Duncan’s Economic Blog

Some Thoughts on Fiscal Policy

Posted in Uncategorized by duncanseconomicblog on August 2, 2010

(I’ve been promising Paul some thoughts on Modern Monetary Theory ( MMT)  for about a week now, I started writing it up this weekend and realised I was actually writing about two different things – MMT and fiscal policy, so I’ve split the post into two – this is on fiscal policy and more specifically on MMT will follow).

In a comment over at Don Paskini’s last week, Paul wrote that we should focus on “enlightened fiscal policy (post-Keynesian) and leave monetary policy as the sideshow that it is”.  

That kind of comment makes me a little uneasy, because as much as I think cutting the deficit now will be unproductive and dangerous – I don’t have that much faith in fiscal policy as a tool alone.

What really worries me about MMT is comments such as this from Warren Mosler, a doyen of MMT,  (emphasis all mine):

UK News – GDP Stronger than Expected

As expected, boom time for now as the massive deficit spending raised savings and incomes, recharging consumer batteries, and supply the financial equity to fuel the subsequent expansion.
Look for rate hikes to add gasoline to the fire as well.
The risk of slowing from fiscal tightening is way down the road.
In fact, it’s usually the automatic stabilizers that tighten things sufficiently to throw the economy into reverse.
Again, years down the road.

I’d bet all the money in my wallet (a grand total of £13.45p it seems), that now is not “boom time” for the UK economy. Leaving aside that most of the “massive deficit spending” was actually a fall in tax revenues (much of it related to property and finance) rather than a stimulus as such and leave aside that Osborne is planning to try and close this deficit anyway – on what level does this analysis actually work?

Is any deficit large enough likely to bring about “boom time”?  

I think at this point we need start considering multipliers and the power of fiscal policy.

Simply put the fiscal multiplier is the relationship between changes in government spending and taxes and changes in economic output.

This long-ish post from Chris Giles over at the FT, runs through the issues in a good amount of detail.

If the multiplier was zero then changes in taxes and spending would have no effect on the economy, if the multiplier was negative then less government spending will lead to faster growth.

The FT summarised the different possible assumptions as follows (my emphasis):

Zero: This is the cop out assumption that fiscal policy has no effect on the economy. It means the growth forecast will be unaltered whatever you do to taxation and public spending. It is not necessarily wrong, as is evident in this rather nice and simple academic paper on the VoxEU.org website. But to say the multiplier is zero at a time of significant impairment of monetary policy and weakness in Britain’s main export market is a strong assumption.

Negative: This is the assumption that sorting out Britain’s fiscal mess will so improve confidence in the economy that growth will be faster than previously thought and borrowing even lower as a result. If the OBR choose a negative multiplier, the Office will give George Osborne the perfect honeymoon gift. In a rather cynical Britain, the OBR would need some quite powerful evidence if it were to go down this route, as it would smack of the OBR having been captured by its political master in its first outing.

Between zero and one: Here we are in “crowding out” territory. Fiscal tightening does impede growth, but cutting £1 of spending reduces gross domestic product by less than £1. This zone would be viewed as a pretty normal assumption for Britain, an open economy with a flexible exchange rate. It is where many economists would implicitly put themselves because they are very prone to talk about the fiscal headwinds to growth.

One: Assuming a multiple of one suggests that taking £1 of public spending out of the economy reduces  GDP also by £1. Such fiscal tightening would have quite a marked effect on growth and significant second round effects, implying more spending cuts and tax increases.

Greater than one: If we are in this zone, cutting the deficit is amplified into lower output and at some point a high multiplier implies that deficit reduction so damages growth as to worsen the budget deficit. This was Labour’s argument in the general election that did not convince the public. It was based on the assumption that the economy was too fragile now to take deficit reduction, not that the multiplier is always greater than one. Were Sir Alan Budd’s new OBR to take this assumption, it would represent a declaration of war on the Treasury and the new government. I think we can rule it out, but given that makes the OBR’s decision highly political.

