Why I'm a contrarian on fiscal policy
Over the last decade, it has become obvious that the decline in real interest rates forced us to revisit the scope and the role of fiscal policy. This is what I have tried to do in a book that I just finished. The book, Fiscal Policy Under Low Interest Rates, is now available on an MIT Press open source site, where I encourage you to leave comments and suggestions. I shall revise the book in light of those comments early next year, and the book will come out in hard copy at the end of 2022.
Then Blanchard carefully explains why he believes that low interest rates are likely to be around for a long time, and why this makes fiscal policy a more attractive option. Blanchard’s analysis of the causes of low rates is excellent, but I don’t find his policy views to be persuasive. Here’s how I’d rate the options for responding to low equilibrium interest rates, in order of desirability:
1. NGDP level targeting at 4%/year combined with a “whatever it takes” approach to asset purchases, in order to keep NGDP expectations on target.
2. Raising the inflation target high enough to avoid the zero bound issue—probably around 4% inflation.
3. Aggressive use of fiscal stimulus during recessions.
4. Ban or severely restrict the use of currency.
5. Do nothing—allow deep recessions when money demand exceeds money supply.
In my view, Keynesians overestimate the costs of the first two options, and thus move too quickly to the third option.
Because many developed countries have used aggressive QE and still fallen short of their targets for inflation, it is often assumed that hitting those targets would require even larger levels of QE. In my view, the opposite is true. If the Japanese had maintained an average inflation rate of 2%, instead of near zero inflation, the demand for base money in Japan would be lower than it is today and the Bank of Japan would have engaged in less QE than they have actually done thus far.
What evidence do I have that Keynesians are misinterpreting Japan? Consider the following from Blanchard, from a concluding discussion of where fiscal policy has worked, and where it has failed:
A case of just right? Faced with a strong case of secular stagnation, Japan has run large deficits for three decades and debt ratios have increased to very high levels, while the Bank of Japan remained at the effective lower bound. Was it the right strategy (if indeed it was a strategy)? The answer is a qualified yes, but, looking forward, the high debt ratios raise issues of debt sustainability. Alternative ways of boosting demand should be a high priority.
The case he cites as “just right” is actually perhaps the greatest failure of demand stimulus in all of world history. Because the Bank of Japan has had a low inflation monetary policy since the mid-1990s, even massive fiscal stimulus has failed to boost aggregate demand in Japan. Indeed Japanese NGDP has barely increased at all over the past 25 years. I know of no other country with such a dismal record of stimulating spending.
To be sure, the Japanese economy has not done all that poorly over the past 25 years, but to the extent it has done OK (not great) in real terms it is 100% due to supply-side factors. But Blanchard is focusing his analysis on the problem of maintaining adequate aggregate demand, and so Japan is absolutely the last country you’d want to cite as even a qualified success story.
Even worse, the only brief period of strong growth in Japanese NGDP occurred during the first few years of the Abe government, when Japan did exactly the opposite of what Keynesians (and MMTers) recommend. They relied on monetary stimulus and actually tightened fiscal policy, as Paul Krugman pointed out back in 2018. Check out what happened to Japanese aggregate demand (i.e. NGDP) in the 5 years after Abe took office:
To summarize, not only is Japan not a good argument for fiscal stimulus, it’s the most powerful argument against fiscal stimulus that I know of.
Nonetheless, my first option does have one potential downside. It is possible that in order to achieve a 4% NGDP level target the central bank would have to buy more than just government securities. They might also have to purchase lots of risky assets. In that case, the second option might be best—raise the inflation (or NGDP growth) target. Why is that option still better than fiscal policy?
The major downside of raising the inflation target is that it results in higher nominal returns on capital, which increases the effective tax rate on capital income. But if this target were raised because the equilibrium interest rate had fallen sharply, then this downside to a higher inflation target would hardly matter. Real tax rates on capital income would not be significantly affected.
Another cost of inflation in the textbooks is called the “shoe leather cost”, the cost of having to walk to ATMs more frequently because you don’t want to hold a lot of cash when other assets offer higher nominal rates of return. But again, this cost is trivial in a world where nominal interest rates are low, and in any case most Americans don’t even carry very much cash these days. Most people holding huge stores of $100 bills are either foreigners or Americans avoiding taxes, making a little bit more inflation a minor problem for law-abiding Americans.
The cost of adjusting prices due to higher inflation is also trivial. Most prices that are adjusted frequently reflect changes in relative prices, not inflation. Gas stations and groceries are going to adjust gasoline and produce prices almost as frequently with 4% inflation as with 2% inflation.
So while raising the inflation rate to 4% is not my first choice, it’s a far less bad option than massive and wasteful fiscal stimulus.
If I’m right, then what exactly is the case for fiscal policy? I still don’t get it.