Download MFE Macroeconomics Option - World Economy and Finance

Fiscal stabilisation and debt
Simon Wren-Lewis
Economics Department and Merton College,
Oxford
This talk draws heavily on joint work with Campbell Leith at Glasgow
University under the ESRC’s World Economy and Finance programme,
and also joint work with Tatiana Kirsanova at Exeter University. However
neither co-author should be implicated by any views I express here
January 2010
WEF Event: Picking Up the Pieces
Summary
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Fiscal countercyclical policy
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The traditional assignment
Zero bounds
The right type of fiscal policy
Stimulus without raising debt?
Optimal debt policy
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January 2010
The random walk result: its importance and
limitations
Fiscal councils
WEF Event: Picking Up the Pieces
The conventional assignment
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Monetary policy
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Fiscal policy
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Short term stabilisation of demand consistent with
achieving a medium term inflation target
Debt stabilisation or reduction is not an objective
To meet some objective for government debt over the
medium/long term
Short term demand stabilisation is not an objective
With the occasional exception, this was the consensus
among policy makers and academics before 2008/9
A key caveat was, or should have been, that monetary
policy is not constrained by a zero lower bound
January 2010
WEF Event: Picking Up the Pieces
Zero bound implies fiscal action
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Impact of QE uncertain
Policy makers are unwilling to raise inflation
targets or adopt a price level target
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Time inconsistency problem
Misinterpreted as debt stabilisation
Damage anti-inflation credibility
Fiscal stabilisation has to step in at the zero
bound, and can be very effective
See Eggertsson, G. and Woodford, M.
2003/2004 on all these points
Some fiscal instruments are much more
effective than others.
January 2010
WEF Event: Picking Up the Pieces
Some fiscal policy myths
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“Ricardian Equivalence means fiscal policy
does not work”
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In an open economy independent fiscal action
gets crowded out through an appreciation
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Temporary increases in government spending raise
demand even if consumers are totally Ricardian
If interest rates are stuck at zero, and the fiscal
expansion is temporary, the exchange rate should not
appreciate.
Any increase in government borrowing crowds
out private borrowing
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January 2010
Even if we deny that prices can be sticky, the zero
bound is a fact, and it prevents demand adjustment
WEF Event: Picking Up the Pieces
Macroeconomics, ideology and ivory towers
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Eugene Fama (Professor, Chicago)
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The problem is simple: bailouts and stimulus plans
are funded by issuing more government debt. (The
money must come from somewhere!) The added
debt absorbs savings that would otherwise go to
private investment. In the end, despite the existence
of idle resources, bailouts and stimulus plans do not
add to current resources in use. They just move
resources from one use to another.
John Cochrane (Professor, Chicago)
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January 2010
Every dollar of increased government spending must
correspond to one less dollar of private spending.
WEF Event: Picking Up the Pieces
On theory that denies the possibility of deficient
aggregate demand
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Keynes (1936) General Theory
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January 2010
That it [Classical Theory] reached conclusions quite
different from what the ordinary uninstructed person would
expect, added, I suppose, to its intellectual prestige. That
its teaching, translated into practice, was austere and often
unpalatable, lent it virtue. That it was adapted to carry a
vast and consistent logical superstructure, gave it beauty.
That it could explain much social injustice and apparent
cruelty as an inevitable incident in the scheme of progress,
and the attempt to change such things as likely on the
whole to do more harm than good, commanded it to
authority. That it afforded a measure of justification to the
free activities of the individual capitalist, attracted to it the
support of the dominant social force behind authority.
WEF Event: Picking Up the Pieces
Fiscal expansion without higher debt?
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Intertemporal incentives
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Tax financed temporary increases in
government spending
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Anticipated VAT increases – fiscal policy as
monetary policy
Will expand demand if consumers are Ricardian
Redistribution from unconstrained to credit
constrained consumers
All redistribute, but so does monetary policy
January 2010
WEF Event: Picking Up the Pieces
Outside of the zero bound, is the
conventional assignment still right?
