VoxEU Column Macroeconomic policy

Why we need not fear that a bigger stimulus will be counterproductive

There are legitimate reasons to fear that deficit-spending fiscal boost programs will not work well enough and have high enough longer-term costs to be not worth doing. This column says we do not need to fear bottleneck-driven inflation, capital flight-driven inflation, crowding-out of investment spending, nor reaching the limits of debt capacity because we will see them coming in time.

My favourite line from Jaws is uttered police chief Martin Brody (Roy Scheider) when he finally sees the shark: “You are going to need a bigger boat.”

We are at last seeing the shape of this downturn – and we are going to need a bigger fiscal stimulus than the deficit-spending package President Barack Obama pushed through the US Congress in February. We might get lucky; maybe the next four months will be months of unreserved good luck; maybe four months from now we will think that what we have collectively done to stabilise the North American and world economies is appropriate. That is not very likely; mixed news would mean that four months from now we are going to want to do another round of government spending boosts and tax cuts to try to keep the unemployment rate from rising too much higher and capacity utilisation from falling too much lower. (And the legislative calendar means that we should start thinking about laying the groundwork for such a second round of stimulus right now; in order to be in the budget reconciliation bill that will pass the congress in August, provision for fiscal stimulus must be in the budget resolution that will pass the congress in April.) Moreover, if the next four months are months of worse-than-expected bad news – well, let’s not go there right now.

Getting another round of spending boosts and tax cuts will, however, be problematic. Partisan opposition is mounting. That there is partisan opposition is very strange. We know John McCain’s chief economic advisers – people like Douglas Holtz-Eakin, who made an excellent reputation for himself as head of the Congressional Budget Office, like well-respected forecaster Mark Zandi, like AEI’s Kevin “Dow 36000” Hassett. We know how they think. We know that had John McCain won last November’s presidential election a very similar stimulus plan (but with fewer spending increases and more tax cuts) would just have moved through congress with solid Republican support. So the current 98% Republican opposition (except by governors who have to, you know, govern) leaves us scratching our heads.

So as we get ready to try to go and buy a bigger fiscal stimulus boat to deal with this Jaws recession, whose bite pushed the unemployment rate up to 8.1% in February, it is important to be clear why we ought to be doing this. And the first point that needs to be made is that the strange right-wing talking point that a government fiscal boost would not spur the economy because... because... well, it's not sure why... is badly mistaken at best and disingenuous at worst.

Four legitimate fears

But there are legitimate reasons to fear that deficit-spending fiscal boost programs would not work well enough and would have high enough longer-term costs to be not worth doing. I classify these legitimate fears into four groups.

  • Bottleneck-driven inflation. The fear is that although more deficit spending will increase total spending, and although businesses seeing increased demand for their products will indeed try to hire more workers to boost production, they will succeed only by offering their new workers higher wages – wages higher enough that they then have to boost their prices – and by snatching scarce commodities out of the supply chain by paying more and then having to boost their prices more as well. Thus rising inflation will make the increase in real demand an order of magnitude less than the increase in nominal demand. And if the inflation produces general expectations that prices will continue to rise – well, then we are back where we were in the 1970s, with everybody focusing on changes in the overall price level rather than whether their business plan made sense given individual goods and services prices. An inflationary economy is one in which the price system does not do a very good job of telling people and businesses where to focus their energy. It is likely, over the decades, to be a slow-growth economy. Breaking an inflationary spiral would require another recession on the order of 1979-1982. It is better not to go there, and a fiscal stimulus plan that takes us there is not worth doing.
  • Capital flight-driven inflation. The fear is that the stimulus package will cause foreign holders of domestic bonds to believe that inflation is on the way and trigger a mass sell-off of US Treasuries and other dollar-denominated assets that will push the value of the dollar down. And as the value of the dollar falls, the dollar prices of imported goods and services rise – and we are off to the inflation races once again.
  • Crowding-out of investment spending. The fear is that additional government borrowing may – not will, not must, but may, for this is a fear not a certainty – push up interest rates, make financing expansion even more expensive for businesses, and so discourage private investment. The boost to spending would thus come at a high cost-benefit ratio as much additional borrowing leaves us with only a little additional demand. Moreover, it would leave us with a low productivity-growth recovery that has too little productivity-boosting private investment and too much government spending in the mix.
  • Reaching the limits of debt capacity. The fear is that the long-term costs of additional fiscal boosts via deficit spending will be very large because those from whom the US government will have to borrow the money to finance spending will only loan it on lousy terms – high and unfavourable real interest rates that impose substantial amortisation burdens and associated deadweight losses from taxation on America’s taxpayers.

All of these are legitimate fears when a government undertakes a deficit-spending plan. We can all recall historical episodes when they turned out to be not just fears but realities. We remember bottleneck-driven and wage-push inflation from the late 1960s and from the oil shock-ridden 1970s – those episodes were the first fear coming home to roost. Nobody today is happy with American fiscal policy in the late 1960s or American demand management policy in the 1970s.

The second fear became a reality in France in the early 1980s. Capital flight and anticipated-depreciation-driven inflation were the immediate result of Francois Mitterand’s attempt to institute Keynesianism in one country and drive for full employment when he became president of France in 1981.

The third fear was perhaps not a reality but it certainly was greatly feared in the winter of 1992 and 1993, back when I carried spears for Lloyd Bentsen and his subordinates Roger Altman and Lawrence Summers in the Clinton Treasury. They argued that the Clinton-era economy could not afford the crowding-out of private investment that even the steady-course deficits then projected for the mid-1990s were threatening to produce through high and rising interest rates.

And the fourth fear is an even older legitimate fear yet. It goes back to Adam Smith and his Wealth of Nations, which contains pages warning that deficit spending on the imperial adventures of George III and his ministers would produce an unsustainable debt burden that would crack the British economy like an egg – as had been the consequences of debt-financed wars in Holland, France, Spain, and the Italian city-states over the previous three centuries.

Why we need not fear

These four fears are all legitimate fears, but I believe that we, here, now do not need to fear them.

In each of the cases in which these fears are legitimate, we can see in advance that the stimulus program is going wrong. Stimulus packages produce increases in nominal but not real demand when exchange rates fall and prices rise; we can watch the exchange rates fall and the prices rise, and we can watch as financial markets anticipate these events beforehand. Stimulus packages crowd-out private investment when the government’s borrowing causes medium-term interest rates on corporate borrowings to rise. Stimulus packages impose a heavy financing burden on the government when they cause long-term interest rates on government securities to rise.

In all of these cases, that the stimulus is going to go wrong becomes very visible in advance. If the stimulus is going to be ineffective because it generates bottleneck-driven inflation, we can identify that problem as the price or wage of the bottleneck good or service spikes. If the stimulus is going to fail because of capital flight-driven inflation, we will see the value of the dollar collapse as foreign-exchange speculators front-run the capital flight – and then we will see import prices spike and put upward pressure on prices in the rest of the economy. If the stimulus is going to fail by crowding out private investment, we first will see the medium-term corporate interest rates relevant to financing plant expansion spike. And if it is going to impose a crushing debt repayment burden, we will see long-term Treasury bond interest rates spike instead.

Right now, however, we see none of these things. No signs of bottleneck-driven or wage-push inflation gathering force. No signs of approaching rapid dollar depreciation. No signs that the stimulus is pushing up medium-term interest rates on corporate borrowing. No signs that the stimulus is pushing up long-term interest rates on government bonds.

If any of these start to materialise, expect me and a number of other stimulus advocates to start backpedalling rapidly. But so far, so good.

Editors’ note: This was first posted on theweek.com. Reposted here with permission.

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