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STIMULUS OR AUSTERITY
The story economists like to tell is one of Panglossian (Voltaire, 1759) tranquility: markets tend toward
equilibrium, the whole economy, therefore, tends toward equilibrium (Walras, 1877). Market
equilibrium means everyone who wanted to buy the product at the market price was able and everyone
who wanted to sell the product at the market price did so. The last buyer pays exactly how much the
item is worth to her. The last seller receives exactly how much it cost to produce the last item. All the
previous buyers paid less than what it was worth to them and all the previous sellers received more than
the cost of the unit. This is what we economists call “demand and supply.” Of course, for this story to
work, there are a bunch of conditions that are thought to exist: consumers get less satisfaction from
each successive unit consumed within a time frame; producers face increasing costs for each successive
unit they produce; no one has power over the price in the market because each participant is a very
small portion of the total number of producers and consumers.
Eighteenth and nineteenth century economists used variants of this basic story to reason about the
general economy. If all the markets are in equilibrium, then the economy must be in equilibrium.
Classical and neo-classical traditions built their analysis on the equilibrium of markets. It was the Great
Depression and John M. Keynes’ response (1936) that shook the belief that markets always reached
equilibrium. Keynes claimed the required price adjustment to equate supply to demand may not
happen in labor markets because nominal wages do not adjust downward. Bosses do not reduce wages
when demand for the product falls – at least not usually. The typical reaction is to cut production down,
and hence the hours worked. It is an output adjustment, not combined price and output adjustment as
envisioned by the classical economists. If the market prices are not adjusting in the short run, then a
general drop of demand in majority of markets will result in less output produced and consequently less
hours employed.
Why do recessions occur?
Recessions come about either because of a demand shock, or a supply shock, or a bubble burst.
A random drop in spending of the major actors (consumers, businesses, government, and foreigners)
can instigate a recession. Less demand will force the producers to cut back on production and reduce
their labor usage.
A random drop in labor, or capital, or technology will reduce production and trigger a recession
accompanied by a price rise. Natural or man-made calamities may be the culprit. A significant rise in
the prices of capital, raw materials, labor also may result in reduced use of the resources. Major
changes in physical, legal, or social environment may also be responsible for a supply shock.
A major asset price bubble burst that collapses the financial markets will have a devastating effect on
the economy. Not all asset price collapses trigger a financial meltdown; but stock market collapse,
exchange rate free-fall, sovereign default, housing price crash all were responsible for a major recession
one time or another. (Reinhart and Rogoff, 2009). The freezing of the financial markets dries up credit
and forces bankruptcies or layoffs in otherwise healthy businesses.
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In all instances, incomes will drop, affecting demand. Under normal conditions when a general drop in
demand occurs, production shrinks, recession starts, and unemployment rate rises. Prices respond
eventually: inflation rate drops luring the marginal consumers to enter the market. Also, lower inflation
might attract foreigners to purchase the domestic products. Lower inflation also reduces nominal
interest rates giving extra impetus to businesses to borrow for expansion when they expect conditions
to improve. All of these would boost demand conditions and markets would eventually clear as
expected. Notice the engine of the equilibrium. It is the price adjustment.
During the Great Depression, the faithful expected markets to adjust on their own according to the
script, and the prolonged unemployment baffled them. Eventually Keynes’ formulation provided an
explanation: wages do not get reduced even in the face of a recession, and in times of declining prices
real wages effectively rise, increasing costs of production and forcing businesses to contract. His
solution was even simpler: since consumers, businesses and foreigners cannot be relied for increasing
the demand shortfall for output, only government could bridge the gap. By covering the demand
shortfall the government could conceivably bring the economy to the equilibrium that existed before
the drop in spending.
Government has two lines of policies to affect the total demand. Fiscal policy works through changing
taxes and government spending. Ideally, fiscal policy should move the government’s budget toward
deficit in recessions and toward surplus in booms. Monetary policy works through changing the money
supply and hence the interest rate. Reducing the interest rate in recessions gives a boost to the
economy. During booms the government can apply the brakes on the economy by raising the interest
rate. Keynes advocated for both increasing the deficit and lowering the interest rate during the Great
Depression. The next generation of economists thought fine-tuning of monetary and fiscal policies
would allow the governments to eradicate recessions.
