Monetary offset is more mainstream than you think
By Scott Sumner
I frequently argue that the fiscal multiplier is roughly zero in an economy where the central bank targets some variable linked to aggregate demand, such as inflation or NGDP. I don’t claim it is precisely zero, just that zero is a good baseline assumption to start the analysis.
This claim is often viewed as being quite heterodox. In fact, at the upper levels of economics it is a quite mainstream view of how things work when the economy is not at the zero bound (like right now.)
Here are DeLong and Summers (2012):
From the time of Keynes’ General Theory to the 1960s, the default assumption was that interest rates would remain constant as fiscal policy changed, because the central bank and the fiscal authority would cooperate to support aggregate demand: fiscal expansion would be accompanied by monetary policy accommodation that produced not crowding out but crowding in. With the changes in macroeconomic thinking and the inflationary experience of the 1970s, the natural assumption in the United States came to be that the Federal Reserve was managing aggregate demand. Thus, changes in fiscal policy, just like changes in private investment demand, would be offset as the Federal Reserve pursued the appropriate balance between inflation and investment. Today, however, at least until the economy exits from the zero lower bound or cyclical unemployment drops substantially, the economy is once again in a regime in which real interest rate movements amplify rather than offset the effects of fiscal stimulus.
Their paper has a nice graph that illustrates the case when interest rates are positive:
In 1997, Paul Krugman wrote an article criticizing “vulgar Keynesianism”, which is the version of Keynesianism that tries to apply ideas such as the “paradox of thrift” to modern economies with positive interest rates and inflation targeting central banks:
Consider, for example, the “paradox of thrift.” Suppose that for some reason the savings rate–the fraction of income not spent–goes up. According to the early Keynesian models, this will actually lead to a decline in total savings and investment. . . .
Or consider the “widow’s cruse” theory of wages and employment (named after an old folk tale). You might think that raising wages would reduce the demand for labor; but some early Keynesians argued that redistributing income from profits to wages would raise consumption demand, because workers save less than capitalists (actually they don’t, but that’s another story), and therefore increase output and employment.
Such paradoxes are still fun to contemplate; they still appear in some freshman textbooks. Nonetheless, few economists take them seriously these days. There are a number of reasons, but the most important can be stated in two words: Alan Greenspan.
But putting Greenspan (or his successor) into the picture restores much of the classical vision of the macroeconomy. Instead of an invisible hand pushing the economy toward full employment in some unspecified long run, we have the visible hand of the Fed pushing us toward its estimate of the noninflationary unemployment rate over the course of two or three years. To accomplish this, the board must raise or lower interest rates to bring savings and investment at that target unemployment rate in line with each other. And so all the paradoxes of thrift, widow’s cruses, and so on become irrelevant. In particular, an increase in the savings rate will translate into higher investment after all, because the Fed will make sure that it does.
To me, at least, the idea that changes in demand will normally be offset by Fed policy–so that they will, on average, have no effect on employment–seems both simple and entirely reasonable. Yet it is clear that very few people outside the world of academic economics think about things that way.
The one area I disagree with modern Keynesians is the effect of fiscal policy at zero interest rates. They argue that the fiscal multiplier becomes strongly positive, whereas I am skeptical—due to examples such as the fiscal austerity of 2013, which was successfully offset by the Fed.
But even there the differences are more a question of nuance. I concede that monetary offset does not always occur. Under the gold standard, central banks may have difficulty in offsetting fiscal shocks. (On the other hand, even Keynes acknowledged that the gold standard also makes fiscal stimulus much harder to do, due to the risk of a loss of confidence.) And there may be dysfunctional fiat money central banks (the BOJ or the ECB?) that do not fully offset fiscal shocks due to incompetence. Still a fiscal multiplier of roughly zero is the baseline assumption I use when considering shocks such as the recent Japanese tax increase. I doubt it will significantly impact employment, although it might briefly impact GDP.
So why do so many people believe in the fiscal multiplier, even when rates are positive? Perhaps it reflects memories of EC101 classes, where professors cover the fiscal multiplier but rarely get to the subject of monetary offset. Paul Krugman is clearly frustrated that so many people believe in the vulgar Keynesian model:
What has made it into the public consciousness–including, alas, that of many policy intellectuals who imagine themselves well informed–is a sort of caricature Keynesianism, the hallmark of which is an uncritical acceptance of the idea that reduced consumer spending is always a bad thing.