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Given lags, precautionary fiscal expansion may
on occasion be warranted
Theory – fusion of two literatures
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Dynamic optimal taxation theory
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Schmitt-Grohe, S. and Uribe, M. (2004) – sticky prices
make an important difference
Keynesian theory (Woodford – social welfare
measure of business cycle costs)
(Robust?) Result: If monetary policy
unconstrained, optimal fiscal demand
management is no demand management
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January 2010
Eser, F, Leith, C and Wren-Lewis, S (2008)
WEF Event: Picking Up the Pieces
Fiscal policy still has a stabilisation role in
changing relative prices
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If wages as well as prices are sticky, tax
changes can help ‘correct’ the real wage
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Leith, C. and Wren-Lewis, S. (2007), 'CounterCyclical Fiscal Policy: Which Instrument is
Best?', Glasgow University.
Tax changes can offset cost-push shocks
Tax measures may be more efficient at
pricking asset bubbles in particular markets
than general interest rate changes.
January 2010
WEF Event: Picking Up the Pieces
Optimal debt policy: the random walk result
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Assume away default risk, and assume infinitely
lived Ricardian consumers
Taxation is distortionary, so any non-negative
government debt has social costs
Despite this, if a demand shock raises
government debt, the optimal response is to live
with this higher level of debt
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January 2010
Schmitt-Grohe, Stephanie and Uribe, Martyn (2007)
Benigno, P and Woodford, M (2003)
Essentially a tax smoothing result
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Limitations
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Assumes time inconsistent policy
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Under time consistent policy, optimal policy would
involve rapid debt correction
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Leith, C and Wren-Lewis, S (2007), Fiscal Sustainability in a
New Keynesian Model, Oxford University Discussion Paper
No. 310
Assumes benevolent policy makers
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Leith, C and Wren-Lewis, S (2009), Electoral Uncertainty, the
Deficit Bias and the Electoral Cycle in a New Keynesian
Economy, Oxford University Discussion Paper No 460
Ignores default risk
With finitely lived, intergenerationally selfish
consumers, debt crowds out capital
January 2010
WEF Event: Picking Up the Pieces
Debt and long run crowding out: log utility
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Ricardian model
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2 period OLG model with zero labour income in second period
 More than 1 for 1 crowding out of capital
Blanchard-Yaari C (r     )  A( p   )( p   )
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No crowding out of capital
C=consumption, r=real rates, =impatience, =decline in income with
age
A=total assets (debt+capital), p=probability of death
Calibration (annual): K=1,Y=Debt=0.25, =0.04,p=0.02,
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January 2010
=0
Implies r=5%
Reduce debt to zero – interest rates fall to 4.8%
Steady state A falls by almost as much as debt, so K rises by just 3.13%
Steady state consumption rises by 1%
Making =3% pa will double the long run impact of lower debt
WEF Event: Picking Up the Pieces
Implications
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The random walk result demonstrates that debt
should be a shock absorber and not a target.
The possibility of hitting a zero bound means
that we need, in other times, to be gradually
reducing debt
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Constant debt/GDP objectives not enough
Supported by OLG crowding out
Unless the emergence of default risk premium
is a significant possibility, debt reduction should
be gradual and erratic.
January 2010
WEF Event: Picking Up the Pieces
How best to achieve gradual and erratic debt
reduction?
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Targets set by governments are likely to be economically
and politically sub-optimal
Governments have a temptation to be over optimistic in
making fiscal projections
Need Fiscal Councils to
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January 2010
Independently forecast development of government debt
Advise on the optimal timing and speed of debt reduction
Have the political authority to act as an effective public
watchdog
See Kirsanova, T, Leith, C and Wren-Lewis, S (2007),
Optimal Debt Policy, and an Institutional Proposal to help in
its Implementation, European Economy Economic Papers No
275
And Sweden, Canada, Hungary and others
And Conservative Party policy
WEF Event: Picking Up the Pieces