Commentary | Budget Taxes and Public Investment

The Great Mistake: How Academic Economists and Policymakers Wrongly Abandoned Fiscal Policy

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This commentary originally appeared in Restoring Shared Prosperity: A Policy Agenda from Leading Keynesian Economists, edited by Thomas I. Palley and Gustav A. Horn.

Introduction: an unacceptably slow recovery

As of the middle of 2013, the US economy remained far from fully recovered from the effects of the Great Recession. The “output gap” between actual GDP and potential GDP – how much could have been produced had unemployment and capacity utilization not been depressed due to insufficient aggregate demand – stood at 5.8 percent of potential GDP, or roughly $900 billion. This is by far the largest output gap measured in terms of time from either the previous business cycle peak or the trough of the recession. Furthermore, the cumulative lost output since the beginning of the Great Recession is nearly double the amount lost during any other recession since the Great Depression (and will in coming years surely rise to more than double any other previous losses). Perhaps worst of all, this gap had barely changed in the previous two years – shrinking by only 0.5 percent of GDP since the beginning of 2011.

The stubbornly slow progress of recovery has consistently surprised policymakers. This is captured in Figure A which shows the projected course of recovery as forecast by successive iterations of the Congressional Budget Office’s (CBO) Budget and Economic Outlooks.

Macroeconomic roots and context of the Great Recession call for fiscal response

However, the roots of this slow recovery are far from mysterious: the very large negative shock to aggregate demand provided by the bursting housing bubble (starting in 2007) has never been fully neutralized by policy measures to boost demand. Moreover, because the housing bubble burst in a macroeconomic environment characterized by already low interest rates and inflation, monetary policymakers quickly found themselves hard up against the zero lower bound on the nominal “policy” interest rates controlled by the Federal Reserve. This made conventional counter-cyclical monetary policy ineffective, a state of play that is often referred to as a “liquidity trap”.

Liquidity trap conditions argue strongly that expansionary fiscal policy should be the primary tool used to spur recovery. However, fiscal policy as a macroeconomic stabilization tool had fallen deeply out of favor among many academic macroeconomists in recent decades – and had reached the depths of disfavor immediately preceding the Great Recession. This degree of disfavor is tellingly captured by the fact that the most rousing defense offered by an influential academic in the 2000s was not titled “The Case For Discretionary Fiscal Policy”, but rather “The Case Against the Case Against Discretionary Fiscal Policy”.

Normal arguments against fiscal stabilization invalid during Great Recession

The “case against discretionary fiscal policy” rests on two arguments: first, the possibility of interest rate “crowding-out” that keeps fiscal multipliers close to zero, and second the possibility that expenditure timing lags would cause any discretionary fiscal impulse to come too late and actually make policy pro-cyclical.

The “crowding out” argument simply states that by increasing its borrowing, the federal government is competing with private sector borrowers for loanable funds. This increased competition may well raise overall interest rates, and some private sector borrowers may decide at these higher rates to not engage in the investment or consumption project they would have engaged in at lower rates. Hence, the extra activity spurred by fiscal policy “crowds out” some degree of private-sector activity by pushing up interest rates. In the extreme, this crowding-out can be complete, leading to no increase at all in economic activity stemming from large increases in fiscal support.1 A second cause of crowding out can result from the central bank’s “reaction function” which may respond to increased fiscal support by making monetary policy less expansionary.

The mistiming case against discretionary fiscal policy stabilizations holds that fiscal policy support is often associated with lags both in deliberation (the inside lag) as well as implementation (the outside lag). These lags imply that that fiscal policy support may be injected into the economy after an economic recovery has already (spontaneously) begun. Because monetary policy tends to operate with a much-shorter inside lag, recent decades had seen a growing (but not universal) agreement among policymakers and macroeconomists that most recession-fighting responsibilities should be borne by the Federal Reserve, and not by Congress and the President.2

Neither of these two arguments against discretionary fiscal policy applied to the Great Recession. Worries that budget deficits would sharply boost interest rates, choking off spending and neutralizing any fiscal impulse, were particularly misplaced. The demand shock spurred by the housing bubble’s burst was so large that national savings far exceeded desired investment at positive interest rates, meaning that there was ferocious downward pressure on interest rates. And the Federal Reserve also made clear that it would not try to neutralize expansionary fiscal policy measures by raising its short-term policy interest rate. In fact, it even promised to support expansionary fiscal policy by undertaking unconventional measures to lower longer-term interest rates through large-scale asset purchases.

