September 16, 2011
The Fall 2011 World Economic Outlook
The analytic chapters were released yesterday.
- Chapter 3: Target What You Can Hit: Commodity Price Swings and Monetary Policy
- Chapter 4: Separated at Birth? The Twin Budget and Trade Balances
From Chapter 4:
How do changes in taxes and government spending affect an economy’s external balance? Based on a historical analysis of documented fiscal policy changes and on model simulations, this chapter finds that the current account responds substantially to fiscal policy—a fiscal consolidation of 1 percent of GDP typically improves an economy’s current account balance by over a half percent of GDP. This comes about not only through lower imports due to a decline in domestic demand but also from a rise in exports due to a weakening currency. When the nominal exchange rate is fixed or the scope for monetary stimulus is limited, the current account adjusts by as much, but the adjustment is more painful: economic activity contracts more and the real exchange rate depreciates through domestic wage and price compression. When economies tighten fiscal policies simultaneously, what matters for the current account is how much an economy consolidates relative to others. Looking ahead, the differing magnitudes of fiscal adjustment plans across the world will help lower imbalances within the euro area and reduce emerging Asia’s external surpluses. The relative lack of permanent consolidation measures in the United States suggests that fiscal policy will contribute little to lessening the U.S. external deficit.
The analysis relies upon an empirical model that uses action based indicators of fiscal policy (see this post on how using such measures results in findings on expansionary contractions different from the Alesina-Ardagna (2010) results so beloved by some), as well as results from the IMF's GIMF model. From the first approach, they obtain results that are not empirically dissimilar to the Chinn-Prasad [pdf] and Chinn-Ito [pdf] [pdf] studies.
From the conclusion of the chapter, some words that are relevant to the adherents to the expansionary fiscal contraction thesis, as applied to the United States:
...The contractionary effect of fiscal consolidation is now well established, with consequent effects on import demand, and this is something policymakers cannot ignore—fiscal consolidation hurts. ...
This doesn't necessarily mean that one shouldn't pursue fiscal consolidation; merely it reiterates that one has to be careful about how -- and when -- to implement the consolidation.
Posted by Menzie Chinn at September 16, 2011 07:19 AMdigg this | reddit
No doubt austerity will slow down the nation's economy. Is slowing down consumption, as painful as it is, necessarily a bad thing if the result is balance sheet repair? Fed statistics consistently show that household debt is going down and that this is a drag on consumption. The reduction in indebtedness could be considered a good thing, even if it means a reduction in GDP. Trying to make up for that by taxing our children and grandchildren could be seen as a bad thing.
I realize that extreme austerity of the kind that the EU is imposing on Greece is stupid, since all it does is create deflation and make it impossible for Greece to pay its bills. But we are in far better shape here although not in great shape.
Conservatives and liberals both seem to belong to the Cult of GDP. This is particularly amusing when for so long liberals kept talking about the need to rwin in the developed countries' overconsumption to save Mother Earth. I guess election politics trumps ideology.
Posted by: colonelmoore at September 16, 2011 09:40 AM
I think the $4 trn deficit spending of the last few years is viewed as a failure broadly by the public. Spending has not turned around the economy. Not here (and not with Greek bailouts, either).
As you know, I've called for a recession by the end of summer (now), and it feels like a recession to me, but the numbers are backing Jim's slowdown, not recession, thesis (albeit init jobless claims look ominous to me). If there is a recession or continued slowdown,the Kenysian approach will be ever more discredited, because earlier promised upturns were not delivered. The average person simply does not believe at this point that we can spend our way to prosperity.
I think more likely that we will see material spending reductions and increased taxes in the next cycle (first half of next year?). Thus, Mayor Bloomberg's warnings of riots will likely prove on the mark as the weather turns warmer next spring. I think that's the reality we face: we are likely beyond the 'careful' version of fiscal consolidation.
Posted by: Steven Kopits at September 16, 2011 11:08 AM
"this chapter finds that the current account responds substantially to fiscal policy—a fiscal consolidation of 1 percent of GDP typically improves an economy’s current account balance by over a half percent of GDP."
Does this mean that we can expect half of the AD created by expansionary fiscal policy to be bled off by increased current account deficit? That seems on the low side to me, but it is still significant.
