Unpleasant Fiscal Dominance?
Paul Krugman appears confused:
Paul Krugman: Chris and the Ricardianoids:
Here’s [Chris] Sims on fiscal policy:
Fiscal expansion can replace ineffective monetary policy at the zero lower bound, but fiscal expansion is not the same thing as deficit finance. It requires deficits aimed at, and conditioned on, generating inflation. The deficits must be seen as financed by future inflation, not future taxes or spending cuts…
I think he’s saying that fiscal expansion works only if it leads to a rise in expected inflation…. [That] is certainly something I’ve heard from helicopter money types, who warn that something like Ricardian equivalence will undermine fiscal expansion unless it’s money-financed. But this is a misunderstanding of Ricardian equivalence, on two levels. First, as I’ve tried repeatedly to explain, a TEMPORARY increase in government purchases of goods and services will NOT be offset by expectations of future taxes even if full Ricardian equivalence holds. The kind of argument people like Robert Lucas made sounded Ricardian, but wasn’t–it was Ricardianoid. Second, less relevant to Sims but very relevant to other helicopter people, a deficit ultimately financed by inflation is just as much of a burden on households as one ultimately financed by ordinary taxes, because inflation is a kind of tax on money holders. From a Ricardian point of view, there’s no difference. So I’m trying to figure out exactly what Sims is saying…
As I understand where Sims and company are coming from, they are working in a model in which there are no government purchases. Or perhaps government purchases are useless, and so are not part of “true” real GDP. But in any event, either there is no difference between government purchases and tax cuts–hence no balanced-budget multiplier–or fiscal policy consists entirely of changes in taxes and transfers.
They are also working in a model in which total spending is given by something like:
C = C(r, W)
where W is the real wealth of the representative agent, and r is the real interest rate. The more wealth the more spending. The lower the real interest rate, the more spending.
The real interest rate is the difference between the nominal interest rate i and the inflation rate π:
r = i – π
And the economy is in a liquidity trap with i=0.
Now as I understand Sims, W is given by something like:
W = Y/r – T/(r + ρ)
where Y is the flow of income, T is the flow of taxes, and ρ is some sort of risk premium–that the finances of the government will become unstable and the government will not manage to collect its taxes.
Then the only ways fiscal policy can affect spending and output now are if:
- deficits raise expectations of money-printing and so raise inflation π.
- deficits raise expectations of future fiscal collapse and so increase current wealth by increasing the rate at which future tax liabilities are discounted.
And as I understand Sims, quantitative easing is counterproductive: it reduces the risk premium ρ, and so raises the present value of future tax liabilities and so reduces household wealth without doing anything to alter the real interest rate.
I think this is what is going on.
Is this a consistent model? I am not sure. Is this the model that Chris Sims has in mind that lies behind his talk? I am not sure. Is this the right model for the questions at hand? I am pretty sure it is not one of the first five models I would write does as most relevant.
Cf.: Gavyn Davies: Sims highlights fiscal dominance at Jackson Hole