Is there a case for a further co-ordinated global fiscal stimulus? Part 4 & ultima

(VI) Will a fiscal stimulus work as effectively when the economy has been hit by a credit crunch?

The credit crunch is now hitting the non-financial enterprise sector hard.  How does a fiscal boost affect demand when the enterprise sector is credit-constrained?  If the constraints are tight enough, they will weaken and may even completely neutralise the effect of a fiscal stimulus on output and employment not (just) because of financial crowding out of consumer and business demand, but because of credit constraints on supply, what Alan Blinder (1987) has called effective supply failure.  This is most easily seen if production is subject to a lag (inputs go in before saleable output comes out).  This means that firms need working capital to get production going.  Increased demand can be met from inventories, and that may provide some working capital, but once inventories have been worked off, the credit constraint on production and employment becomes binding.

The notion that a credit crunch could lead to effective supply constraints being binding in the market for goods and services, even if demand is depressed, was first developed by the South-American structuralist school of Raul Prebisch and Celso Furtado, and its neo-Structuralist successors (e.g. Lance Taylor and Domingo Cavallo (1977)), although its antecedents go back much further to the Austrian school of Hayek, Mises and to Marx.

The “Austrian” or working capital supply side model of the supply side was introduced into mainstream macroeconomic analysis by Alan Blinder (1987), but it has not become part of the standard professional tool set (for a non-technical description, see Buiter (2008)).  I believe that the Great Credit Crunch of the Noughties will demonstrate its usefulness, because of its key assumption that production cannot take place without credit.  A severe contraction in economic activity induced by a credit crunch could, if effective supply contracts even faster than effective demand, lead to greater upward pressure on prices or inflation than would be inferred by considering the output gap defined not as the gap between effective demand and effective supply, but instead between effective demand and notional supply.  Notional supply or potential output, which is determined by the available physical resources of capital, land and labour and is independent, in the short run, of the cost and availability of credit.[1]

Proposition 8: Because production takes time, working capital is essential for effective supply, even in the short run.  Policies to provide credit to the non-financial enterprise sector may therefore be a precondition for expansionary fiscal policy to have any material demand on production and employment. Qualitative easing or credit easing are therefore likely to be complementary to fiscal policy in economies badly affected by a credit squeeze.

(VII) Neoclassical fiscal measures

Keynesians believe in the power of (current) income effects on spending.  Neoclassical economists believe in the power of the intertemporal substitution effect.  Why not use both when there is no additional price tag attached to the Neoclassical effect?

A temporary VAT cut

I believe the temporary VAT cut introduced in the UK by Chancellor Darling last year (2.5% down now to 15%, up 20% after 13 months), and which was given such as hard time by many observers, made sense.  In principle, twisting the intertemporal terms of trade like that causes consumers to switch their expenditures (especially on durables) to the temporarily low tax period.  It so happened that the fierce price wars that were going on at the time may have drowned out these relative minor cuts, but apart from that (and apart from the menu costs inflicted on restaurants and shopkeepers), this was not a stupid idea.  Perhaps a cut to 10 % for a shorter period would have had more impact on the cognitively challenged, but the principle of using the substitution effect where it reinforces the income effect is surely correct.

A temporary investment tax credit/subsidy

Provided there is no binding external finance constraint on investment, a temporary investment tax credit or investment subsidy could be an effective means of shifting investment towards the present.  The budgetary cost of such measures (which target just the flow of new investment) is much lower, for a given effect on investment demand, than that of measures that target the flow of new investment indirectly by giving a boost to owners of existing capital as well as those considering investing in new capital.  A cut in corporation tax or in the capital gains tax would be examples of such inefficient measures, from the point of view of maximum investment demand impact per dollar of government tax revenue lost..

(VIII) Further unconventional measures to increase fiscal policy effectiveness

(VIIIA) Turning unsecured bank debt into equity.

Too little capital and excessive debt are limiting the ability and willingness of banks to lend to households and to the non-financial private sector.  Credit constraints on supply and demand limit the effectiveness of fiscal policy.  An obvious solution would be mandatory conversions of unsecured bank debt into equity.  An appropriate special resolution regime (SRR) for banks and other systemically important highly leveraged institutions with asset-liability mismatch as regards maturity, liquidity (and possibly currency denomination) could turn unsecured bank creditors into shareholders and could thus recapitalise banks to the point that they fulfil their designated function again of intermediating between financial deficit and financial surplus units in the economy, without dipping into the pockets of the taxpayers.

(VIIIB) Turning household mortgage debt into equity claims of the banks

A household whose income is reduced through unemployment, short-time working or other negative labour market developments is at risk of losing his homes through repossession by the mortgage lender – a process that involves serious real resource costs (estimated at as much as $50,000 per repossession) and considerable deleterious neighbourhood effects.  If there is negative equity, the bank also makes a loss, especially if the mortgage is non-recourse.  Even if the household does not lose its home, the cost of meeting the mortgage obligations can force a sharp reduction in private consumption demand.