Posted by: don at September 16, 2011 12:27 PM
colonelmoore The reduction in indebtedness could be considered a good thing, even if it means a reduction in GDP. Trying to make up for that by taxing our children and grandchildren could be seen as a bad thing.
You're confusing private debt and public debt. As you say, households are trying to repair balance sheets, so they consume less and try to save more. But in the aggregate the economy cannot save more than an amount that someone else is willing to borrow. You can physically put money in the bank and it might appear that you have saved as an individual, but in the aggregate what happens is that income shrinks all around. If you want to help consumers repair balance sheets in the face of ZIRP and a negative Wicksellian interest rate, then we need deficit spending by the government.
As to passing along debt to our children, the only economic burden we pass along to them is the interest cost, and at 2 percent they would be far better off if we repaired physical infrastructure through deficit financing.
Conservatives and liberals both seem to belong to the Cult of GDP. This is particularly amusing when for so long liberals kept talking about the need to rwin in the developed countries' overconsumption to save Mother Earth.
Actually, most of the consumption talk is coming from conservatives. Income tax cuts increase GDP almost exclusively through increased consumption. Infrastructure spending of the kind favored by liberals has a first order effect on improving the country's physical capital stock (e.g., bridges, roads, water & sewer, etc.) as well as human capital stock (e.g., education, training, payroll holidays, healthcare subsidies, etc.). Increased consumption from government spending is only a second order effect in the multiplier.
Posted by: 2slugbaits at September 16, 2011 02:10 PM
Interesting to read above studies in conjunction with Monetary Science, Fiscal Alchemy Eric M. Leeper.
Revolving around modesty when dealing with fiscal multipliers and monetaries policies buying a lease of time.The author is prompt to quote Faust (not the "Uhr Faust")
"Faust (2005) observes that applied monetary policy analysis is “hard” in the sense that even the best dynamic models are “grossly deficient”and this condition is not likely to improve dramatically in the near term"
The couple monetary policy,fiscal policy can be viable only if and when the monetary policy,fiscal policy are interchangable instruments aiming at maintening the value of the debt and stabilize inflation.
Monetary policies have been proved to politically less sensitive than fiscal policies untill rude awakening.
Empirical evidences are explicit
"Fiscal dynamics can take decades to play out. With an estimated dynamic model of
fiscal policy in hand, one can ask, “How long does it take for long-run fiscal balance to be
restored after various fiscal actions?” Leeper et al. (2010) estimate that fiscal adjustments
in the United States have been extremely gradual, taking three or more decades. This is
roughly consistent with the U.S. experience after World War II: debt fell from a peak of 113
percent in 1945 to about 33 percent in the mid-1960s. Adjustments have been most gradual
for government spending and labor tax shocks."
Posted by: ppcm at September 17, 2011 03:04 AM
But in the aggregate the economy cannot save more than an amount that someone else is willing to borrow. You can physically put money in the bank and it might appear that you have saved as an individual, but in the aggregate what happens is that income shrinks all around. If you want to help consumers repair balance sheets in the face of ZIRP and a negative Wicksellian interest rate, then we need deficit spending by the government.
I think you are referring to the paradox of thrift. So what I understand you saying is that there is only one time for the populace as a whole to pay down debt, which is when the economy is growing.
I have noticed that economists tend to argue a lot over theories, meaning that blanket statements such as yours may draw some detractors among the credentialed set. I am not part of the credentialed set so I'll just say that I am skeptical that the way the economy responds to a controlled, modest paying down of debt may be different than the textbook answer you gave.
Certainly while the debt is being paid down, everyone is impoverished, but better balance sheets set the stage for future consumption increases, which would have the opposite effect of making everyone richer. Fixation on the short term seems to be what has caused problems.
As for the solution of infrastructure spending, this too is a textbook answer that I am skeptical of. I know people in city government in charge of working up the budgets for projects to spend the ARRA funds. Because of the rush to get shovels in the ground, the projects that were chosen were things that were gathering dust on the shelf, not because they lacked money but because they were not high priority. However they got funded because they could get going quickly. So the payback to society will be low to nonexistent. There are a lot more paved trails out there today thanks to ARRA.
