In the last year, the protracted weak activity data in the Eurozone, and in the UK, has emboldened those who thought that ‘austerity’ policies were misguided, and that think that a renewed fiscal expansion will help solve the problem. I think more fiscal stimulus would be a mistake, and explain why below.
We have had high and broadly stable inflation for several years. Seen through the lens of most mainstream theories of how inflation and monetary policy works, this is not a bad way to infer that there is actually no gap between level of activity we see, and the level that monetary and fiscal policy should seek to bring about. More demand side fiscal stimulus would push up activity, but only temporarily, and at the cost of a further surge in inflation. For the boost in activity to be sustained for long periods we would need ever more inflation from either more fiscal stimulus or looser monetary policy. Policies like this were tried in the 70s, before it was properly understood that higher inflation didn’t buy lower unemployment forever.
You might reasonably ask why output and activity is so low, and unemployment so high, and isn’t there anything the authorities should try to do about that? There may be all kinds of reasons for this, and many of those would lead to courses of action for the public authorities, but the possibility that it’s the fault of too-weak demand engendered by monetary or fiscal policy is ruled out by our stable inflation rate. There are those who think that a jolt of increased demand will somehow allow the economy to settle at a higher steady state level of activity, with no extra inflation. This seems to be the implication of the use of terms like ‘escape velocity’ (by Mark Carney and others). But I think that this is misguided.
There are theories that allow for such escapes, that allow for multiple possible resting places for the economy, each consistent with a particular set of beliefs, and where the government can potentially select between them. However, these theories seem very special to me. Many of them rest on thinking that the world is characterised by rational expectations for a start, which I think is too extreme. And some of them would involve throwing out all that we thought we knew about how monetary policy worked in normal times too. I also remain sceptical that public policy could be used to select between these economic resting places with any precision. You might retort that throwing away all we knew about how monetary policy and inflation works might be just what we should do: doesn’t the crisis tell us that? Perhaps, but it would necessarily follow from this nihilism that more fiscal stimulus is needed.
If demand side fiscal stimulus is not warranted, what about a splurge on supply side public projects, like infrastructure? These may be a good idea, provided the social returns exceed the costs. But the case is no more pressing now than before. For a while at least, their demand side effects (because of the associated spending) will of course exceed the supply side effects (because the project will take time to complete) so such a policy would push up on inflation too, assuming the MPC left monetary policy untouched, and so leave the MPC with the job of figuring out how to trade off the two effects of the infrastructure spending. In fact, not only is the case not more pressing, it’s arguably less pressing. For a start, I would hope that small group responsible for forming policy at the top of the government and central bank focus on the financial sector, and not on trying to pull off general supply side miracles. Second, I think that we need to preserve some capacity to borrow.
To explain: substantial fiscal room needs to be left to allow for another, large-scale injection into the banking sector. This might follow a Eurozone break-up, or might be needed anyway.
It’s possible, though not likely, in my view, that the Eurozone may yet break up. Political instability in Spain and Italy could yet mean that the promise of the ECB to engage in OMT’s to buy troubled sovereign bonds is not credible any longer. And it’s possible that in this event, there would not be sufficient political support for overt direct fiscal transfers large enough to stop the break-up. Such a break up would very likely take down our entire banking system, given the direct and indirect exposures to Spanish and Italian sovereign bonds. If this happens, not only would there be the direct cost of recapitalising banks, but the automatic stabilisers would also be turned on even further, and perhaps also the cost of nominal debt finance would rise too as worries crept in about the government having to fund this with higher inflation down the road. An outcome like this is not likely, but the possibility is not far-fetched either. Perhaps there is something like a 2-5% chance?
Even without a Euro break-up, it’s conceivable that the authorities will be forced to conclude that the existing large banks are not going to be able to recapitalise themselves to the point where they can lend normally, and that government assistance is needed.
So the government needs to maintain room for manoeuvre for a very rainy fiscal day.
Of course, a further fiscal stimulus would amount to a disastrous change of course for the Coalition Government, and so it would not happen, probably, without an election. That itself I don’t think an adequate reason for not doing it. In general, I do believe that discretionary fiscal policy can and should be used to stabilise real activity, perhaps especially at the zero bound to interest rates. [I even surmise that the Coalition has been doing it, tweaking the debt target, and feel that its silly and dishonest protestations to the contrary missed a chance to put such policies on a proper footing]. I just don’t think that current circumstances merit looser fiscal policy.