred inflation, while the 2009 Obama stimulus package did not. The Biden package took place in a low interest rate environment when the Federal Reserve seemed more inclined to allow higher inflation than normal. This suggests that for fiscal policy to be stimulative, the central bank generally needs to be on board.
Monetary Policy Still Reigns Supreme
Even during those times when the stars align in a way that fiscal policy can be more effective, monetary policy still has advantages over it. Central banks tend to be more insulated from political pressure than legislatures, so they will tend to be less inclined to hand out money to privileged special interests. Additionally, mistakes in monetary policy can be more easily corrected than mistakes in fiscal policy. Once a new government program is created, it is often hard to unwind the program, since programs create constituencies that benefit from them. This is why “temporary” stimulus has a funny way of becoming permanent.
That said, monetary policy also has fiscal-like elements. When the Federal Reserve purchases mortgage-backed securities or corporate debt securities, it is in essence engaging in fiscal policy by influencing not just how much spending there is, but also what type of spending there is. So the line between fiscal and monetary policy is never completely clear cut. This is an argument (along with reasons like time inconsistency in policy setting) for requiring central banks to adhere to strict rules in the conduct of monetary policy.
Conclusion
My views on fiscal policy can be summed up as follows: Fiscal policy during ordinary times is generally not very effective at influencing aggregate demand, even during recessions. During some unusual times, such as when interest rates are very low, fiscal policy becomes more effective. The last few years are probably examples of such times. But even then, the central bank has to be accommodating of fiscal policy for it to work, and monetary policy still tends to work better. Monetary policy still has its own problems, however, and rules-based regimes can help resolve them, but that’s mostly a topic for another post.
Again, I would welcome feedback or criticisms of these views from anyone who might have them.
[1] One exception would be in the case of small open economies that receive large inflows of investment or transfers from abroad. In such an environment, spending by the fiscal authority can often be stimulative.