I also know a person in GSA in charge of energy efficiency. Because the funds had to be rushed out to get people working, he was not able to get a proposal approved for the new buildings wired with sensors so that they could gather baseline energy data. These were construction propoaals already in the pipeliine that were rushed through. So the fixation on short term stimulus is having precisely the opposite effect of reducing the long-term benefit.
In chemistry there is the concept of yield. A reaction has a theoretical conversion of reactants to products and then there is what really happens. Real world stimulus projects is very often have a poor yield for reasons similar to what I described. Examples abound of this in ARRA.
Posted by: colonelmoore at September 17, 2011 09:47 AM
colonelmoore So what I understand you saying is that there is only one time for the populace as a whole to pay down debt, which is when the economy is growing.
No. Not even close. Households should be repairing balance sheets now. But the point is that they cannot save unless someone is willing to borrow. If they try, then this is the equivalent of stuffing money into the proverbial mattress. National income falls needlessly. During a liquidity crisis the government should be the borrower of last resort and soak up private saving.
As to rushed shovel ready projects...remember, back in early 2009 it was the GOP that erroneously believed a recovery was right around the corner and stimulus wasn't even needed. They insisted that only short-term projects be included. For example, resident Tea Party apologist and Fox News viewer poster CoRev went ballistic over what he felt was "backloading" of the stimulus in ARRA. As hindsight has plainly shown, his concern about backloading was ridiculous on the face of it. Some economists (e.g., Menzie) were well acquainted with the history of financial recessions and saw little danger of planning for longer term projects. Shovel ready was nice, but not a requirement. This recession is likely to last the better part of the decade, so there's not much risk of having fiscal stimulus kick in at just the wrong time.
BTW, "saving" is a verb and is associated with a flow variable. "Savings" is a noun and associated with a stock variable that can be represented by pieces of paper with pictures of dead Presidents. When economists talk about the paradox of thrift they have in mind the verb form.
Posted by: 2slugbaits at September 17, 2011 06:38 PM
2slugs, isn't a liquidity crisis what we had in 2008? I was not opposed to keeping the spigot turned on then.
Europe is in a liquidity crisis and the Fed appropriately jumped in. If it reaches our shores I expect it to jump in here.
What makes 2011 a liquidity "crisis?" in the USA?
Posted by: colonelmoore at September 17, 2011 09:12 PM
colonelmoore I didn't say there was a liqidity crisis, I said we were in a liquidity trap. Very different animal. A liquidity trap is where bonds and money become virtually perfect substitutes for one another; i.e., the short term interest rate is zero. In terms of the old school Hicks IS-LM model, a liquidity trap is when the LM curve is horizontal and the only way to shift income is through the government taking fiscal actions to shift the IS curve. Back in the day when I took macro courses the professors always told us that this IS-LM stuff about a horizntal LM curve was mostly just some theoretical musings and would never actually happen. Well, it happened.
Posted by: 2slugbaits at September 18, 2011 07:21 AM
What I would like to know is what level of consumption we should expect to be "normal", granting that we've used debt expansion to artificially, unsustainably increase our consumption for some three decades. If we get serious about paying down the debt, we should probably expect many decades of reduced consumption (from the "normal" level). But even just servicing the debt would cut into consumption, would it not? Not so deep, but quite indefinitely.
Posted by: endorendil at September 18, 2011 10:52 PM
2slugs, I grant that you may have meant liquidity trap but you wrote this:
"During a liquidity crisis the government should be the borrower of last resort and soak up private saving."
It is pretty certain that the country will not apply your solution to the problem given the political winds, so then we will have a test case for determininhg whether the liquidity trap exists and whether it is essential to counter it with deficits.
Where we have come to with your latest comment is this:
You agree with me that households paying down their debts can be a good thing when the economy is stagnating. But you believe that they cannot do it without someone else doing the borrowing because you postulate a liquidity trap. This is a concept proposed by some economists. I am not convinced of this. I see the primary appropriate role of the Fed to make sure that, no matter what the economy is doing, there is neither inflation nor deflation. In other words, if people are deciding to pay down debt rather than consume, the money supply should reflect that.
