(IV). When does a fiscal stimulus boost aggregate demand?

A fiscal stimulus is a key weapon in the policy arsenal used to address an undesirable weakening of aggregate demand.  For the policy to make sense, either an increase in public spending on goods and services (public consumption or investment) or a tax cut (an increase in transfer payments) must raise aggregate demand at a given price level, wage, interest rates, exchange rates and other asset prices.  In the textbook IS-LM model this means that the fiscal measure shifts the IS curve to the right in output - interest rate space - there is no full direct crowding out, Ricardian equivalence or Minsky equivalence.

We may still not get any effect on output and employment, even if the IS curve shifts to the right, either because there could be ‘financial crowding out’ through higher interest rates, lower asset prices or a stronger exchange rate or because there is ‘real crowding out’ through scare real resources on the supply side; real crowding out or ‘factor market crowding out’ occurs through rising real wages and other real factor costs, and through rising inflationary pressures.

But unless the fiscal stimulus shifts the IS curve to the right, it achieves nothing at all - we don’t even have to investigate whether there is financial or real crowding out. Continue reading "Is there a case for a further co-ordinated global fiscal stimulus? Part 3"

(III) Fiscal policy

With monetary policy, both conventional and unconventional, having reached the limits of its effectiveness in most of the advanced industrial countries, the only instrument left for boosting demand is fiscal policy.  By this I mean, until further notice) a cut in taxes or an increase in public spending financed either by borrowing from the public (domestic or foreign) or by borrowing from the central bank, that is, by creating base money.

Like all debt, public debt is both a wonderful and a dangerous social invention.  It permits individuals and groups of individuals, including nations, to smooth consumption over time - it permits saving to be de-coupled from investment.  In what follows it will be important not to use the word ‘debt’ as equivalent to ‘financial instrument’ or ‘financial claim’.  Equity and other profit-, loss- and risk-sharing instruments also permit the de-coupling of saving and investment and the smoothing of consumption over time and across generations.  When I refer to debt, it is narrowly defined as a financial instrument imposing fixed, non-contingent payment obligations on the borrower. Borrowing in this narrow sense creates a legal obligation to repay the debt with interest at some future date. Continue reading "Is there a case for a further co-ordinated global fiscal stimulus? Part 2"

On September 16 and 17, the Earth Institute at Columbia University (well, at least it’s not called the Universe Institute) and the Asian Development Bank organised a conference at Columbia University on The Future of the Global Reserve System.  Papers were presented by the members of the Asian Development Bank’s International Monetary Advisory Group (IMAG), of which I am one (the other members are Prof. Jeffrey Sachs, Dr. Nirupam Bajpai, Dr. Maria Socorro G. Bautista, Prof. Barry Eichengreen, Dr. Masahiro Kawai, Prof. Felipe Larrain, Prof. Joseph Stiglitz, Prof. Charles Wyplosz, Dr. Yu Yongding).

The paper “Is there a case for a further co-ordinated global fiscal stimulus” is my take on the subject assigned to me for the New York conference: “Are the coordinated stimulus plans working and are they effective? Should we continue with fiscal stimulus? Are there other approaches to aggregate demand management?”

I will publish the paper in this blog in two or three installments, as I revise the initial draft.  Installment one follows below.

Introduction

For further internationally co-ordinated expansionary fiscal policy measures to be desirable today, a number of conditions must be satisfied.

First, there must be idle resources - involuntary unemployment of labour and unwanted excess capacity.  Output and employment must be demand-constrained.

Second, there must be no more effective way of stimulating demand, say through expansionary monetary policy.

Third, expansionary fiscal policy must not drive up interest rates, either by raising the risk-free real interest rate or by raising the sovereign default risk premium, to such an extent that the fiscal stimulus is emasculated through financial crowding out.

Fourth, at given interest rates, the expansionary fiscal policy measures are not neutralised by direct crowding out (the displacement of private spending by public spending or of public dissaving by private saving at given present and future interest rates, prices and activity levels).  Such direct crowding out can occur in the case of tax cuts (strictly speaking, cuts in lump-sum taxes matched by future increases in lump-sum taxes of equal present discounted value) because of Ricardian equivalence/debt neutrality.  In economies with very highly indebted households, debt neutrality can occur when taxes on households are cut, because of what I shall call “Minsky equivalence” (see Minsky (2008)).  Increases in public spending on real goods and services (”exhaustive” public spending) can fail to boost aggregate demand because of a high degree of substitutability (in the utility functions or the production technology) between private consumption and investment on the one hand and public consumption and investment on the other.

Fifth, there must be cross-border externalities from expansionary fiscal policies that cause decentralised, uncoordinated national fiscal expansions to be suboptimal.

This paper will consider these issues in turn.  After reaching some fairly discouraging conclusions on the scope for further conventional expansionary fiscal policy now, unless there are significant political realignments in fiscally challenged nations that support coalitions in favour of significant future fiscal tightening through tax increases or public spending cuts, I briefly outline some unconventional fiscal/financial policies that may be effective in their own right and may help to enhance the effectiveness of conventional expansionary fiscal policy.  Collectively, they can be characterised as the equitization of debt - household mortgage debt, bank debt and public debt. Continue reading "Is there a case for a further co-ordinated global fiscal stimulus? Part 1"

Until yesterday’s defeat of Roger Federer in the final of the US Open at Flushing Meadows, the most disappointing development this year was the performance of president Barack Obama and his administration - and my expectations were modest to begin with. Continue reading "Expect little and you may yet be disappointed"

Lord Turner, chairman of the UK’s Financial Services Authority, has set the cat among the financial pigeons by making highly critical comments about the City of London and financial intermediation in general. He recommended some drastic remedies, and suggested considering a global tax on financial transactions – a generalised Tobin tax. James Tobin proposed a tax on foreign exchange transactions to stabilise floating exchange rates and achieve greater national monetary policy autonomy in a world of increasing financial integration.