Ironically, as regards timing, the case against discretionary fiscal stabilizations seems to have won greatest agreement among policymakers and economists just as the argument was losing much of its force. Between 1947 and 1990, recessions were indeed quite short and recoveries tended to follow rapidly after business cycle troughs. However, beginning in 1981, it has taken progressively longer for recoveries to generate anything close to full resource utilization. Thus, the last three recessions – even those with a relatively mild depth (like in 2001) – only saw full recovery of employment years after the official recession ended.

The “Keynesian Moment” of 2008/9 proves too short

During the downturn phase of the Great Recession, as job-losses reached a staggering 750,000 per month, this bias against discretionary fiscal stabilization was relaxed. This created a temporary “Keynesian Moment” in policymaking, which it reached its apogee with the passage of the American Recovery and Reinvestment Act (ARRA) in early 2009. This moment is clearly captured in Figure B which shows growth in real federal government expenditures across post-war recessions. The important feature is the jump in growth of spending five quarters after the beginning of the 2007 recession.

This burst of fiscal activism halted the economy’s free-fall by mid-2009, and even created demand growth sufficient to push down measured unemployment by late 2010. However, the Keynesian moment was clearly too short.

The ARRA provided a fiscal boost that was both temporary and left the economy well short of full-employment. Recognizing this, the Obama administration also made efforts to keep fiscal policy from whipsawing sharply negative in 2011 and 2012, even to the extent of delaying long-standing priorities like rolling back the Bush-era tax cuts for high-income in exchange for some measures of fiscal support (notably, the 2 percent temporary payroll tax cut in 2011 and 2012).

But even with these efforts, fiscal policy since the official end of the Great Recession (in June 2009) has been sharply contractionary when compared with historical averages, particularly once one factors in state and local expenditures. Figure C below extends the measures of real government (federal and state/local this time) spending past the official end of recessions and into the subsequent recovery periods. It shows that fiscal policy has been much weaker in the 2007 recession than in prior recessions.

The most striking comparison is with the recovery following the steep recession of the early 1980s. The output gap at the trough of the early 1980s recession was actually larger than that at the trough of the Great Recession, yet two years following that trough 80 percent of the output gap had been erased. In contrast, four years after the trough of the Great Recession less than 20 percent of the output gap has been erased.

Furthermore, the scope for monetary policy to boost recovery was far larger in the early 1980s recession as the Federal Reserve was able to lower the federal funds rate by almost 10 percentage points. This was not possible in the Great Recession, and it means there should have been even larger compensating fiscal stimulus.

Given the similar size of output gaps at the trough of these two recessions and given that the Federal Reserve was able to do more to counter the 1980 recession, it is axiomatic that a larger fiscal expansion was needed after the end of the Great Recession to sustain recovery. Instead, real government spending four years into recovery is approximately 15 percent below what it would be had it just it matched average government spending patterns in prior recoveries. The result has been tragic. Had these average patterns been replicated in the current recovery, roughly 90 percent of today’s output gap would have been closed.

There is an important lesson here. Calls to address the jobs-crisis with a fiscal boost commensurate to the scale of the problem are often greeted by implicit claims that this would constitute wild and historically unprecedented degree of public spending. That is not so. The US economy has implemented such fiscal support for prior recoveries, including the recent past. There is nothing either economically or historically “unrealistic” about the calls for such fiscal stimulus now. If enacted, ending austerity and returning to past fiscal stimulus patterns would end the jobs-crisis.

Winning the intellectual debate but losing the policy debate on austerity

Among academic macroeconomists, the debate over the merits of austerity versus stimulus as a precondition to pushing economies back to full-employment was largely over by the end of 2012, with austerity the clear loser.

The most-visible manifestation of austerity’s intellectual defeat is captured in a paper by Herndon, Ash, and Pollin (2013, HAP). Their paper exposed the extreme weakness of the claim put forward by Reinhart and Rogoff (2010, R&R) that economic growth falls off a cliff once public debt to GDP ratios exceed 90 percent. Building on earlier work by Bivens and Irons (2010), HAP showed that the R&R result was wholly driven by a combination of inappropriate (and oddly idiosyncratic) methods for weighting country/year episodes of high debt plus a sample selection that simply omitted country/debt episodes that weakened their results. The tragedy is that the R&R paper was initially extremely influential in the stimulus policy debate, providing a result that fed the intellectual bias against fiscal policy that had developed over the past thirty years.