I am more than willing to discover to my disappointment that I was wrong by waiting to see whether we actually fall into this liquidity trap without government doing what you propose.
So as to whether we are in a liquidity trap, let us agree to disagree both on the diagnosis and the cure. And let us also agree not to call names at each other for disagreeing.
Posted by: colonelmoore at September 19, 2011 07:27 AM
colonelmoore Good catch. I intended to say "liquidity trap."
The standard definition of a liquidity trap is when the short term interest rate is zero, so we are in a liquidity trap.
Households don't have much choice other than to pay down debt and repair balance sheets during a deep recession. It's just a fact of life. But if they save, and if demand for private investment doesn't close the gap, and if net exports don't close the gap then we have to look to some other sector to soak up that extra saving. We're not likely to get enough demand from net exports and the Fed doesn't have any significant room to stimulate investment demand with lower interest rates, that only leaves the government as the borrower of last resort. The government must soak up the extra saving generated by households.
You're probably right that the political winds don't look promising for fiscal expansion. So what's likely to happen. Well, we have the 1937 experience. We have the ongoing experience in Britain. We have the Japan experience. We have our own experiences with financial bubble recessions in 1837 and again in 1873. And we have theory. All of which tell us to expect a lost generation of workers that will never recover. They picked a bad time to be born.
On the lighter side, it turns out that there is one booming industry in Japan: crematorium services for an aging population. There's such a huge backlog right now that's created demand for "hotel" services that provide refrigerated rooms where friends and relatives can visit the dearly departed until there's a cremation opening. And the bodies keep piling up. By the end of the next decade there will be 20 million fewer people in Japan than today. Not exactly a receipe for a growing economy for the living.
Posted by: 2slugbaits at September 19, 2011 11:18 AM
I was not thinking of folks saving. I was thinking of people paying down debt. According to the Fed the average household debt service peaked at 17.55% of disposable income in the 3rd quarter of 2007. 1st quarter 2011 it was whittled down to 14.84%, which is the exact level it was in Q2 of 1996. This is around the average for the last few decades.
If people are reducing current expenditures to pay down debt they are increasing cash flow, not necessarily saving. They could still be living hand to mouth.
At this point our dividing lines are pretty clear. I will leave off with the following quote from The New Palgrave Dictionary of Economics:
The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective. The modern literature, in contrast, emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future money supply in states of the world in which interest rates are positive.
My notion is that the Fed's main task is to prevent a deflationary spiral. So far so good.
Posted by: colonelmoore at September 19, 2011 06:32 PM
Steven K has done a great job of offering up the standard GOP talking points on fiscal stimulus. By careful selection of language, he has managed only to refer to perception, while avoiding reality, which gives him a bit more wiggle room than most purveyors of GOP spin. The timing is also interesting, in that "the last few years" of deficits are singled out as bad, when the stage was set over 8 years of the Bush administration, when a structural deficit was creasted.
If the public views the deficit spending "of the last few years" as a failure, that is partly because of a massive propaganda effort to claim it was a failure. In fact, a look at the overall fiscal stance of government at all levels shows that in the face of the biggest economic contraction in 7 decades, fiscal policy was not all that expansionary. It was, in fact, roughly neutral. Anyone with any understanding of how fiscal policy works can confirm this for themselves just by looking at the data. Those who pretend otherwise either don't know enough to use the data or are simply not telling the truth.
Stack federal fiscal policy up against real GDP and you'll see that the rapid upswing in ARRA spending arrives in the same quarter as renewed GDP growth, and that the subsequent slowdown in ARRA spending is coincident with a slowdown in GDP growth. That is what many in the GOP describe as "failure" and what Steven says is "viewed as a failure". This claim that fiscal policy has failed is used to justify contractionary fiscal policy, which will then lead to an "ever more discredited" view of Keynesian policy, even though the fact of contractionary fiscal policy leading to contraction is objectively a confirmation of Keynesian policy.
Finally, as a matter of social policy, if fiscal contraction will lead to disorder, then the obvious conclusion is to employ fiscal expansion. Fiscal expansion works as economic policy, and it works as social policy.
Posted by: kharris at September 20, 2011 06:42 AM