The Weakness Of Conventional Fiscal Policy

by: Brian Romanchuk

Brad DeLong has a good discussion on the convergence of views between New Keynesian and Market Monetarist theories of why economies face aggregate demand shortfalls. (Real Business Cycle theorists do not recognise the concept of an aggregate demand shortfall, so they are obviously not going to converge with the other groups.) The idea is that monetary and fiscal policy need to be coordinated, instead of a monetary policy-centric viewpoint that was the consensus before the crisis. In this article, I augment his analysis by applying the labour market analysis Minsky originally developed in the 1960s.

Brad DeLong describes three theories that could explain a demand shortfall, which he labels:

  1. Monetarist - a short of cash (money), which gums up the economy.
  2. Keynesian - if you hit the zero lower bound, bond yields will hit the lower bond which is created by term premia and the fact that yield positions become a one-way bet. (This was described by Keynes in the General Theory, and this is generally referred to as the "liquidity trap".) Since monetary policy can no longer reduce term interest rates, monetary policy becomes ineffective.
  3. Minskyite (as labelled by DeLong) - the credit channel has broken down, making monetary policy ineffective.

I believe that these categories describe what happened during the financial crisis itself; policy was aimed to restore the credit channel. This allowed the current recovery to begin. Correspondingly, I would agree with Brad DeLong's analysis (which I recommend reading if you have not already done so), when it is applied to that rather narrow time period.

However, the current recovery in the United States is weak, and unacceptable to policy makers. (Note that I am referring to the United States economy in this article; other countries like Canada are in a different position, although there are obvious overlaps.)

If we want to explain the current malaise, we need to turn to another theory - Minskyite (Version 2). In this version, we look at Minsky's analysis of labour markets.

Why Conventional Fiscal Policy Is Problematic

The main problem the economy faces is the high level of unemployment (particularly amongst young and less-skilled workers); other factors are secondary. Policy will only be effective if it targets the pace of job growth.

Although I emphasise the role of fiscal policy, I think it is mainly going to be effective in the form of automatic stabilisers (reduced tax collection as incomes and transactions fall, and increased social transfer payments). Tax cuts are also useful, at least if they are targeted sensibly. (Many are aimed at increasing the profitability of corporations, and we have abundant evidence from this cycle that high profits do not translate into increased hiring.)

But what I would refer to as conventional fiscal policy response is the government "buying stuff," and it appears that is what many people have in mind when talking about using fiscal policy to stimulate the economy. In particular, Brad DeLong is a prominent advocate of increased infrastructure spending. (Since government borrowing real rates are negative, the theory is that almost any infrastructure spending "pays for itself.")

In general, governments' "buying stuff" has limited impact on the domestic labour market.

  • If they bought gold (as might happen in a Gold Standard), it will create jobs in foreign gold-producing nations. (The fact that the Soviet Union and the dubious South African apartheid regime were the main beneficiaries of the Bretton Woods gold peg was a major reason why it was so easily dropped.)
  • If the government buys manufactured goods, it raises the question of what it will do with those goods, and it runs into the reality is that the goods are either produced by cheap labour overseas or in highly automated domestic factories.
  • There is no way the government can sensibly ramp up the purchases of domestic services. (Bankroll sending government employees to the Cheesecake Factory, and have them tip generously? I'm sure that would be a real vote winner amongst Republicans.)
  • Increasing residential construction would target the losses in that sector. But buying existing houses does not create jobs, and if the government orders new housing units, what would it do with them?
  • If the government buys even more military equipment, it will just raise profits and wages in an already high wage sector.
  • Infrastructure spending will probably also just be absorbed by the existing non-residential civil engineering contractor infrastructure. Modern infrastructure is highly capital intensive; we no longer hand shovels to ditch diggers and tell them to go at it.

This bias towards infrastructure (and military) spending has a long history; Minsky wrote extensively about it in the 1960s. He originally noted the drawbacks I note above in his discussions of "military Keynesianism." Very simply, government spending, unless it is targeted towards creating jobs for low-skilled workers, will just increase the profits and already high wages in the recipient industries. This will probably only increase consumption amongst those at the top end of income distribution, which creates inflationary pressures in the basket of goods that they consume. (Assuming that there is a single basket of consumer goods is rather silly; I doubt that there is any overlap between the consumption basket of a high-flyer in Manhattan and that of someone on government relief in upstate New York.) The inflation of prices in the high end consumption basket will be enough to impart an inflationary bias to the economy, despite the slack in the low-wage labour markets. Although oil prices were a factor, this mechanism was a key factor behind the "stagflation" of the 1970s.

Monetary Policy - An Even Blunter Tool

To return to the subject of Brad DeLong's article, monetary policy is an even blunter tool to influence job growth. Increasing aggregate demand broadly may just create jobs overseas, or put even more demand pressures on the sectors that are already running near capacity ("high pressure"). The lack of targeting makes it even more likely that inflation will rise before there is significant job creation in the "low pressure" industries.

Concluding Remarks

Broadly speaking, the only way out of the current malaise is to hope that a new bubble inflates large enough to drag along disadvantaged workers for the ride (at least until the bubble pops), or "to take the labor force as it is" (as Minsky wrote) and create jobs correspondingly. My reading of the tea leaves is that neither is an immediate possibility, and so I will be writing about malaise for a considerable period.