CHART 1: U.S. Business Cycle Expansions and Contractions
Source: http://www.dallasfed.org/research/swe/2005/swe0502.pdf
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Although we may snicker at such hubris, Chart 1 shows, compared to the 19th and first half of the 20th
centuries, recessions became rarer and less severe. The dark contraction periods have been less
frequent indicating a change in the economic environment. Keynesians use this as an evidence of the
success of the activist policies.
This success did not come as a “free lunch.” The cost of dampening recessions has been sustained
inflation.
Robert Sahr calculated price levels from 1665 to today. Prices moved up during wars but settled back
afterwards. The price level in 1905 was not much different than 1665. Chart 2 is a reproduction of
Sahr’s data. During the Great Depression prices fell but afterwards, in a period of sixty years, prices rose
twelve-fold.
CHART 2: U.S. Price Levels 1665 to estimated 2013, with 2002 = 100
Source: http://oregonstate.edu/cla/polisci/faculty-research/sahr/sumprice.pdf
Most people alive today are familiar with the pressures and difficulties of living with inflation, but
deflations are extremely costly, too. If people expect prices to drop, they postpone purchases
depressing the total demand in times of recession. Furthermore, deflation increases the real burden of
debt tremendously, triggering bankruptcies.
The people of the 20th century were somewhat spared from the evils of deflation to wallow in the
persistent pain of inflation. In fact, by the start of the 20th century, financial meltdowns had created
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enough political will to create a Central Bank. The Federal Reserve was established in 1913 to lend to
the banks in trouble to weather the panic. Later on, The Fed realized it can increase or decrease the
money supply which changed the short run interest rates downward or upward, respectively.
After the acceptance of Keynesian perspectives, governments countered drop in demand through
monetary and fiscal policies. The drop in consumer and business demand was replaced by government
demand or interest rate reduction, eliminating the need for prices to adjust downward.
There are basically three options for governments to deal with recessions.
(1) Do nothing.
During an onset of recession, when the government doesn’t react to counter it, eventually
inflation will go down as the drop in incomes depresses demand. This will happen even if
initially the recession was the result of a negative supply shock, spiking prices. Disinflation may
increase consumer spending if price elasticity of consumer demand is greater than one – it may
not be in recessions. Disinflation also boosts exports since domestic products will be more
competitive. As inflation drops so will the nominal interest rates, making it cheaper to borrow
for business expansion or housing construction or big ticket items. All of these developments
will first slow down and then reverse the recession. Lower inflation reduces uncertainty and
gives an additional reason for businesses to plan for the future with confidence, undertaking
expansion projects more readily.
The problem with “do nothing” approach is the political fallout from waiting for the economy to
recover. If the recovery takes too long, political cost for the government may be too high.
During recessions bankruptcies rise and some communities may feel the devastating effects
more than others. If local government services are dependent on public revenues, since tax
collections fall during recessions, service cuts will exacerbate the pain on vulnerable
populations. Businesses and individuals who find their incomes slashed during recessions may
try to weather the storm by borrowing but getting a loan in recessions is much harder than
under normal times. So, “do nothing” may not be the politically preferred option.
The expectation is given enough time the economy will recover and operate on its long-run
path. The picture of the 19th century experience corroborates this story.
(2) Use of monetary policy.
After the experience of the 19th century and a few recessions in the beginning of the 20th
century when bank runs forced banks into bankruptcy and froze the financial markets, the
political atmosphere was ready for a lender of last resort to support the banks. During bank
panics, this institution would lend to the banks to help them weather the storm and avoid
bankruptcies forced upon them. The need for a “lender of last resort” forced the establishment
of the Fed, US Central Bank. Once this Central Bank was established it did not take long to
realize that it can be not only reactive but also proactive. Initially, the Federal Reserve was
supposed to buy assets from banks at a discount to provide cash to the struggling banks. But
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any time the Fed purchased assets it noticed that the amount of money in the system increased.
