Fiscal Multipliers and Rational Expectations

by: IPE at UNC

Back in March I wrote this:

Presumably, Krugman thinks we are in a liquidity trap because the Fed can't credibly commit to boost future inflation. In other words, expectations of (low) future inflation prevent monetary policy from taking hold in the present circumstances, thus reducing the monetary "multiplier" (i.e. velocity of money). In Krugman's mind, this is so self-evident that he doesn't even need to consider things like quantitative easing or eliminating interest payments for excess bank reserves. Banks (and investors) have expectations of [low] future inflation, which makes monetary policy ineffective in a liquidity trap, full stop.

Why, then, are Krugman and his minions so dismissive of the "Treasury View" that the fiscal multiplier is greatly diminished by crowding out private spending because of expectations of future tax increases? Why are one set of expectations enough to make monetary policy completely ineffective, but not have any effect on fiscal policy? For this view to be coherent, there must be some fundamental difference between expectations over future inflation and future taxes, but I can't see what it is. Both expectations come from beliefs about future real net income.

Especially since, as Krugman himself noted earlier today, both banks and consumers are hoarding cash right now. I would expect Krugman to say that we need to government to spend precisely because banks and consumers are hoarding cash. But that only moves the money once: after the government spend the cash, whoever receives it will just hoard it and there is no stimulative effect. In order to get the money moving on a more sustained basis, there has be a story about how consumer expectations improve when faced with fiscal stimulus but remain unchanged when faced with monetary stimulus.

On Friday, Tyler Cowen said the same thing:

It is frequently suggested that the multiplier today is best estimated at 1.5 or 1.6. My point today is this: if you postulate a potent multiplier you cannot easily also postulate a liquidity trap. The whole point of the multiplier is that if the government buys cement from my company (say for a road) I ask the company owner take those cash receipts and spend them elsewhere. Maybe so but that means people are willing to spend cash when they receive it. It means that a helicopter drop (and maybe other forms of monetary policy as well) would stimulate AD quite readily and for free. You don't need exotic or balance sheet-distorting QE here, a simple injection of cash will do.

Indeed, the Christiano, Eichenbaum, and Rebelo model of fiscal policy in a liquidity trap, no matter what you think of it both implies and states that monetary policy will work too. And if that monetary policy is truly a free lunch in terms of GDP, it should be quite credible (if it's not credible in the real world maybe the problem wasn't AD in the first place).

This in response to Robert Barro's recent research (see this op-ed for a summary) and the chatter it has inspired. Just to be clear here: Krugman's position is incoherent. That doesn't mean that Barro's argument is empirically true. But if there is a way that fiscal money multiplies while monetary money does not multiply then Krugman or one of his fellow-travelers has to show how that happens.