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Monday, January 07, 2008

Fiscal policy to the rescue?

Writing in the Financial Times, Larry Summers says that the odds of a US recession have risen further in the last six weeks, and that there is a strong case for a fiscal stimulus of roughly $50 to $75 billion, delivered to poor people in the US.

What are the coefficients on your Taylor rule?

He says that a sharp easing of monetary policy is a done deal, and that the policy rate will go to roughly 3 percent. I don't see how it's easy for the US Fed to cut rates given how bad things are on inflation in the US. The latest data for TIPS-derived expected inflation in the US are showing values above 2.8%. This is not a pleasant environment in which cutting rates can be envisaged. To the extent that Larry Summers is effectively advocating a high weightage on the unemployment coefficient and a low weight on the inflation coefficient of the Taylor rule, this is a source for concern.

The US lacks a de jure inflation targeting framework for monetary policy. Trusting the Fed on inflation is, then, only a matter of the personalities of the people in charge. The Fed is mistrusted more than (say) the Bank of England where, since inflation targeting is written into the law, there is no question about the credibility with which the BOE will take on innovations in expected inflation. In this paradoxical way, writing down inflation targeting into the law actually gives more space to respond to events. In the US, the law does not tie down Ben Bernanke's monetary policy rule, so he has to worry about how the market sees the coefficients on his Taylor rule, and has to be concerned about the threat to his credibility if he eases rates and ignites inflation.

Can fiscal policy do stabilisation?

A few weeks ago, I wrote a paper titled New issues in Indian macro policy which is forthcoming in a book edited by T. N. Ninan. There, I argue that the right strategy for both monetary policy and fiscal policy in India consists of devoting these tools to the task of stabilising the business cycle. The question arises: Why not lock down fiscal policy into a relatively dumb rule (like the existing FRBM), and leave the entire job of stabilisation to an inflation-targeting monetary policy? I think the answer lies in two parts.

First, a dumb fiscal rule like the existing FRBM is not implementable. If we set out to achieve a 3% central fiscal deficit every year through a dumb fiscal rule, in a bad year, the outcome will be worse. In February 2008, little is known about business cycle conditions that will prevail over 2008-09, so the budgeting process will inevitably go wrong. This will adversely affect the credibility of the fiscal rule, and possibly induce fiscal instability with a non-decreasing debt/GDP ratio.

The second reason is that fiscal policy can, in an ideal world, help do good things for stabilisation. Larry Summers offers four elements of this logic:

The question is whether it is better for all the stimulus to come from discretionary monetary policy or for some of the stimulus to come from discretionary fiscal policy. A diversified policy approach seems clearly preferable in that (i) in a world where judging the impact of policy measures is difficult, the outcome is less uncertain with a diversified mix of stimulus measures; (ii) the proximate impact of fiscal policies is felt by the families bearing the brunt of recession, in contrast to monetary policies whose immediate impact is on financial institutions; (iii) use of fiscal policy reduces the amount by which interest rates have to be reduced, thereby reducing downward pressure on the dollar, which in turn contributes to upward pressure on US inflation and international instability; (iv) partial reliance on fiscal policy mitigates the various risks of bubble creation associated with excessively low interest rates.

He also offers a fifth reason: When there are difficulties in the financial sector, as in the present situation in the US, the effectiveness of monetary policy (as in cutting rates) as a tool for stabilisation is lowered.

These are all good reasons, though some of them are unique to the present situation in the US. I do think there is a case for building business cycle considerations into the fiscal rule. But this is hard; the experience of many decades, all over the world, has shown that fiscal policy is too slow and too politicised. All too often, fiscal policy flirts with the danger of a rising debt/GDP ratio and/or election cycles. The formulation that I offer in the paper mentioned above is one where government always budgets for a fiscal deficit of 1% of GDP, but slippage to 3% is considered acceptable if (and only if) business cycle conditions are adverse.

As Richard Clarida once explained to me, the 9/11 attacks were a singular moment in the history of macroeconomic policy, because on the morning of 12 September 2001, the day he started work at the US Treasury, there was full clarity that a downturn was coming. There was no difficulty of reading the tea leaves with old data; you knew for sure that a counter-cyclical response was needed. US fiscal policy and monetary policy worked very effectively in the aftermath of the attacks. We should treat that episode as being on the frontier of what is possible. Most of the time, what macroeconomic policy can deliver will be worse than that episode.


  1. How do you calculate the the latest TIPS derived expected inflation rate of 2.8%. if you subtract the 10 year Treasury yield (3.86%) from the 10 year TIPS yield of 1.58 you get an expected inflation rate of 2.29%.

    this number peaked at about 2.4% in June but has since remained contained. i don't believe that signals all clear on "inflation" but that is another story.

  2. The link that I was giving earlier for TIPS-estimated inflation expectations was wrong. I have put the correct link there. The calculations are from the Federal Reserve Bank of Cleveland. Click on the link in the post now for details.


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