This led to the major monetary tool of the Fed: open-market-operations, buying and selling of
bonds to manipulate the money supply. There is a one to one relationship between increasing
the money supply and lowering the overnight interest rate banks charge each other, called
federal funds rate.
To keep the economy on an even keel, not too hot or too cold, the Central Bank increases the
federal funds rate during the booms and reduces it at the onset of recessions. In mild recessions
this approach seems acceptable to spur consumption and investment spending.
During expansions that trigger inflation, raising interest rates is the policy response of the
Central Banks. Last thirty years central banks around the world used inflation targeting as their
guiding policy. If the forecast inflation rose they raised the interest rates; if it fell below the
target, they lowered the short term interest rate they control. Since central banks devise their
reaction six to eighteen months ahead, any recessionary fears will make them reduce the
interest rates right away. Chart 3 shows that in every recession during the last half century, the
Fed reduced the interest rate it controls.
CHART 3: Effective Federal Funds Rate
Source: Federal Reserve Bank of St. Louis
In 1981-82 the Fed did not keep the interest rate low even though recession was looming because it
wanted to eradicate the high and persistent inflation. 1982 recession was engineered by the Fed. To
counter the stimulative effects of Reagan tax cuts and military spending increases, the overnight interest
rates were pushed up to close to 20% by the Fed and the economy plunged into two back-to-back
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recessions. Chart 4 shows the relationship of interest rate policy to the inflation and unemployment
rates through the years.
CHART 4: Federal Funds Rate, Unemployment Rate, and CPI
Source: Federal Reserve Bank of St. Louis
(3) Use of fiscal policy.
The Keynesian solution to the Great Depression was to have government compensate for the
lost spending of the private sector. The model he developed indicated that government can
help the economy out of the recession through either increasing its spending or decreasing its
tax collections. The ensuing budget deficit and the increasing national debt could be dealt with
after the economy recovered. In fact, during growth periods, it was expected that tax
collections will grow faster than the government expenditures and the economy will experience
a fiscal drag, the only remedy being occasional tax deductions.
There are automatic fiscal stabilizers built into the system that provide a boost to the economy
in recessions and operate as brakes during booms. For instance, as economy expands and
incomes rise, tax collections increase. During contractions tax collections fall. Also safety net
payments through unemployment insurance, welfare payments, etc. also increase during
recessions.
Keynesian approach during the severe recession was also to keep the interest rate low, to avoid
crowding out. This hand-in-hand approach of both fiscal and monetary policy was to stimulate
the economy from the depths of depression. As the Keynesian approach became part of the
accepted mantra, the remedies were applied in any kind of recession, no matter how mild.
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The outcome of this practice brought a backlash against the activist approach. Under mild
recessions, fiscal stimulus ended up creating inflationary pressures and shrinking the private
sector. Because fiscal measures require a long, protracted, and messy process to clear the
Congress and get signed by the President, by the time the fiscal stimulus actually is put to
practice the economy might already be out of the recession. In this case the extra demand on
the goods, services and resources would trigger inflation. On the other hand, the pressure of
the government budget deficit will put pressure on interest rates and will discourage the
businesses from expansion. People decrease their consumption spending to save for future
taxes. These results have been verified with numerous studies and have become part of the
textbooks. Fiscal solutions during recessions were frowned upon. However, for decades under
both Democratic and Republican presidents taxes have been reduced for stimulative and
political benefits.
The kind of recessions experienced since WWII have not been in the order of the Great
Depression for the United States. The collapse of the financial markets had not been part of the
recessions for three generations. The accumulated knowledge, tests, data, and analysis,
therefore, did not address the unusual meltdown of the Great Recession. The cure offered as a
result of the accumulated knowledge was more to manage a chronic condition than a sudden
life-threatening episode. Other countries had experienced similar meltdowns but the existing
wealth of studies on the American economy doesn’t encourage one to look for answers abroad.
Recent Controversies
As soon as the housing bubble burst and it was obvious that the economy was heading for a
major recession some prominent economists clamored for fiscal measures to counter the
impending doom. (Krugman 2008 and 2012, DeLong 2012). Romer and Bernstein (2010)
estimated that a stimulus of “slightly over $775 billion” will increase GDP by 3.7% compared to
no stimulus and generate 3-4 million jobs.
