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Sunday, December 7, 2014

Fiscal Policy Links

Some comments on a couple of few good recent articles on fiscal policy.

Simon Wren-Lewis: Government Debt And Dead Parrots

Professor Simon Wren-Lewis' article "Government debt, financial markets and dead parrotscovers similar ground to my last article on the JGB market, but with a European perspective.

He discussed the possibility of "rollover risk":

Second, you need to worry about forced default, where the government is unable to ‘roll over’ (refinance) its existing debt, because the market will no longer lend to it. ... The second risk [rollover risk - BR] admits the possibility of a self-fulfilling crisis: default occurs because the market believes default will happen, even if the government actually has no intention to default and can continue to pay the interest on its debt.
This is where your own central bank is very useful. It eliminates this second type of risk, because it acts like a lender of last resort, buying any debt the government cannot refinance through the markets. This is what the ECB [European Central Bank - BR] refused to do until its OMT programme in September 2012.
In my article, I said that 'rollover risk' just represents incompetence by the central bank, and has little to do with government finances. In the case of the ECB, it is hard to say whether their inaction was incompetence, malevolence, or bureaucrats following treaty rules to the letter. I am not an expert on European law, so I have no answer to that question. To an external observer, an incompetent ECB is indistinguishable from an ECB hamstrung by incompetently drafted treaty documents.

I should note that I believe that I disagree with Wren-Lewis' framework for analysing fiscal policy (I have discussed one of his contributions on 'optimal fiscal policy' here). In my view, his modelling is a step in a more realistic direction, but it still embeds questionable assumptions from standard DSGE modelling frameworks. I have my doubts about how he defines "sustainability" for government finances. Despite these theoretical differences, I think we have similar policy views.

And yes, the dead parrot referred to is from the Monty Python "Dead Parrot Sketch".

JW Mason: 4 Questions About Fiscal Policy

In the article "Four Questions About Fiscal Policy", J.W. Mason summarises what he presented at a round table discussion on Functional Finance at the 12th Post-Keynesian Conference in Kansas City.

His remarks [NOTE: I have formatted the questions here in point form to make the text easier to follow.]:

It’s not productive to repeat points on which we all agree. So instead, I want to pose four questions about functional finance on which there is not a consensus. These aren’t questions I necessarily have (or expect to hear) good answers to at the moment, but ones that I hope will be the focus of future work.
  • First, the political economy question. Why does the idea of a government financial constraint have such a tenacious hold on both the policy conversation and the economics profession? What function, what interest, does this idea serve? 
  • Second, how confident are we about the level of aggregate expenditure that policy should target? Is there a well-defined level of potential output that corresponds to both full employment and price stability? 
  • Third, what is the problem that we imagine fiscal policy to be solving? Is it stabilizing of output in the face of “shocks” of some kind, or is it adjusting the long term trend? And what are the sources for the variation in private demand to which policy must respond? 
  • Finally, if functional finance means that fiscal policy replaces monetary policy as the main tool for managing aggregate expenditure, what role does that leave for the interest rate?
I do not have the answers to these questions. My bias is that it is very difficult for policy to smooth out the business cycle (which is a way of dodging the questions). The business cycle is driven mainly by private investment, and private investment depends on volatile expectations and bubbles ('animal spirits'). If you want to stabilise activity, you have to time the shifts in expectations accurately. (If you could do that, investing would be quite easy. Although investors can often diagnose bubbles, they typically have to wait a long time before they are vindicated.) Policymakers could attempt to dampen volatility in private sector investment. Although an interesting possibility, how this would be structured in the current political environment is not clear to me.

Instead, my preference is for a robust welfare state to protect workers from the business cycle (with something like the Modern Monetary Theory 'Job Guarantee'). Businesses would still fall victim to recessions. Policymakers are free to attempt to further attenuate the business cycle with active fiscal and monetary policy, but realistically, the policies would most likely constitute a lagged reaction to events (such as what happened after the financial crisis).

Alex Little: Smaller State ≠ Smaller Deficit

[Update: Added this.] Alex Little points out that there is little relationship between the size of government and the size of deficits in "Smaller state ≠ smaller deficit".

He notes,
This doesn’t make a lot of sense to me however, because lower government spending as a proportion of GDP does not mean the deficit would be lower. You can just as easily have a 5% deficit with government spending 50% of GDP as you could if they were only spending 35%. The two just aren’t related. For example, Denmark’s government spends about 57% or GDP, but has a budget deficit below 1%. The US government on the other hand spends about 40% of GDP, but has a deficit of over 5%.
The conflation between the two concepts is political.

It should be noted that the lack of relationship follows from stock-flow norms (as discussed here). Net savings desires in the private sector are not dependent upon the size of the government, and deficits are related to those savings desires.

However, there are limits to the argument. If you have an extremely small government (such as the United States before the Great Depression) where the government is about 5% of GDP, it is difficult to reach a deficit of 8% of GDP (which was common after the recent financial crisis). But as Hyman Minsky argued, such a small government has a hard time to stabilise economic activity. He argued that the government needs to be at least 20% of GDP in order to dampen the business cycle..

(c) Brian Romanchuk 2014


  1. This is a good response. I even think you undersell your position a bit. A job guarantee (or basic income, etc.) would not just shelter workers from the business cycle, it would help dampen the cycle. Because it would reduce the reductions in consumption by liquidity-constrained households that are the biggest part of the fall in demand during downturns. (I'm sure you realize this, just spelling it out.)

    I'm also glad to see you citing Minsky on the stabilizing effect of big G. This side of his thought seems to be much less familiar to people than the financial instability hypothesis.

    1. Yes, it would dampen the cycle, like other welfare state programmes. But it would not be enough to 'abolish the business cycle', (which some of the "Great Moderation" propaganda seemed to imply).

      The financial instability work is probably the most interesting for those who are in finance, and has the coolest terms ('hedge finance', 'Ponzi unit'!) and so it catches most of the attention. I assume it is his most 'Minsky-an' work. But I find a lot more of his work very useful, like his comments on the size of the state, and his analysis of the labour market (some of which led to the Job Guarantee).


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