Stuck at Zero

April 2nd, 2012 at 5:20 pm

I’ve pretty much stopped writing posts exhorting policy makers to engage in deficit-financed fiscal stimulus, not because we no longer need it—we do—but because it feels like a waste of time.  With the fading of the Recovery Act along with state and local budget cuts, US fiscal policy has turned contractionary (see fiscal drag figure here). 

Yes, the economy is getting better, and pretty consistently at that.  But it’s still a slog, gas prices are pushing the other way, housing remains in the tank (more on that in a later post), joblessness is still highly elevated, with 40% of the unemployed stuck in joblessness for at least six months (before the Great Recession, the average share of the long-term unemployed was about 15%).

But I’m going to briefly drag this critique out of hiding for two reasons.  First, there’s been a spate of research on the bang from fiscal stimulus when monetary policy is “at the zero lower bound” (ZLB) as it is now (meaning the Federal Reserve is holding the main interest rate they control at about zero in order to stimulate more borrowing and investment).  And second, because Europe is providing such a sad, natural experiment of this thesis.

On the first point, the ZLB is important because once the nominal interest rate that the Fed sets—the Federal Funds rate—is at zero, they can’t take it down further, even if weak growth and high unemployment suggest they should.  DeLong and Summers have a new paper that takes 52 pages and lots of Greek letters to prove that fiscal stimulus is particularly helpful in this situation and not particularly costly either (see low interest rates noted above; btw, if the Greeks could claim royalties on the use of their letters, that could help relieve another big economic problem we currently face). 

These dynamics have been known since Keynes but have been forgotten, so good for Brad and Larry, but if Paul K’s relentless flogging of the point hasn’t broken through, I fear nothing will.

There’s been a lot of debate about the magnitude of fiscal multipliers—how much bang you get for each buck of stimulus—when interest rates are at the ZLB (a multiplier of 1.5 means $1 of fiscal stimulus returns $1.50 of growth).  In normal times, the Feds can raise rates to offset the extra spending, or government borrowing can crowd out private borrowing, but at the zero bound, that’s not the case, and that means the fiscal multiplier is larger. 

Researchers at Goldman have some careful new work which derives the magnitude of the multiplier under different degrees of the lower bound.  The “mild” case is a ZLB that doesn’t last for too long and while the short-term rate is stuck at zero, longer term rates can still come down (which helps to offset the demand contraction).  The “severe” case is generally what we’ve been dealing with in this downturn—the Fed has the rate at zero and intends to hold it there though 2014!—and it assumes longer term rates won’t fall either (here’s where QE comes in—that’s how the Fed targets the longer term rates, so perhaps we’re actually somewhere closer to the mild ZLB than we’d be without QE).

The figure, which simulates a 1% of GDP fiscal contraction (so reverse the signs for a stimulus) shows large multipliers after a few years of between 2-4.


Still not convinced?  Then let’s turn to the second point…Europe.  If the GS findings are ballpark correct, then the UK and EU’s fiscal consolidations should be contractionary, recessionary, and inducing of higher unemployment.  Voila:

Source: Eurostat

Like I said, on this side of the pond we’re busy debating the most austere budget in recent memory—the one adopted by House R’s—and trying to figure out how to stop a planned fiscal train wreck—consolidation of 3.5% of GDP—in January of 2013.  So all of this is for naught in the current context.  The reason I raise it at all is because there’s another recession out there somewhere and who knows?  Maybe by then we’ll be ready to relearn old lessons and get this right next time.

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8 comments in reply to "Stuck at Zero"

  1. foosion says:

    We need to repair roads, build schools, etc. We can do more today, when everything is cheap (interest rates are low, plenty of unemployed who would work for less, etc.) or later when things are more expensive. Which would be a better time?

    • Michael says:

      Never. We should never repair roads or make our schools good. The purpose of the US economy is to create suckers for our financial elites to drain, not widespread prosperity for its citizens.

  2. pjr says:

    Please do not stop. Your final paragraph points to the reason that the lessons must be repeated and repeated, for a long time. Economists, politicians, students and knowledgeable voters must have this hammered into their heads continuously lest we repeat mistakes. Secondarily, we’re still in trouble and whatever can be done needs to be done–if the pressure from the accurate side of the argument dissipates, the pressure from the wrong side of the argument will win-out.

  3. Michael says:

    Sorry, dude, Obama only cares about the economy if it’ll get him reelected. The GOP Presidential candidate is self-immolating, so Obama’s going to go back to making all of our productivity easier for bankers to steal.

  4. Tom in MN says:

    What about debt overhang? The President tried a bit in this area recently, but it seems that much more can be done. Without all the underwater mortgages and pending foreclosures, I suspect the recovery would be much stronger.

  5. Christiaan says:

    You should not stop pointing this out until it’s common wisdom again, because the other side does not stop either.

  6. Fred Donaldson says:

    Third World countries have followed the advice of bankers, politicians and other financial wizards to structure their economies as sources of goods and labor for developing nations at low prices. Most advanced countries have promoted national goals for production of best quality goods and services at relatively high labor rates.

    Poor nations have privatized what was once owned by the public, and most rich nations have invested in public roads, services, transit, health and education to improve the lives of their citizens.

    We were once the premiere developing country, but if present trends continue there will be one more Third World entry, a nation of insular wealth and widespread depression with toll roads and paid toilets from sea to shining sea.

  7. Forrest Leeson says:

    “…because it feels like a waste of time.”

    What was that line from the GOP operative — “we will keep pushing until stopped by a superior force”?

    The ability to ignore lack of progress is highly useful.