Many macroeconomics experts, however, insisted that the stimulus multipliers were less than
one. That means for one dollar spent by the government the income of the economy increases
by less than one because other sources of spending drops. For instance, in February 2009, in a
short note entitled “Voodoo Multipliers,” Robert Barro claimed that stimulus will have a
multiplier of 0.7-0.8. John Taylor (http://www.johnbtaylor.com/) published a variety of papers
and testified extensively at Congressional committees during the last four years. He also
subscribes to fiscal multiplier of 0.7 calculated by the IMF (Testimony before the Senate Budget
Committee on 9/22/10). Taylor faults monetary policy followed since 2003 for creating the
underpinnings of explosive inflation (2012) and he blames the administration for being
expedient and fueling uncertainty. Uncertainty curbs consumer and business spending (9/23/11
Testimony). The pro-stimulus people, on the other hand, wonder when the inflation will appear
after half a decade of unprecedented money growth and indicate the existence of liquidity trap.
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At the beginning of 2009, Mark Zandi published his multipliers. He claimed that unemployment
insurance, food stamps, and infrastructure spending all had multipliers of greater than 1.5,
supporting policies that channeled funds into these areas.. Chart 5 is a reproduction of Zandi’s
multipliers.
CHART 5: Fiscal Stimulus Bang for the Buck
Source:
http://www.economy.com/markzandi/documents/Economic_Stimulus_House_Plan_012109.pdf
Alesina and Ardagna (2012) showed that there were instances of fiscal contraction that yielded
expansion rather than contraction. They indicated that successful episodes of deficit and debt
reduction accompanied by labor and goods markets liberalization meant falling of interest rates
as risk premiums fell. In some cases, they conceded that monetary accommodation may have
been the culprit. They say reducing spending is more effective than increasing taxes in bringing
a positive output result. The recent official British stand is also austerity is lowering interest
rates; but of course, when contraction is in sight interest rates fall, too.
(http://krugman.blogs.nytimes.com/2012/11/25/incredible-credibility/).
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According to Auerbach and Gorodnichenko (2010) the effect of fiscal interventions are not
symmetrical, contrary to the simple introductory textbook representations. They find fiscal
tools to be more effective in recessions than in expansions. However, according to their
calculations, reducing taxes during recessions do not budge the total output; increasing military
spending does.
During periods of liquidity trap - what Christiano, Eichenbaum and Rebelo (2009) term “zero
lower bound on the nominal interest,” - government spending multipliers display much larger
values than usual. Under normal conditions when federal funds rate is positive, multipliers may
be around one, meaning an increase in government spending does not create any second, third
round incomes. However, in their study, when federal funds rate is zero, the multipliers are
around three, which is for every dollar the government spends, GDP increases by $3.
IMF in the October 2012 World Economic Outlook concedes that the impact of fiscal multipliers
turned out to be two to three times larger than thought just a couple of years ago. That meant
austerity had a larger negative effect on the economy, not only pushing it toward recession, but
also increasing the government deficit because of the drop in tax collections as incomes fall.
In the instances where the banking system froze or government defaulted, the rescue had been
harsh in other countries with unemployment rates reaching historically very high levels and
staying there for a long time. (Reinhart and Rogoff, 2009). The Great Recession has been the
outcome of a financial meltdown and followed similar pattern to those experiences, unlike the
typical recession of post-war U.S. contraction.
As late as January 2013, the experts were still divided and unyielding on the importance of
stimulus (http://delong.typepad.com/sdj/2013/01/rough-transcript-stimulus-or-stymied-themacroeconomics-of-recessions.html). Stimulus proponents like Bradford DeLong, Mark Thoma
and Paul Krugman use the divergent experiences of UK and USA as a natural laboratory test that
condemns the austerity approach and vindicates the stimulus approach
(http://krugman.blogs.nytimes.com/2012/11/17/transatlantic-divergence/?smid=twNytimesKrugman&seid=auto). Austerity proponents like Michael Boskin, Niall Ferguson, William
Kristol, and John B. Taylor not only wanted to reduce deficits but also wrote an open letter to
Federal Reserve Chairman on November 15, 2010 to reverse his monetary policy of increasing
money supply.( http://economics21.org/commentary/e21s-open-letter-ben-bernanke).
