Thoughts on Stimulus Advocacy

Since ~2008–09, two main stimulus advocacy camps have formed. One emphasizes fiscal stimulus, and the other mostly argues in favor of monetary stimulus. Two represents of these camps are Paul Krugman and Scott Sumner, respectively. Scott Sumner is an incessant advocate of NGDP targeting. He has criticized Krugman for focusing on fiscal stimulus, preferring his own policy, because certain kinds of monetary policy are relatively neutral (with respect to market outcomes). Krugman and Sumner operate from similar-enough frameworks, so they will have overlapping cost–benefit analyses concerning fiscal and monetary policy — if you, the reader, disagree with stimulus of whatever kind, temporarily put that aside and consider my point from their perspective. Sumner is right.

During the 1990s, Krugman was actually very skeptical of fiscal policy. He was a Keynesian, but he developed a unique theory of the liquidity trap, applying it to the Japanese “lost decade,” and proposed a monetary policy that targets inflation expectations. Between 2007–09, he did advocate for this kind of unconventional monetary policy. Concerning fiscal stimulus, Krugman has been consistent in arguing that it’s only justified during a liquidity trap, because at the zero lower bound there’s no crowding out. Forgetting about monetary stimulus momentarily, fiscal policy here is only optimal when we add a constraint, which is a market failure — sans higher public spending, the market fails to allocate a large number of resources. In other words, this constrained outcome is sub-optimal relative to the unconstrained outcome. But, Krugman has an alternative monetary solution, and so, in a constrained world, inflation expectations targeting is superior to fiscal stimulus. I’m fairly certain that Krugman would agree with everything so far.

Why did Krugman stop emphasizing monetary policy then? (Just to be clear, “stop emphasizing” is a bit misleading. He did continue to post and discuss monetary policy, but his main emphasis became fiscal policy.) If I remember correctly, the reasoning for the change of emphasis to fiscal policy was mainly “political.” Krugman felt that it was more worthwhile to draw attention to fiscal stimulus, because inflation hawks were making it difficult for the Federal Reserve to change its position on the two percent inflation target.

But, things have changed between 2011–13. Consider the following,

  1. The Fed moved in a favorable direction by changing monetary policy, including making clear that the two percent target is no longer strictly observed (the height of the inflation rate is determined by the relationship with changes in employment);
  2. On the fiscal front, things seem hopeless, given how combative Republicans are;
  3. The inflation hawks have been proven wrong — inflation is tame and and treasuries are still low;
  4. As made clear by the response to the Reinhart–Rogoff mistake, austerity has been mostly discredited. But, there are still a lot of people who support austerity nonetheless. Monetary policy is a good face saving escape route, where austerity can be “vindicated” if Fed policy can do the job instead.

It seems to me that now is the perfect moment to switch emphasis to monetary policy. There’s already a large chunk of the blogosphere constantly calling for things like NGDP targeting or higher inflation targeting. A trickle of inflation hawks are steadily changing their views. If current fiscal policy advocates — Krugman, DeLong, Thoma, et cetera — started to focus predominately on unconventional monetary policy, the probability of influencing actual Fed decision-making would be greater than the current probability of influencing fiscal policy. I have to agree with Sumner, Krugman is making a mistake.

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Update: Daniel Kuehn comments. I’m actually not trying to show support for NGDP targeting. If I support monetary policy at all it’s because I think there can be money shortages. Also, if, for whatever reason (it’s natural to the market or it’s the outcome of bad policy), prices are sticky and the recovery is moving slower than it could be, the welfare loss from over-expansionary monetary policy may be smaller than the welfare loss of a sub-optimal recovery. Nevertheless, the truth is that I really haven’t made up my mind yet. But, I tried to have readers drop their personal beliefs concerning any of these policies and look at the two options from the point of view of Krugman and Sumner. My argument can be summarized as,

  1. Fiscal policy is only justified at the zero lower bound, but broadly “market allocations” are still superior;
  2. NGDP targeting or expectations targeting are relatively “market neutral” policies that resonate with most people, and they work at the lower zero bound, making fiscal stimulus sub-optimal;
  3. Since conditions have made it more politically feasible to change monetary policy, it makes more sense to emphasize monetary over fiscal stimulus.

Daniel talks about how it doesn’t make sense to draw borders where there aren’t any. But, if consistent fiscal policy advocacy induces others to do this, then this is another good reason to switching to an emphasis on monetary policy. It will make the profession appear less divided. Of course, the blogosphere isn’t “the profession,” but it’s the part of the profession that the public sees the most. This gives bloggers like Krugman and Sumner a lot of influence. Krugman and Sumner arguing for essentially the same thing has a higher probability of making an impact than them two pushing for two completely different policies, debating each other on the side.

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Update 2: Paul Krugman comments on the subject. His last paragraph,

Sorry, guys, but as a practical matter the Fed – while it should be doing more – can’t make up for contractionary fiscal policy in the face of a depressed economy.

This is where I think Krugman is wrong. If fiscal policy is contractionary, my point is all the stronger. As a “practical matter,” Krugman’s austerity advocacy has failed to change policy. Maybe recent events will reduce the resistance, but by how much? Yet, as he points out, we have a Fed interested in testing new strategies. Maybe the outcome so far hasn’t been that great, but we could say the same thing about whatever fiscal stimulus was pushed through Congress directly after the financial crisis. On the “practical” front, monetary trumps fiscal.

  • Roman P.

    I’m personally targeting for a villa somewhere in Majorca, but I guess my expectations channel is a bust since it’s still the same cold wind and rain outside.

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  • John S

    May I ask what might be a dumb question: why can’t the GOP meet the Dems halfway and push for fiscal stimulus in the form of tax cuts for the lower and middle classes? Specifically, a large, progressive, permanent payroll tax cut.

    The Dems can claim increased disposable income for the poor + increased stimulus. The GOP can say that they cut taxes, shrank govt, and helped to improve incentives for hiring (by reducing employer matching funds).

    I can anticipate the opposing arguments from both parties. But at least on paper, isn’t it a reasonable compromise? Plus, shouldn’t libertarians try to seize any opportunity to reduce taxes?

    • JCatalan

      Democrats may be willing to cut taxes on lower income families, while Republicans seem mostly interested in stopping tax hikes on higher income families. There’s some friction there. There’s also the fact that tax increases, for some reason, seem preferable to budget cuts, for both parties. On a more theoretical level, there’s been some doubt on the efficacy of tax cuts during these types of recessions, where Keynesians typically think that there is too little consumption. For example, much of the Spanish stimulus early during the recession was in the form of tax cuts, and it was blamed for using up all of Spain’s “fiscal space” (the budget flexibility to increase expenditure) without much effect on private production. But, I’ve read some advocacy for greater tax benefits for employers. In general, though, I’m not sure if there is the same degree of agreement as there is with monetary policy.

      • John S

        I’ve posted some stats on payroll and income taxes on Henderson’s last blogpost (“Budget cuts”). They’re are the bottom of the comments.

        “There’s also the fact that tax increases, for some reason, seem preferable to budget cuts, for both parties.”

        This is a real puzzle on the GOP side. Really makes them look hypocritical.