David Levey directed me to a thoughtful post by Olivier Blanchard, which discusses the case for using fiscal policy. Here’s how he starts the post:
Over the last decade, it has become obvious that the decline in real interest rates forced us to revisit the scope and the role of fiscal policy. This is what I have tried to do in a book that I just finished. The book, Fiscal Policy Under Low Interest Rates, is now available on an MIT Press open source site, where I encourage you to leave comments and suggestions. I shall revise the book in light of those comments early next year, and the book will come out in hard copy at the end of 2022.
Then Blanchard carefully explains why he believes that low interest rates are likely to be around for a long time, and why this makes fiscal policy a more attractive option. Blanchard’s analysis of the causes of low rates is excellent, but I don’t find his policy views to be persuasive. Here’s how I’d rate the options for responding to low equilibrium interest rates, in order of desirability:
1. NGDP level targeting at 4%/year combined with a “whatever it takes” approach to asset purchases, in order to keep NGDP expectations on target.
2. Raising the inflation target high enough to avoid the zero bound issue—probably around 4% inflation.
3. Aggressive use of fiscal stimulus during recessions.
4. Ban or severely restrict the use of currency.
5. Do nothing—allow deep recessions when money demand exceeds money supply.
In my view, Keynesians overestimate the costs of the first two options, and thus move too quickly to the third option.
Because many developed countries have used aggressive QE and still fallen short of their targets for inflation, it is often assumed that hitting those targets would require even larger levels of QE. In my view, the opposite is true. If the Japanese had maintained an average inflation rate of 2%, instead of near zero inflation, the demand for base money in Japan would be lower than it is today and the Bank of Japan would have engaged in less QE than they have actually done thus far.
What evidence do I have that Keynesians are misinterpreting Japan? Consider the following from Blanchard, from a concluding discussion of where fiscal policy has worked, and where it has failed:
A case of just right? Faced with a strong case of secular stagnation, Japan has run large deficits for three decades and debt ratios have increased to very high levels, while the Bank of Japan remained at the effective lower bound. Was it the right strategy (if indeed it was a strategy)? The answer is a qualified yes, but, looking forward, the high debt ratios raise issues of debt sustainability. Alternative ways of boosting demand should be a high priority.
The case he cites as “just right” is actually perhaps the greatest failure of demand stimulus in all of world history. Because the Bank of Japan has had a low inflation monetary policy since the mid-1990s, even massive fiscal stimulus has failed to boost aggregate demand in Japan. Indeed Japanese NGDP has barely increased at all over the past 25 years. I know of no other country with such a dismal record of stimulating spending.
To be sure, the Japanese economy has not done all that poorly over the past 25 years, but to the extent it has done OK (not great) in real terms it is 100% due to supply-side factors. But Blanchard is focusing his analysis on the problem of maintaining adequate aggregate demand, and so Japan is absolutely the last country you’d want to cite as even a qualified success story.
Even worse, the only brief period of strong growth in Japanese NGDP occurred during the first few years of the Abe government, when Japan did exactly the opposite of what Keynesians (and MMTers) recommend. They relied on monetary stimulus and actually tightened fiscal policy, as Paul Krugman pointed out back in 2018. Check out what happened to Japanese aggregate demand (i.e. NGDP) in the 5 years after Abe took office:
To summarize, not only is Japan not a good argument for fiscal stimulus, it’s the most powerful argument against fiscal stimulus that I know of.
Nonetheless, my first option does have one potential downside. It is possible that in order to achieve a 4% NGDP level target the central bank would have to buy more than just government securities. They might also have to purchase lots of risky assets. In that case, the second option might be best—raise the inflation (or NGDP growth) target. Why is that option still better than fiscal policy?
The major downside of raising the inflation target is that it results in higher nominal returns on capital, which increases the effective tax rate on capital income. But if this target were raised because the equilibrium interest rate had fallen sharply, then this downside to a higher inflation target would hardly matter. Real tax rates on capital income would not be significantly affected.
Another cost of inflation in the textbooks is called the “shoe leather cost”, the cost of having to walk to ATMs more frequently because you don’t want to hold a lot of cash when other assets offer higher nominal rates of return. But again, this cost is trivial in a world where nominal interest rates are low, and in any case most Americans don’t even carry very much cash these days. Most people holding huge stores of $100 bills are either foreigners or Americans avoiding taxes, making a little bit more inflation a minor problem for law-abiding Americans.
