Download Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?

Fiscal Stimulus, Fiscal Inflation, or
Fiscal Fallacies?
John H. Cochrane
Myron S. Scholes Professor of Finance
University of Chicago Booth School of Business
By Alex Macri
11/30/11
• Cochrane sets out to examine the fallacies of fiscal stimulus
and its poor track record of efficacy across
countries/continents in which it has been applied.
• The familiar argument for this policy is that “animal spirits”
cause aggregate demand to tumble to a prolonged and
undesirably low level which only government orchestrated
stimulus can resurrect to the status quo ante.
• If a trillion $ were to be dropped from helicopters people
would trigger inflation by spending it on goods and
services. That this or any combination of transfer payments
is a last resort for preventing deflation is a virtually
unanimous conclusion amongst economists.
• The caveat to this reflation mechanism is that people
expect the government debt to be monetized rather than
retired via taxation.
• If higher future taxes are expected in order to pay for the
stimulus then at least some of the transfer payments will
be saved to cover the future higher tax liability instead of
consumed.
• The trillion dollar demand stimulating channel is not to be
interpreted as good Rx for the current predicament as the
economic dislocations this inflow would unleash are “too
frightful to contemplate”
• Cochran then returns the discussion back to a hypothetical
stimulus paid with future taxes.
• The discussion debuts with 3 fallacies often overlooked or
ignored by stimulus proponents:
• 1st Crowding out. If money is not being printed, every $
spent by government is a $ drained out of the private
sector which can’t create additional jobs, demand etc.
• 2nd Private investment and consumption are identical from
an overall macroeconomic accounting. Whether you
choose to invest in a stock which capitalizes a car factory or
buy the car of the lot is irrelevant. Both events qualify as
consumption and both stimulate demand.
• 3rd, if future taxes are raised in order to pay for the stimulus
then people’s aggregate demand will be blunted in
anticipation of higher tax rates.
• The real question in not if the multiplier exceeds one but if
it exceeds 0.
• A dislocated credit market rather than depressed aggregate
demand is a far more accurate diagnosis of our current
economic malaise.
• There is a pervasive capital flight to the perceived safety of
government backed securities.
• The currently glacial rate of privately securitized debt is
making credit is very expensive.
• A simultaneous destruction of strategic refineries in the
gasoline supply chain is a good analogy:
• While oil (capital) would be sitting in the harbor and the
cost of capital would be the same as before, gas (credit)
prices would be high because oil cannot be refined into
gasoline. To complete the analogy, the refineries are the
credit markets.
• Cochran posits that in the appropriate response is for
temporary government credit market management until
the private market can reclaim its rightful role.
• The Fed can meet the tremendous demand for government
• debt by issuing treasuries against high quality commercial
paper, corporate bonds and other private debt instruments.
• This mechanism would temporarily substitute for the
currently missing private intermediation channels (credit
market). Furthermore, once the economy recovers, an
eventual threat of inflation caused by this infusion of
government monetary instruments can be averted with the
Fed simply taking back government issued debt in
exchange for the private debt and make a nice profit in the
bargain.
• The current policy of buying troubled assets to the tune of
$700 billion will not make the remaining $10 trillion more
valuable.
• All the aforementioned amounts to subsidies to banks to be
ultimately paid for by future taxpayers or inflation.
• If government debt is wisely invested in good, tax stream
revenue generating assets then soaking up the massive
increase in government debt will not create the massive
economic dislocations it would if it were spent unwisely or
given away.
• If the massive debt incurred is paid off by correspondingly
higher future taxes we run the risk of a decade of anemic
economic growth.
• If taxes are insufficient to pay for the debt and government
outlays are not reduced, then the magnitude of ensuing
inflation will not be tamed by monetary/interest rate policy.
• The argument that the current recession does not allow the
luxury of worrying about future inflation does not hold
water.
• Inflation is a real possibility which combined with high
unemployment can unleash tremendous stagflation.
• The various Obama tax rebates are ineffectual because they
have short horizons, are means tested and do not change
incentives.
• In order for incentives to change ,tax rates must be
predictably lowered for an extended period of time thus
broadening the tax base and lowering government
overhead.
• By the 1970’s classical Keynesians gave up on the view that
• Fiscal stimulus will inject sufficient demand in a timely
enough manner to matter.
• The equilibrium school of thought which began to replace
Keynesianism by the mid 1970’s is skeptical of stimulus
measures.
• Nobody argues that expectations do not matter; if people
realize that stimulus will be paid for via higher tax rates or
inflation then the rationale for present stimulus vanishes.
• New Keynesians do not contest equilibrium theory; they
merely argue that some frictions can prevent immediate reequilibration and unlike their classical counterparts, stress
the importance of monetary policy.
• The classic Keynesians could no longer defend their views
• In view of the evident failure of their policies; Britain 30
years of anemic growth, the US economic misery of the
1970’s foretold by Friedman in 1968.
• Keynes emphasized consumption, minimized the
importance of investment, ignored the incentive changing
nature of tax rates and in general believed in centralized
government planning.
• Hayek demonstrated why prices must be allowed to adjust
via the free market and why central planning is a fool’s
errand.
• Ignoring this caution will lead us to one of many
undesirable roads: British style anemic growth,
bureaucratic India, spend –inflate-spend-borrow South
America etc.
• In short fiscal stimuli have a very poor track record across
countries and continents where it has been applied.
• The administration’s touted fiscal stimulus multipliers do
not have any theoretical or evidentiary underpinnings and
embody all 3 of the aforementioned fallacies.
• Some economists insist that the efficacy of fiscal stimulus
must be believed in despite 40 years of contradictory
evidence.
• Restoring the public’s confidence is another argument
posited by fiscal stimulus proponents, which again goes
against concrete evidence.
• Economists must acknowledge that they do not have any
specific or knowledge or expertise in divining what
• “intrinsically meaningless” gestures will or will not restore
confidence
• The government must remove itself from the business of
deciding whom will subsidize whom for imprudent lending
and focus on stopgap credit market intermediation until the
private sector credit market can channel new savings to
new borrowing.
• This will prove difficult because of the political dimensions
imbedded in fiscal stimulus policy. (i.e. buying influential
votes).. FDR understood this