Simon-Wren Lewis Is Puzzled by Economists and Monetary Policymakers Calling for More Contractionary Monetary and More Contractionary Fiscal Policy: Tuesday Focus: January 28, 2014

He is puzzled. And so am I…

Simon Wren-Lewis: Mainly Macro: Bullard on the ‘Death of a Theory’:

James Bullard, President of the St. Louis Fed… kindly sent me his article (pdf) entitled ‘Death of a Theory’… the theory he is referring to is the idea of fiscal stimulus at the Zero Lower Bound (ZLB)…. I… think the article reflects the views of many economists. For these reasons, I thought it would be useful to say why I disagree…. Bullard gives three reasons why “Fiscal policy should return to being set for the medium and longer run.” They are that:

1. Actual political systems are ill-suited to implement the advice from the theory.
2. Monetary stabilization policy has been quite effective [at the ZLB], making fiscal experiments redundant.
3. Governments pushed distortionary taxes into the future, which in the theory reduces or eliminates the desired effects.

Let me take each in reverse order….

I have argued that we should focus on what I call a ‘pure’ countercyclical increase in government spending, where the additional current spending today is financed by reduced spending (not higher taxes) in the future…. So criticism (iii) is specific to one particular form of countercyclical fiscal policy [but not to my proposal.

Point (ii) is generic. However we need to be careful about what is being claimed here. Does ‘quite effective’ mean has some effect, or does it mean as effective as conventional policy? I agree with the former, but not the latter. Nor do I think Bullard tries to claim the latter. Yet the latter is what you need if you want to assert that fiscal policy is unnecessary, because fiscal policy is unnecessary only when it is dominated by monetary action. By “dominated” I mean that monetary policy can do everything that fiscal policy can do, but with more certainty and at less cost. I know of no reason why this should be true for unconventional monetary policy…. But we do not need to get into theory here. We just need to look at what has happened since 2008, and what is still happening in the Eurozone. There are three possible explanations for the deep and prolonged recession:

1. Monetary policymakers have been particularly inept.
2. Monetary policy makers have succeeded in finding the optimal combination of inflation and output, so the recession was just an unfortunate consequence of an inflationary shock.
3. The ZLB has created limitations to what monetary policymakers can do.

I do not agree with (1). I suspect the only people who believe (2) are central bankers.

I find the first of Bullard’s criticisms the most perplexing…. What we are talking about today is a very large and prolonged recession. The fiscal actions that are required are not fine-tuning…. Now perhaps ‘ill-suited’ is code for ‘many politicians dislike this policy’. But if it is, then you do not talk about the ‘death of a theory’, but instead you discuss the political problems of implementing a theory….

We have had cuts in government spending in varying degrees across countries, and where the cuts have been largest, the recession has been more severe. That is the ‘dying theory’ working, and politicians for whatever reason choosing to go against it. What worries me about the ‘monetary policy is still all you need’ line is that (to put it most politely) it encourages these misguided policy actions. That is not good for most people in the economy, but it also does monetary policymakers no good either, because they promise too much.

I find this particularly puzzling given that Bullard is not saying that (a) fiscal policy should be carried out on “classical” terms and (b) central banks need to do more to restore nominal GDP to something closer to its pre-2008 growth path. Instead, he seems to be saying that we need (a) more contractionary fiscal policy, as well as (b) more contractionary monetary policy to guard against risks–vague risks–of central-bank overextension.

I can understand advocates of more aggressive and expansionary monetary policy saying that it is time for governments to step back from expansionary fiscal policy–I disagree with them, but I can understand them. But I find that I am not understanding James Bullard.