The Tobin tax was never implemented, which is just as well from the perspective of its declared objectives: it could have increased exchange rate instability and was unlikely materially to enhance national monetary policy autonomy. From a political perspective, it may be more surprising that it was never implemented. Even at a very low rate, the Tobin tax could have been a massive government revenue raiser. Distortionary taxes that raise large revenues, including transaction taxes on financial and real assets – such as the UK’s stamp duty on property – are, after all, a common feature of the political landscape.

What problem would a Tobin tax on financial transactions solve? Lord Turner asserts, in an interview with Prospect magazine, that the UK financial sector has grown too big; that some financial sector activity is worthless from a social perspective; that the sector is destabilising the British economy; and that new taxes may be required to curb excessive profits and pay in the sector. “If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector or apply special taxes to its pre-remuneration profit,” he says. Even if all these assertions are correct, they do not imply the need for a Tobin tax.

Continue reading “Forget Tobin tax: there is a better way to curb finance”

Central bank governors should serve one non-renewable term

Central bank governors should be appointed for one fixed, non-renewable term.  The ECB got that one right.  Members of the Board, including the President, serve for one, non-renewable eight-year term.  The Bank of England’s arrangements are deficient in this regard.  The governor is appointed for a five-year term but can be re-appointed as many times as the Chancellor of the Exchequer sees fit.

The Fed’s arrangements for appointments to the Board are also flawed. From the Fed’s website, Board appointments following the following set of rules: “The Board is composed of seven members, who are appointed by the President of the United States and confirmed by the U.S. Senate. The full term of a Board member is fourteen years, …. After serving a full term, a Board member may not be reappointed. …

The Chairman and the Vice Chairman of the Board are also appointed by the President and confirmed by the Senate. The nominees to these posts must already be members of the Board or must be simultaneously appointed to the Board. The terms for these positions are four years.”

The chairman of the Federal Reserve Board can therefore at most serve three consecutive full terms as chairman, followed by one two-year term.  This would exhaust the maximum 14 year stint on the Board. [Addition on 29th July 2009: a reader of this blog (yes, I still have some) writes: "If a Board member is initially appointed to fill the remaining term of a member who has departed early, he can then be reappointed for a full term.  So, potentially, one could serve almost 28 years, and be chairman the whole time." ]

Why is the possibility of re-appointing the chairman of the Fed, and indeed the re-appointment of the governor of any central bank, a bad thing?  Clearly, it undermines the appearance and possibly the substance of independence of the chairman.  The incentive to suck up to/please the power(s) that can reappoint you may be difficult to resist.  It is not necessarily the case that the actions and policies most likely to secure the re-appointment of the chairman are the actions and policies that are best from the perspective of the central bank’s mandate - price stability or macroeconomic stability, and financial stability. Continue reading "Should Fed chairmen go around kissing babies?"

The problem

Further expansionary monetary policy has become rather ineffective in the overdeveloped world because banks are capital-constrained rather than liquidity-constrained and because liquidity spreads in financial markets that bypass the banks have shrunk remarkably.  Remaining spreads between sovereign debt instruments and assorted private securities of similar maturities can now be rationalised quite easily as reflecting just differential default risk.  Until the banks get significantly more capital on their balance sheets, quantitative easing, credit easing and enhanced credit support are examples of pushing on a string.

The banks will take the liquidity offered and redeposit the bulk of it with the central bank again rather than lending it to the private sector or purchasing more risk financial instruments.  Low official policy rates (and the expectation of the official policy rate being kept at a low level for a further significant period of time) will help recapitalise the banks.  So will the quasi-fiscal subsidies most central banks have been channelling into the banking system through the favourable terms offered by the central banks to the private banks in their transactions, facilities etc., but such gradual recapitalisation through wide margins on low volumes of lending is slow and could lead to a re-run of Japan’s lost decade for much of the G7.

Further expansionary fiscal policy is likely to be ineffective in most of the G7 countries (possibly excepting Germany and Canada).  This is, first,  because households are short of capital and overly indebted and, second, because any further increase in short-term fiscal deficits is likely to undermine confidence in the sustainability of the fiscal-financial-monetary programme of the state.  Continue reading "Islamic finance principles to restore policy effectiveness"

Today’s guest blogger is Elena Panaritis,  an expert in property rights, creating markets in illiquid real estate assets, and public sector management.  She is also the author of Prosperity Unbound; Building Property Markets with Trust, which is definitely not one of those odious get-rich-quick-in-real-estate-without-capital-brains-or-effort books.  Instead it is a get real book for social entrepreneurs about how to turn real estate possessions into socially productive, and indeed also privately profitable, capital.

This Crisis Demands Non-Traditional Solutions to Get to a Path of Quick Recovery

By Elena Panaritis

Two years after it began, there is now a coalescing of opinion about the causes of the U.S. financial crisis and what should be done to resolve it, yet there is a serious element missing both in the causation analysis as well as in the prescriptive solution. This crisis, which has infected the global economy so severely, is very much a non-traditional one that calls for a non-traditional solution. The impact in the United States so far has been worse than anything since the Great Depression: unemployment reached 9.5 percent in June, up from 7.8 percent in January, home prices were down 27% at the end of the first quarter from their 2006 peak, and 1.5 million homes were in foreclosure.  After jumping by 30 percent in February, home foreclosure rates tapered off but are again on the rise. According to the New York Times, the loss in property value could total $500 billion. Continue reading "The real estate roots of the crisis in the US"