The OBR in the budget set out the multipliers as follows:

Table C8: Estimates of fiscal multipliers

Impact multipliers

Change in VAT rate                                                                                                            0.35

Changes in the personal tax allowance and National Insurance Contributions (NICs)                                                                                                                                        0.3

AME welfare measures                                                                                                      0.6

Implied Resource Departmental Expenditure Limits (RDEL)                                                                                                                                     0.6

Implied Capital Departmental Expenditure Limits (CDEL)                                                                                                                                     1.0

To give this context the IMF (page 35 of this) in March 2009 gave its multiplier assumptions as:

The range of growth estimates reflects different assumptions on fiscal multipliers. The low set of multipliers included a multiplier of 0.3 on revenue, 0.5 on capital spending and 0.3 on other spending.

The high set of multipliers included a multiplier of 0.6 on revenue, 1.8 on capital spending and 1 for other spending.

In the US Moodys estimated (page 3 of this) multipliers as follows:

Tax Cuts

Nonrefundable Lump-Sum Tax Rebate                                1.02

Refundable Lump-Sum Tax Rebate                                     1.26

Temporary Tax Cuts

Payroll Tax Holiday                                                               1.29

Across the Board Tax Cut                                                     1.03

Accelerated Depreciation                                                      0.27

Permanent Tax Cuts

Extend Alternative Minimum Tax Patch                                 0.48

Make Bush Income Tax Cuts Permanent                              0.29

Make Dividend and Capital Gains Tax Cuts Permanent       0.37

Cut Corporate Tax Rate                                                        0.30

Spending Increases

Extend Unemployment Insurance Benefits                         1.64

Temporarily Increase Food Stamps                                    1.73

Issue General Aid to State Governments                            1.36

Increase Infrastructure Spending                                        1.59

As can been seen, above there are a range of estimates of different multipliers, to take two examples:

Capital spending: The OBR estimated the UK capital spending multiplier at 1.0. But in the US Moody’s estimated it as 1.59. The IMF suggests a range running from 0.5 to 1.8.

Welfare spending: The OBR estimates this multiplier 0.6. In the US estimates of similar measures were 1.64 and 1.73. The IMF suggests 0.3 to 1.0.

One thing leaps out – no matter which set of numbers one uses (IMF, OBR, Moodys) capital spending and transfers to those most in need (AME Welfare in the UK, food stamps, unemployment insurance, etc in the States) – have the highest multipliers.

Now, for what it’s worth I think the OBR multiplier numbers all look a little on the low side but I don’t think they are massively off. UK fiscal policy multipliers are lower than US numbers as we are a more open economy. Put more money in people’s hands (either through a tax cut or a benefit increase) and they’ll spend more of it on imports (which subtract from growth).

The overall lesson of this is – fiscal policy is not a panacea that can fix the economy. Cutting spending now will lead to lower growth and increase the risk of a double dip but this doesn’t mean fiscal policy can solve all of our problems, in the long run – especially in an open economy like the UK, monetary policy is far more important. As are other tools – industrial policy, skills policy, regional policy.

So Labour should be setting an economic policy that moves the debate well beyond the size of the deficit.


10 Responses

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  1. vimothy said, on August 4, 2010 at 12:15 pm

    Good to see this post. I think that this is an important and necessary debate. Labour and the left need to distinguish themselves from their “neoliberal” antecedants for both political and economic reasons. Opting for a radical MMT approach is certainly one way to do that.

    On the other hand, I kind of feel the same way about the fiscal multplier as I do about MMT–we don’t necessarily need it. I have always found the idea that there is a single stable objective and independent variable that determines the efficacy of fiscal policy to be rather silly. And even if we decompose, why should the multiplier for capital spending, say, stay the same at every level of aggregate income? Unemployment? Output gap? Capacity utilisation? Etc, etc?

    Maybe we should focus on the supply and demand for funds: why is the corporate sector retaining large amounts agg income as profits (equivalent to most of the deficit) rather than spending it and borrowing the household sector’s saving-flow…

    • duncanseconomicblog said, on August 4, 2010 at 1:00 pm


      I agree on the need for distinctive left political economy.