The cost of adjusting prices due to higher inflation is also trivial. Most prices that are adjusted frequently reflect changes in relative prices, not inflation. Gas stations and groceries are going to adjust gasoline and produce prices almost as frequently with 4% inflation as with 2% inflation.
So while raising the inflation rate to 4% is not my first choice, it’s a far less bad option than massive and wasteful fiscal stimulus.
If I’m right, then what exactly is the case for fiscal policy? I still don’t get it.
READER COMMENTS
Andrew_FL
Jan 9 2022 at 5:28pm
Shocking, shocking that monetary and financial freedom doesn’t even make the list. You’d sooner ban currency.
Scott Sumner
Jan 9 2022 at 11:42pm
Where did I say that?
Andrew_FL
Jan 10 2022 at 10:55am
Incredible, your list is right there, there are five items on it. You rate at least five proposals, including “Ban or severely restrict the use of currency.” higher, implicitly, than deregulating banking and denationalizing money, which doesn’t even make the list. God only knows where you would actually rate it, probably much lower than 6th.
Scott Sumner
Jan 10 2022 at 11:41am
I have absolutely no idea what you mean by deregulating money.
Andrew_FL
Jan 10 2022 at 12:17pm
Not content with pretending you don’t know what you’ve said you’re now misquoting what I’ve said? I said denationalizing money, not deregulating money.
ssumner
Jan 10 2022 at 9:33pm
OK, what does “denationalizing money” mean? Are US dollars no longer legal tender?
Andrew_FL
Jan 11 2022 at 9:46am
Existing dollar denominated debts are still legally obligated to be paid back from the existing stock of dollars, if that’s what you’re wondering. But the government would issue no more dollars nor prosecute anyone like, say, Bernard von NotHaus, for the heinous crime of minting his own currency.
Arqiduka
Jan 9 2022 at 5:37pm
Japan is very interesting on the monetary side too: what is wrong with a de facto stable NGDP target?
“The official target is 2% inflation and falling short is hurting credibility”. Surely a much stronger argument in the early ’90 but its been 25 years and expectations must have adjusted.
“Japanese NGDP is only stable in the long run and hindsight, but quarter to quarter is too variable” . Yes.
But leaving both aside, what is wrong in principle with a zero growth target? Is it that you need to buy up unsustainable amounts of assets to achieve this?
Scott Sumner
Jan 9 2022 at 11:43pm
Arqiduka, That’s basically George Selgin’s proposal in Less Than Zero.
Arqiduka
Jan 10 2022 at 1:08am
Indeed it is, was wondering if you meant an in-principle critique of what is becoming a real-world example when you claim that some of Japan’s issues are demand-side.
Matthias
Jan 10 2022 at 6:30am
Scott seems mostly concerned with hitting a pre-announced target.
Wether that level target is 4% ngdp growth or 5% or even 0% doesn’t matter for first order effects.
George Selgin made some good argumwnts for stable ngdp per capita. Scott seems to mildly prefer 4% for reasons to do with wage stickiness or so, I think
Btw, George Selgin’s excellent book Less than Zero is available for free online.
Scott Sumner
Jan 10 2022 at 11:44am
As I said in the post, a very low inflation (or NGDP) target leads to a high demand for base money, forcing the central bank to buy lots of assets. The BOJ buys lots of common stocks. That doesn’t seem ideal.
MarkLouis
Jan 9 2022 at 6:22pm
The major cost of a central bank raising the inflation target is the creation of massive winners and losers by unelected officials. A shift of this magnitude should come from congress. As just one simple example, compare the impact on someone on a fixed income (big loser) vs a leveraged real estate investor like Donald trump (big winner). That’s a recipe for large political costs as well.
We may decide we like those outcomes but that should require broad acceptance by the electorate.
Scott Sumner
Jan 9 2022 at 11:44pm
I don’t agree that it would create massive winners and losers. But you can make a good argument that it should come from Congress.
Mark Brady
Jan 9 2022 at 6:24pm
Which David Levey is this? As far as I can make out, there’s more than one person with that name writing on economics. Or do you mean David Levy (without the “e”) at George Mason University?
Scott Sumner
Jan 9 2022 at 11:46pm
No, not David Levy.
Thomas Lee Hutcheson
Jan 9 2022 at 9:17pm
For clarification, is it your view that “doing whatever it takes” to keep inflation and inflation expectations at 2% PCE would require allowing ST rates to fall below zero? Is there not the possibility that NGDP targeting at 4% would also require negative ST rates?
Scott Sumner
Jan 10 2022 at 11:45am
I don’t think it requires negative rates, but it might require a large CB balance sheet.
