Fiscal stabilisation and debt

Simon Wren-Lewis

Economics Department and Merton College, Oxford

This talk draws heavily on joint work with Campbell Leith at Glasgow University under the ESRC’s World Economy and Finance programme,

and also joint work with Tatiana Kirsanova at Exeter University. However neither co-author should be implicated by any views I express here

January 2010

WEF Event: Picking Up the Pieces

Summary

Fiscal countercyclical policy The traditional assignment Zero bounds The right type of fiscal policy Stimulus without raising debt?

Optimal debt policy The random walk result: its importance and

limitations Fiscal councils

January 2010WEF Event: Picking Up the

Pieces

The conventional assignment

Monetary policy Short term stabilisation of demand consistent with

achieving a medium term inflation target Debt stabilisation or reduction is not an objective

Fiscal policy To meet some objective for government debt over the

medium/long term Short term demand stabilisation is not an objective

With the occasional exception, this was the consensus among policy makers and academics before 2008/9

A key caveat was, or should have been, that monetary policy is not constrained by a zero lower bound

January 2010WEF Event: Picking Up the

Pieces

Zero bound implies fiscal action

Impact of QE uncertain Policy makers are unwilling to raise inflation targets or

adopt a price level target Time inconsistency problem Misinterpreted as debt stabilisation Damage anti-inflation credibility

Fiscal stabilisation has to step in at the zero bound, and can be very effective

See Eggertsson, G. and Woodford, M. 2003/2004 on all these points

Some fiscal instruments are much more effective than others.

January 2010WEF Event: Picking Up the

Pieces

Some fiscal policy myths

“Ricardian Equivalence means fiscal policy does not work”

Temporary increases in government spending raise demand even if consumers are totally Ricardian

In an open economy independent fiscal action gets crowded out through an appreciation

If interest rates are stuck at zero, and the fiscal expansion is temporary, the exchange rate should not appreciate.

Any increase in government borrowing crowds out private borrowing

Even if we deny that prices can be sticky, the zero bound is a fact, and it prevents demand adjustment

January 2010WEF Event: Picking Up the

Pieces

Macroeconomics, ideology and ivory towers

Eugene Fama (Professor, Chicago) The problem is simple: bailouts and stimulus plans

are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

John Cochrane (Professor, Chicago) Every dollar of increased government spending must

correspond to one less dollar of private spending.

January 2010WEF Event: Picking Up the

Pieces

On theory that denies the possibility of deficient aggregate demand

Keynes (1936) General Theory That it [Classical Theory] reached conclusions quite

different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commanded it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

January 2010WEF Event: Picking Up the

Pieces

Fiscal expansion without higher debt?

Intertemporal incentives Anticipated VAT increases – fiscal policy as

monetary policy Tax financed temporary increases in

government spending Will expand demand if consumers are Ricardian

Redistribution from unconstrained to credit constrained consumers

All redistribute, but so does monetary policy

January 2010WEF Event: Picking Up the

Pieces

Outside of the zero bound, is the conventional assignment still right?

Given lags, precautionary fiscal expansion may on occasion be warranted

Theory – fusion of two literatures Dynamic optimal taxation theory

Schmitt-Grohe, S. and Uribe, M. (2004) – sticky prices make an important difference

Keynesian theory (Woodford – social welfare measure of business cycle costs)

(Robust?) Result: If monetary policy unconstrained, optimal fiscal demand management is no demand management

Eser, F, Leith, C and Wren-Lewis, S (2008)

January 2010WEF Event: Picking Up the

Pieces

Fiscal policy still has a stabilisation role in changing relative prices

If wages as well as prices are sticky, tax changes can help ‘correct’ the real wage Leith, C. and Wren-Lewis, S. (2007), 'Counter-

Cyclical Fiscal Policy: Which Instrument is Best?', Glasgow University.

Tax changes can offset cost-push shocks Tax measures may be more efficient at

pricking asset bubbles in particular markets than general interest rate changes.

January 2010WEF Event: Picking Up the

Pieces

Optimal debt policy: the random walk result

Assume away default risk, and assume infinitely lived Ricardian consumers

Taxation is distortionary, so any non-negative government debt has social costs

Despite this, if a demand shock raises government debt, the optimal response is to live with this higher level of debt

Schmitt-Grohe, Stephanie and Uribe, Martyn (2007) Benigno, P and Woodford, M (2003) Essentially a tax smoothing result

January 2010WEF Event: Picking Up the

Pieces

Limitations

Assumes time inconsistent policy Under time consistent policy, optimal policy would

involve rapid debt correction Leith, C and Wren-Lewis, S (2007), Fiscal Sustainability in a New

Keynesian Model, Oxford University Discussion Paper No. 310

Assumes benevolent policy makers Leith, C and Wren-Lewis, S (2009), Electoral Uncertainty, the

Deficit Bias and the Electoral Cycle in a New Keynesian Economy, Oxford University Discussion Paper No 460

Ignores default risk With finitely lived, intergenerationally selfish

consumers, debt crowds out capital

January 2010WEF Event: Picking Up the

Pieces

Debt and long run crowding out: log utility

Ricardian model No crowding out of capital

2 period OLG model with zero labour income in second period More than 1 for 1 crowding out of capital

Blanchard-Yaari C=consumption, r=real rates, =impatience, =decline in income with age A=total assets (debt+capital), p=probability of death

Calibration (annual): K=1,Y=Debt=0.25,=0.04,p=0.02, =0 Implies r=5% Reduce debt to zero – interest rates fall to 4.8% Steady state A falls by almost as much as debt, so K rises by just 3.13% Steady state consumption rises by 1% Making =3% pa will double the long run impact of lower debt

January 2010WEF Event: Picking Up the

Pieces

( ) ( )( )C r A p p

Implications

The random walk result demonstrates that debt should be a shock absorber and not a target.

The possibility of hitting a zero bound means that we need, in other times, to be gradually reducing debt

Constant debt/GDP objectives not enough Supported by OLG crowding out

Unless the emergence of default risk premium is a significant possibility, debt reduction should be gradual and erratic.

January 2010WEF Event: Picking Up the

Pieces

How best to achieve gradual and erratic debt reduction?

Targets set by governments are likely to be economically and politically sub-optimal

Governments have a temptation to be over optimistic in making fiscal projections

Need Fiscal Councils to Independently forecast development of government debt Advise on the optimal timing and speed of debt reduction Have the political authority to act as an effective public watchdog See Kirsanova, T, Leith, C and Wren-Lewis, S (2007), Optimal

Debt Policy, and an Institutional Proposal to help in its Implementation, European Economy Economic Papers No 275

And Sweden, Canada, Hungary and others And Conservative Party policy

January 2010WEF Event: Picking Up the

Pieces