Further evidence on the damage wrought by austerity has been provided in a working paper, co-authored by the chief economist of the International Monetary Fund (IMF), and released in late 2012. That paper showed growth forecast errors were consistently related to the degree of fiscal consolidation undertaken by countries in recent years (with greater consolidation correlating with larger negative growth forecast errors).3 Since the IMF was already assuming moderate damage to growth from fiscal consolidation (information embedded in growth forecasts), this finding was interpreted as strong evidence that fiscal multipliers were consistently larger than had previously been estimated.

US not the E.U., yet

The most compelling evidence regarding the toll of austerity in recent years comes from the experience of the Eurozone countries – particularly the periphery countries of Spain, Greece, and Portugal. Eurozone unemployment has remained over 12 percent in the second half of 2013, up from the 7.5 overall percent rate that prevailed before the start of the Great Recession. This is despite the fact that Germany, which is Europe’s largest economy and accounts for more than a quarter of total Eurozone output, has had a strong employment recovery. Moreover, Eurozone unemployment has worsened markedly since the beginning of 2010, whereas the US has seen some improvement.

The source of this difference in US – Eurozone performance is not mysterious. Though government spending slowed in the United States, there was no turn to outright austerity such as occurred in the Eurozone and the United Kingdom. Consequently, US growth and employment has far outpaced growth in Europe. Of course, it could have been even better had the US embraced greater fiscal stimulus.

Conclusion

The bitter irony is that even as the intellectual case for austerity has crumbled, the politics of austerity have prevailed so that policy has begun ratchet up austerity in 2013. Unless there is a rapid change, US policy is now on a trajectory that will see US fiscal policy increasingly resemble the UK and Eurozone in coming years. The Obama administration was able to avoid the turn to outright austerity for a couple of years after the ARRA’s spending petered out. However, the very large budget cuts demanded by House Republicans in exchange for raising the legislative debt ceiling in August 2011 took effect at the beginning of 2013 (epitomized by the now-infamous “sequester” cuts) and will persist in coming years.

The failure to allow fiscal support to match that provided during past economic recoveries was a serious error on the part of macroeconomic policymakers. That error is now being compounded.

As for professional macroeconomists, their widespread agreement prior to the crisis on the irrelevance of fiscal policy for macroeconomic stabilization looks in hindsight to be a major intellectual blunder. Unfortunately, because ideas change slowly it continues to have massive damaging consequences. In light of the crisis, this view of fiscal policy irrelevance should be high on the list of economic dogmas to be discarded.

References

Blanchard, Olivier and Daniel Leigh (2013), “Growth forecast errors and fiscal multipliers”, IMF Working Paper. International Monetary Fund.

Bivens, Josh and John Irons (2010), “Government debt and economic growth”. Briefing Paper #271. Economic Policy Institute. Washington, DC.

Blinder, Alan (2004), “The case against the case against discretionary fiscal policy”. Center for Economic Policy Studies Working Paper 100, Princeton University.

Friedman, Milton (1953), “The effects of a full-employment policy on economic stability: A formal analysis”, in M. Friedman, Essays in Positive Economics. Chicago: University of Chicago Press.

Herndon, Thomas, Michael Ash and Robert Pollin (2013), “Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff.” Working Paper. Political Economy Research Institute. University of Massachusetts-Amherst.

Endnotes

1. This presentation is the closed-economy version of crowding out. It should also be noted that in models with a fixed global interest rate, fiscal support can be crowded-out by a one-for-one decrease in net exports stemming from a strengthening of the national currency’s value that follows the increased fiscal support.

2. Blinder (2004) outlines the timing arguments in some detail. Probably the most famous statement of how countercyclical interventions have the potential to increase economic instability comes from Friedman (1953).

3. Blanchard, Olivier and Daniel Leigh (2013), “Growth forecast errors and fiscal multipliers”, IMF Working Paper. The key finding of this paper was previewed, however, in the September 2012 World Economic Outlook.