Thomas Lee Hutcheson
Jan 9 2022 at 9:20pm
While low levels of real interest rates may not or ought not affect fiscal policy (in the sense of investing more during recessions than called for by the NPV rule) do you agree that the level of public investment should be greater with low real interest rates?
Thomas Strenge
Jan 10 2022 at 10:21am
TLH, I understand that you are asking Scott, but given the fact that there is no evidence that the public sector is better at investing than then private sector, and that all public resources come from the private sector, then public sector investments should remain as close to zero as possible regardless of how low the interest rate.
Scott Sumner
Jan 10 2022 at 11:45am
“do you agree that the level of public investment should be greater with low real interest rates?”
No, that’s reasoning from a price change.
vince
Jan 9 2022 at 9:29pm
Another option: Ask businesses and banks why they aren’t lending and expanding.
Todd Kreider
Jan 10 2022 at 9:33am
Scott: “To summarize, not only is Japan not a good argument for fiscal stimulus, it’s the most powerful argument against fiscal stimulus that I know of.”
This has bothered me on and off since reading Adam Posen’s book on Japan in 1998 where he argued based on one year that Japan wasn’t trying nearly enough fiscal stimulus, and he has repeated this for many years, although I haven’t followed what he has been writing since around 2017.
By the way, in 2002, Posen was sure that Japan would have a financial crisis by 2004 that didn’t come to pass and several years later Ken Rogoff said Japan would have a financial crisis by 2020 – so far so good.
Todd Kreider
Jan 10 2022 at 10:07am
Scott wrote: “To be sure, the Japanese economy has not done all that poorly over the past 25 years, but to the extent it has done OK (not great) in real terms…”
GDP per capita average growth from 1994 to 2019 before the pandemic hit:
Japan 0.8%
U.S. 1.6%
U.K. 1.5%
Germany 1.3%
France 0.7%
Canada 1.4%
S. Korea 3.8%
=====================
GDP per capita average growth from 2004 to 2019:
Japan 1.1%
U.S. 1.6%
U.K. 0.8%
Germany 1.4%
France 0.7%
Canada 0.8%
Scott Sumner
Jan 10 2022 at 11:48am
Japan had a bad 1990s, and has treaded water ever since. The biggest problem in Japan is supply side, the low level of GDP per person relative to the US or Germany or (in PPP terms) even South Korea.
Todd Kreider
Jan 10 2022 at 12:16pm
“The biggest problem in Japan is supply side, the low level of GDP per person relative to the US or Germany or (in PPP terms) even South Korea.”
GDP per capita PPP, IMF 2021
Japan $44,600
South Korea $47,000
South Korea’s GDP per capita is 5% higher than Japan but Koreans work 20% longer than the Japanese to get that small gain.
ssumner
Jan 10 2022 at 9:36pm
I recall when Japan was 4 times richer than South Korea. To now be poorer is quite a change.
Todd Kreider
Jan 12 2022 at 4:20am
Japan is poorer than South Korea because its GDP per capita per hour is higher? How many economists discount leisure time to zero?
South Korea converging on Japan could be seen a mile away, starting in the 1980s.
David S
Jan 10 2022 at 3:14pm
As a thought experiment, how would #4 even work? I’m assuming you listed as an option in jest, but I’m genuinely curious about how the government could make that happen.
Didn’t the Fed try #5 for a brief period in 2008ish?
ssumner
Jan 10 2022 at 9:37pm
They could stop issuing new currency, and it would gradually stop being used as money. That would allow negative interest rates, eliminating the “liquidity trap”.
Rajat
Jan 10 2022 at 7:43pm
People like Blanchard blissfully ignore Japan as well as the “great (US) market monetarist experiment” of 2013, yet observers breathlessly endorse his policy views because they imply more government spending on their pet proposals. I’m up to the bit in Ed Nelson’s book where Friedman is frustrated that academics like Tobin and US Fed officials refuse to acknowledge (in the late 1960s) that high rates don’t mean tight money. Frustrating!
ssumner
Jan 10 2022 at 9:37pm
Wait until you get to the price control section!
marcus nunes
Jan 11 2022 at 7:53pm
“To summarize, not only is Japan not a good argument for fiscal stimulus, it’s the most powerful argument against fiscal stimulus that I know of.”
If only The Economist had looked at Japan before extoling the powers of fiscal policy to induce inflation…
https://marcusnunes.substack.com/p/the-economist-asks-has-the-pandemic
bill
Jan 11 2022 at 10:17pm
How about a 1.b of NGDPLT at 5%?
Comments are closed.