Fiscal multipliers at the zero bound in an open economy

Let’s continue our look at debates over UK fiscal adjustment.

Will fiscal policy work in an open economy? The standard view has

been that in a Mundell-Fleming model fiscal expansion appreciates

the exchange rate and hurts the trade balance, thus offsetting

the fiscal policy. The U.S. may be too closed an economy for this

to be a big deal, but for the UK it seems this might apply, at

least if one is operating within Keynesian frameworks.

The recent Keynesian response has cited the “lower bound” as a

reason why fiscal policy still may be effective in an open

economy. But what does this literature really show? Let’s take a

brief tour of it, starting with the August 2012 piece by Emmanuel Farhi and Ivan Werning,

brilliant Harvard and MIT guys. Their piece is clear and

excellent, and it shows what the case for fiscal policy in this

setting looks like. (I don’t read them as offering concrete

advice to current governments and thus I have no criticism of

their paper, which I am pleased to have spent time with.)

Here are a few points:

1. “…the effects of government consumption work through

inflation.” In other words, if you think the BOE has greater

influence over inflation than UK government spending, you do not

need the other results of this paper for macro policy. I get the

point of “the central bank cannot precommit to elaborate

targeting schemes over time,” but that’s not what we need here.

We just need some basic money-induced price inflation to render

monetary policy dominant over fiscal policy, even in this case.

And pretty much everyone thinks the BOE can influence the rate of

price inflation. The rates of price inflation we are getting are

not some kind of strange coincidence.

By the way, even with a so-called liquidity trap, the BOE also

can play QE with the exchange rate, as do the Swiss.

2. The zero bound open economy model predicts that fiscal

tightening leads to exchange rate appreciation (contra the usual

Mundell-Fleming case), yet here is the British pound against the

dollar:

Not an obvious fit to the prediction. There are countervailing

factors, to be sure, but maybe that’s the broader story too.

3. The model in the paper suggests that “current” fiscal policy

won’t much help aggregate demand. Fiscal policy does best the

further away in time it is, provided it does not happen

after the liquidity trap goes away. This makes sense if you view

inflation as the channel for the effectiveness of fiscal policy.

Getting the inflation over with won’t help much, but if it hangs

over people’s heads they will spend more in response. In fact

there is even a problem that the multiplier can be infinite if

fiscal policy is sufficiently well-time and back-loaded.

None of this corresponds with the advice we actually are hearing.

4. The greater the nominal stickiness of prices in the model, the

weaker the Keynesian effects and in the limiting case they

approach zero. Yet we are told (by the policy commentators) that

nominal stickiness is of the utmost importance.

Let’s consider a few other pieces and points:

5. It is common for these papers to rely on squirrely mechanisms

of intertemporal substitution, which in other contexts are mocked

by Keynesians. Consider

Fujiwara and Ueda, a commonly cited paper on fiscal

multipliers and the zero bound:

Incomplete stabilization of marginal costs due to the existence

of the zero lower bound is a crucial factor in understanding

the effects of fiscal policy in open economies. Thanks to

this, government spending in the home country raises the

marginal costs of home-produced goods, which increases expected

inflation rates and decreases real interest rates.

Intertemporal optimization causes consumption to increase, so

that the fiscal multiplier exceeds one. While government

spending continues, the price of home-produced goods increases

more than that of foreign-produced goods. Expecting that two

countries are at symmetric equilibrium when government spending

ends, the home currency depreciates and the home terms of trade

worsen on impact when government spending begins. That shifts

demand for goods from foreign-produced goods to home-produced

ones. The fi…scal spillover thus may become negative depending

on the intertemporal elasticity of substitution in consumption.

If a passage like that came from an RBC theorist it would be

mocked, but in support of activist fiscal policy it passes

without critical comment.

6. When it comes to Japan and the Japanese lower bound, the

empirical evidence seems to show that “standard theory” predicts

quite well and the stranger zero bound theories do not predict

well. Here is Braun and

Korber:

We show that a prototypical New Keynesian model fit to Japanese

data exhibits orthodox dynamics during Japan’s episode with

zero interest rates. We then demonstrate that this

specification is more consistent with outcomes in Japan than

alternative specifications that have unorthodox properties….

Those same zero bound Keynesian models predict that economies

should have quite volatile responses to real shocks, yet they do

not:

We also considered specifications of the model that have larger

government purchase multipliers and some which also exhibit

unorthodox predictions for the response of output to labor tax

and technology shocks. We found that these specifications are

difficult to square with the fact that the period of zero

interest rates in Japan between 1999 and 2006 was a period of

low economic volatility. All of the specifications predict the

opposite should have occurred. The specifications with

unorthodox properties also have other problems. They predict

large resource costs of price adjustment which are difficult to

reconcile with empirical evidence that menu costs are small and

they require that households expect the period of zero interest

rates to be counterfactually long.

Need I state the irony that proponents of the relevance of the

zero bound often insist that real shocks simply aren’t making

such a big difference in recent years? That is inconsistent with

the basic model which they otherwise are citing.

7. In these settings (and assuming away all the problems above),

a lot of the effectiveness of fiscal policy, or sometimes all of

it, comes from “beggar thy neighbor” effects. Read Cook

and Devereux for some illustrative cases. Beggar thy neighbor

strategies are criticized and rejected when Germany (supposedly)

does them through its export prowess, but in the context of

fiscal policy they seem to be given a free pass.

8. In fact I could make further points but I believe that is

enough.

The bottom line: A look at this new and

interesting literature shows it does not support the

interpretations which the “policy commentariat” Keynesians are

putting on it and in some regards it even opposes those

interpretations. When it comes to UK fiscal policy, we are seeing

again what I described

last week: exaggeration and a lack of transparency in

argumentation.