Between 2009 and 2013 the U.S. economy was in an environment where nominal interest rates
the federal government had to pay were very low. Real interest rates were negative; lenders
practically paid money to the federal government to loan money. If the government can borrow
for a specific purpose of investment – education, infrastructure, and basic research – the returns
to the society will definitely be higher than the interest to be paid. Prudent business practices
imply a definite choice. As the society will become more productive and incomes will increase,
the future taxes collected will be more at the current tax rates and the borrowed funds will
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easily be paid. Just like a growing successful company, everyone will be better off. To beat the
drums of deficit and debt in this environment may be perceived as a disservice to the future
generations. In effect, by not borrowing, we condemn them to a lower standard of living.
There is obviously a contradiction here. Typically, government deficits and national debt are
seen as crippling burdens on the future generations. And they are, when the lenders perceive
them unsustainable and require higher interest rates to compensate for their risk. Greece,
Spain, Italy, Portugal face this predicament. When interest rates at which the government can
borrow become very high, not only new investment activities by the government not able to pay
off the debt in the future but also the daily consumption activities of the government, unless
curtailed to match its revenues, become an increasingly unsustainable burden. There is no
other way than to increase the suffering of the people to put the finances in order: by cutting
social spending and increasing taxes. But if the interest on the debt is lower than the growth
rate of the economy, then the burden in the future is progressively diminished. If growth
related activities can be financed at historically unprecedented low interest rates, the heavy
unemployment burden imposed on the current generation to lighten the burden of future
generations should not be acceptable by either group. Would the next generation be happy
knowing that their parents and grandparents had to suffer severe economic, psychological,
social hardships to have their children pay lower taxes?
REFERENCES:
Alesina, A. and Ardagna, A. The design of fiscal adjustments, NBER Working Paper #18423,
September 2012
Auerbach, A. and Gorodnichenko, Y. Measuring the output responses to fiscal policy, NBER
Working Paper #16311, August 2010
Barro, R., “Voodoo Multipliers,” Economists’ Voice, www.bepress.com/ev, February, 2009
Christiano, L., Eichenbaum, M. and Rebelo, S. When is the government spending multiplier
large? NBER Working Paper #15394, October 2009
Del Negro, M. and F. Schorfheide, “DSGE Model-Based Forecasting,” Federal Reserve Bank of
New York Staff Reports, No. 554, March 2012
DeLong, B., http://www.project-syndicate.org/commentary/the-shadow-of-depression
(3/29/12)
Keynes, J.M., The General Theory of Employment, Interest, and Money, 1936
Krugman, P., The return of Depression Economics and the crisis of 2008, W.W. Norton, 2000
Krugman, P., End this depression now, W.W. Norton, 2012
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Reinhart, C. M. and K. S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly,
Princeton University Press, 2009.
Romer, C. and J. Bernstein. The job impact of American Recovery and Reinvestment Plan,
January 10, 2010.
Taylor, J.B., “Monetary policy rules work and discretion doesn’t: A tale of two eras,” Journal of
Money, Credit and Banking, Vol. 44, No. 6 (September 2012)
Voltaire, Candide, 1759
http://www.dallasfed.org/research/swe/2005/swe0502.pdf
http://delong.typepad.com/sdj/2013/01/rough-transcript-stimulus-or-stymied-themacroeconomics-of-recessions.html
http://economics21.org/commentary/e21s-open-letter-ben-bernanke
http://economistsview.typepad.com/ (Mark Thoma)
http://www.economy.com/markzandi/documents/Economic_Stimulus_House_Plan_012109.pdf
IMF, World Economic Outlook, http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm
http://www.johnbtaylor.com/
http://oregonstate.edu/cla/polisci/faculty-research/sahr/sumprice.pdf
(Robert Sahr)