It clearly makes sense to convert distressed conventional mortgages into equity-type instruments, where the lender, in return for partial debt forgiveness, gets a stake in any future upside for the value of the house.  Indeed, mortgages could be designed right from the start along ‘Islamic mortgage’ lines, where the bank starts off as the sole owner of the house and the ‘borrower’ pays a rental to the bank and regularly purchases from the bank additional shares in the equity of the house.  If the ‘borrower’ has trouble meeting the terms of the original mortgage, some of the equity already acquired by the ‘borrower’ reverts to the bank.  This form of risk- and profit sharing seems preferable to the debt contracts that characterise most conventional mortgages.  Such equitization of mortgages could reduce the likelihood and severity of Minsky neutrality emasculating fiscal policy in an economy with highly indebted households.

(VIIIC) Turning public debt into public equity

Finally, I would propose that instead of issuing traditional government fixed or variable interest debt instruments (including index-linked instruments), governments instead issue real-GDP-growth-contingent bonds. These instruments are not new.  GDP growth warrants were issued by Argentina following their most recent external debt default in 2002.

As a simple example, government debt could be of the fixed nominal value, variable interest rate type where the interest rate equals the growth rate of nominal GDP plus some constant.  Provided the real GDP and GDP deflator data cannot be manipulated by the borrowing authorities, and provided a rule is devised for handling GDP revisions, this would reduce real interest rates on the public debt when real GDP growth and/or inflation were low.  Should nominal GDP growth go negative (by an amount greater than the constant in the interest rate formula), this would be handled as a reduction in the amount of debt outstanding, so negative interest rates would not be a problem.  GDP growth-contingent bonds are probably the closest we can get to ‘equity in a nation’.  And turning public debt into public equity would be a major enhancement of the policy arsenal of governments in the current phase of the global cycle. This equitization of the public debt would reduce the real burden of debt financing when it is needed most, during a downturn and when deflation threatens.


The rapid deterioration of the public finances of many countries (as measured both by the public debt to GDP ratio and the public sector deficit as a share of GDP) presents a formidable obstacle to any additional use of fiscal stimuli to boost demand, where these fiscal measures would result in even larger deficits.  There are a number of ways to relax these constraints.  One is to have recourse to monetary financing.  This can help, provided the authorities can make it credible that they have enough fiscal spare capacity to reverse this quantitative easing in the future, when the output gap closes and the large injections of central bank liquidity would become inflationary.

A second approach is to use balanced-budget fiscal measures, both Keynesian and Neo-classical, to boost demand.

The third is to shift the political equilibrium of the country to boost fiscal spare capacity.  If President Obama can shift the destructive, polarised US political equilibrium, where Republicans veto all future tax increases and Democrats veto all future public spending cuts, there could be room for an additional fiscal stimulus that would not spook the financial markets.


Blanchard, Olivier and Roberto Perotti (2002), “An empirical characterization of the dynamic effects of changes in government spending,” Quarterly Journal of Economics (2002), pp. 1329‐1368.

Blinder, Alan S. (1987), “Credit Rationing and Effective Supply Failures,” The Economic Journal, Vol. 97, No. 386, June 1987, pp. 327-352.

Buiter, Willem H. (2009), “Negative Nominal Interest Rates; three ways to overcome the zero lower bound”, Paper presented Center for Financial Studies at the Goethe University, Frankfurt on 6th May 2009, at the European Central Bank on 18th May 2009, and at the 13th International Conference on Macroeconomic Analysis and International Finance at the University Campus of the University of Crete in Retymno Crete, May 28-30, 2009.

Cogan, John F., Tobias Cwik, John B. Taylor and Volker Wieland (2009), New Keynesian versus Old Keynesian Government Spending Multipliers,

Carroll, Christopher D. (1992). “The Buffer-Stock Theory of Saving: Some Macroeconomic Evidence.” Brookings Papers on Economic Activity no. 2: 61-156.

Carroll, Christopher D. (1997), “Buffer Stock Saving and the Life Cycle / Permanent Income Hypothesis’. Quarterly Journal of Economics, CXII no., 1: 3-55.

Deaton, Angus (1991), “Saving and Liquidity Constraints”, Econometrica 59(5), 1221-48.

Favero C.A. and F.Giavazzi (2009] “How Large are the Effects of Tax Changes?” CEPR Discussion Paper 7439.

Ilzetzki, Ethan, Enrique Mendoza and Carlos A. Vegh (2009), “How big (small?) are fiscal multipliers?”

Kimball, Miles S. (1990), “Precautionary saving in the small and in the large”, Econometrica,

Minsky, Hyman (2008), (2008) Stabilizing an Unstable Economy, McGraw-Hill Professional

Mountford, Andrew and H. Uhlig (2002). “What Are the Effects of Fiscal Policy Shocks?” CEPR Discussion Paper 3338.

Perotti, Roberto, (2004), “Estimating the effects of fiscal policy in OECD countries,” mimeo (Bocconi University, 2004).

Perotti, Roberto (2008). “In Search of the Transmission Mechanism of Fiscal policy“; NBER Macroeconomic Annual.

Romer, Christina, and Jared Bernstein (2009), “The job impact of the American recovery and reinvestment plan,” Council of Economic Advisers (January).

Romer, Christina and David H. Romer (forthcoming, 2009). The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks“, American Economic Review.

Spilimbergo, Antonio, Steve Symansky, Olivier Blanchard, and Carlo Cottarelli (2008), Fiscal Policy for the Crisis, IMF Staff Position Note, December 29.

[1] In the long run, the physical capital stock is endogenous and is therefore affected by the cost and availability of finance.  Working capital can affect effective supply at much shorter horizons, of months or quarters.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website