Sunday, October 2, 2011

A case for expansionary federal fiscal policy

If you have read most of the posts in SocialMacro leading to this point, you will notice an arc in my narrative.  So far, most of the preceding blog posts have been aimed at building the case for a return to fiscal stimulus.  Hopefully this article will clarify some issues which were intentionally left aside.

The United States' economy is currently depressed well below its trend output and level of employment.  Largely due to the double-whammy of lower real estate asset prices (housing prices) and debt overhang, consumer spending has declined significantly, meaning that until one and/or both of those factors really turn around, a consumer-driven recovery is highly unlikely.  The U.S. economy has continued to grow at roughly the rate before the crisis, but not enough to make up the large decline in 2008-2009.

Unfortunately, traditional monetary policy has little-to-no traction because the monetary policy is constrained by the "zero lower bound", in other words, a liquidity trap.  Add to this the inability and/or unwillingness of states to stimulate their economies, and there's a big problem with an obvious Keynesian solution.

Basically, the federal government should undertake a large stimulus program.  As mentioned in the discussion on state fiscal policy, the government can intentionally run a deficit, which will have a bigger bang for each buck and/or increase taxes and spending, with a somewhat  smaller but still positive balanced budget multiplier.  It might be worth trying a bit of both, to contain the deficit somewhat.

GDP output gap in the U.S. was approximately $3.9 trillion in nominal dollars from April 2010 to April 2011.  Christina Romer estimates that the autonomous spending multiplier is approximately 3 (a 1% of GDP increase in spending will ultimately make GDP 3% higher) and according to the Haavelmo Theorem, the balanced budget multiplier is 1.  Thus, it would take an annual revenue enhancement and spending increase of $3.9 trillion to close the output gap, whereas a purely deficit-financed closing of the output gap would take around $1.3 trillion.  In either scenario, there is no consideration of the effect closing the output gap would have on the existing deficit.

One thing to consider is that because of the problems of consumers trying to elimination a portion of their existing debt and the depressed state of the real estate markets, it may take at least a few years of serious stimulus to have a "return to normalcy", in the lingo of Warren Harding.  Having a depressed economy will just delay the repayment of debt and the housing slump and make it harder for a laissez-faire recovery to build.

The U.S. political system is in the Days of Decision.  Policy-makers can make us all go through pain which does not make recovery any faster or they can do the sensible thing and insist on a full-employment policy.

1 comment:

  1. For clarification, the multiplier presented should be viewed with some caution. Some estimates of the autonomous spending multiplier are considerably smaller. The numbers are used merely to illustrate the point and the approximate scope of the problem and to provide an idea about how large a stimulus may be needed. It is likely that deficit-financed spending would have to increase more than the amount represented if one uses a more conservative estimate of the multiplier.