      And I agree to that multipliers will chnage over time depending on the factors you outline (as will the effectiveness of monetary policy).

      Your last point though is the crucial one… why are corporates saving not investing?

      • vimothy said, on August 4, 2010 at 1:06 pm

        “why are corporates saving not investing?”

        Wait, I know this… Obama!


      • vimothy said, on August 4, 2010 at 1:53 pm

        Less facetiously, I suggest that there are two different issues here: policy in response to the GFC; policy more generally.

        The later question is a lot more difficult to answer, IMO. I would like to see more focus on labour, progressive taxation, full employment, etc, and less on being like a more competent version of the Tories.

        For the former, Labour should focus on explaining the deficit in terms of the circular flow of funds and its origin in the corporate sector–from this perspective, the govt is simply borrowing back the money that corps won’t spend in order to return it to the income stream and prevent a deflationary spiral. If the Tories cut the deficit but corps continue to save, GDP will shrink instead. I think that this makes perfect sense. It’s not even that esoteric, especially compared with the alphabet soup of financial models, derivatives, ABS CDOs and whatever else that are now part of everyday conversation.

        Labour should also focus on correcting some of its errors. The stimulus was a bail-out for the banks and QE was only good for wealthy asset holders. The objects of government largesse should instead have been investment and labour intensive jobs (perhaps accompanied by capital injections). I particularly liked Schiller’s recent NYT op-ed in this vein:

        So here’s a proposal: Why not use government policy to directly create jobs — labor-intensive service jobs in fields like education, public health and safety, urban infrastructure maintenance, youth programs, elder care, conservation, arts and letters, and scientific research?


        Big new programs to create jobs need not be expensive. Suppose the cost of hiring a single employee were as high as $30,000 a year, several times typical AmeriCorps living allowances. Hiring a million people would cost $30 billion a year. That’s only 4 percent of the entire federal stimulus program, and 0.2 percent of the national debt.
        The later is a far harder question, IMO.

  2. warren mosler said, on August 4, 2010 at 12:37 pm

    good post!

    the net financial assets and income deficits add to the non govt sectors also constitute the financial equity and income that supports the private sector credit structure.

    so note how private sector debt ratios come down as deficits increase, and thereby serve to recharge consumer and corporate borrowing power.

    • duncanseconomicblog said, on August 4, 2010 at 12:58 pm

      Thanks Warren. I’#ve got a longer post on MMT on the way. I’d be interested in your views. For what’s it worth – I’m closer to Steve Keen than yourself in terms of monetary analysis, although I find the whole MMT idea very interesting.

  3. Daniel said, on August 5, 2010 at 1:37 pm

    In many cases lage spending cuts have lead to far better long term growth….(Canada and NZ best examples. Chile also a good example) whereas expanded deficit spending has left enconomies in a long term sub-trend path (Japan the best example).

    There is a level where the debt burden acts as a huge fiscal drag. The increase in UK debt is going to add 30bn to interest payments alone by 2015….that money is not recycled into the real economy.

    At best, the bailouts/deficit spending/stimuls packages are nothing really but a short term political filip. They are administrations’ attempts to delay the pain and the voter fallout that would ensue. Data looks terrible the world over, and there is a good chance of a double dip despite all the action that has been taken.

    Simply put, the problems in the world economic and financial systems is still there, and that problem was the asset bubbles created by continued credit expansion and the associated overspending in the western world tied with horrible trade balances. Until the pain is taken from these bubbles and imblanaces are some way reduced (lets hope, competatively) we are not going to see growth back on trend

  4. […] particular, he will build on the lessons from this post by Duncan Weldon, as well as the comments that follow (from Vimothy and Duncan) about the need to adopt radical […]

  5. […] particular, he will build on the lessons from this post by Duncan Weldon, as well as the comments that follow (from Vimothy and Duncan) about the need to adopt radical […]

  6. […] multipliers – which have been criticised as “a little on the low side“ – are contained in Table C8 of the June Budget. Our analysis shows that, using the […]

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