Fiscal policy is effective, safe to use, and markets know it

The Federal Reserve Bank of Kansas City has just hosted its annual Economic Policy Symposium at Jackson Hole in Wyoming where central banks, treasury officials, financial market types and (mainstream) economists from the academy and business gather to discuss economic policy. As you might expect, the agenda is set by the mainstream view of the world and there is little diversity in the discussion. A Groupthink reinforcing session. One paper that was interesting was from two US Berkeley academics – Fiscal Stimulus and Fiscal Sustainability – which the news reports claimed suggested that governments should be increasing fiscal expansion even though they may be carrying high levels of public debt. The conclusion reached by the paper is correct but the methodology is mainstream and so progressives should not get carried away with the idea that there is signs that some give is emerging, which will lead to more progressive outcomes. A progressive solution will only come when the neo-liberal dominance of my profession is terminated and an entirely new macroeconomics paradigm based on Modern Monetary Theory (MMT) is established. There is still a long way to go though.

The Auerback-Gorodnichenko paper (hereafter the “UC-Berkeley Paper”) seeks to explore the idea that:

The Great Recession and the Global Financial Crisis have left many developed countries with low interest rates and high levels of public debt, thus limiting the ability of policymakers to fight the next recession.

They consider the central question to be:

Whether new fiscal stimulus programs would be jeopardized by these already heavy public debt burdens

Their conclusions are:

1. “government spending shocks do not lead to persistent increases in debt-to-GDP ratios or costs of borrowing, especially during periods of economic weakness”.

2. “fiscal stimulus in a weak economy can improve fiscal sustainability”.

3. “Even in countries with high public debt, the penalty for activist discretionary fiscal policy appears to be small”.

These conclusions appear to run counter to much of the mainstream views that are often rehearsed in the financial press.

The Financial Times article (August 27, 2017) – Fed told public spending can lift ailing economies – certainly thought so.

They say that in the context of central banks having “little monetary firepower given benchmark interest rates remain so low” to confront a new recession, “there may be more pressure on governments to help by loosening tax and spending policies”.

They say that such an idea is anathema to “many conservative lawmakers … [who] … are calling for urgent action to pare back the public sector” given that the US public debt ratio is “already at 77 per cent of GDP and heading higher”.

The FT quotes the “former chair of Barack Obama’s Council of Economic Advisers” as saying:

We have been giving catastrophically bad advice to countries with high debt to GDP ratios.”

The fact that economists are starting to say this is one thing. But the findings were obvious all along. I will come back to that. And digging deeper into the UC-Berkeley Paper’s logic we soon learn that not much has really changed.

And before you get excited, consider how the FT concludes its coverage of the paper:

The authors of the new paper cautioned that they are not making an unconditional argument for stimulus. “The experience of Greece and other countries in southern Europe is a grave warning about the political risks and limits of fiscal policy. Bridges to nowhere, “pet” projects and other wasteful spending can outweigh any benefits of countercyclical fiscal policy.”

Most big advanced economies have seen rising debt-to-GDP ratios since 2007, raising worries about their ability to use fiscal stimulus to counter a future recession. In the US, the Congressional Budget Office estimates that debt held by the public will rise to 91 per cent of GDP, or $26tn, by 2027. At that level, debt held by the public would be the largest since 1947.

The authors of the UC-Berkeley Paper have in the past argued that in relation to fiscal policy that there “is growing evidence of the effectiveness of such policy to fight recessions”.

There has always been evidence of the effectiveness of fiscal policy and the ineffectiveness of monetary policy. The fact that most of my profession denied that evidence does not negate it.

The fact they decided that monetary policy was the only reliable counter-stabilisation policy tool and that fiscal policy should become passive and get in the way of inflation targetting monetary policy (that is, a bias toward running fiscal surpluses) reflects the triumph of ideology over reason.

Modern Monetary Theory (MMT) proponents who work outside the conventional neo-liberal Groupthink that has trapped the economics profession since the 1970s emergence of Monetarism have always argued that fiscal policy is the most effective aggregate tool for governments who desire to manipulate aggregate spending in the economy.

Further, any paper that asks the question:

… to what extent does the increase in public debt limit the “fiscal space” available to fight recession?

… is operating within the erroneous mainstream paradigm.

First, it assumes that “fiscal space” is about financial resources, when, in fact, it can only be about real resource availability in a modern monetary economy where the government issues its own currency.

Second, a sovereign government is never revenue constrained because it is the monopoly issuer of the currency. In other words, its public debt level is irrelevant in terms of its capacity to spend in the future unless it deliberately constrains itself with voluntary fiscal rules.

Such a government is never financially constrained in its future choices by its past fiscal position. That is not to say that its past fiscal decisions do not impact on the constraints it might face in the future.

For example, a government that has been running deficits to fill the spending gap left by the non-government spending and saving decisions will probably have ‘less’ fiscal space next year because there will be less idle resources to bring back into productive use.

Such a government would have to increase taxes to deprive the non-government sector of purchasing power and, hence, free up some real resources, if it wanted to expand the size of the public sector (increase the government’s command over real resources).

Alternatively, a government that has been running fiscal surpluses is likely to have much more ‘fiscal space’ because the fiscal drag from the surpluses will have created higher levels of unemployment and stagnant economic activity (in most instances). Thus it has more scope to bring those idle resources back into productive use using its currency capacity.

But the surpluses have not provided the government with more financial resources, which is the popular misconception. Instead, the surpluses have created more idle real resources that in the future the government can, if it chooses, purchase for use.

Please read the following introductory suite of blogs – Fiscal sustainability 101 – Part 1Fiscal sustainability 101 – Part 2Fiscal sustainability 101 – Part 3 – to learn how Modern Monetary Theory (MMT) constructs the concept of fiscal sustainability.

In that context, the other questions posed in the UC-Berkeley Paper are erroneus:

Do high debt-to-GDP ratios limit the strength of fiscal multipliers … Should high-debt countries consider fiscal consolidation, even during a period of economic weakness … And how is the scope for fiscal policy altered by the large implicit liabilities from unfunded pension and health care programs in the United States and other economies with rapidly aging populations?

Although these questions go to the heart of the current dogma that most economists preach and which reverberates throughout financial media commentaries.

The UC-Berkeley Paper provides no insights in the concept of fiscal sustainability. It chooses to rehearse the usual neo-liberal/IMF position that fiscal sustainability is somehow a construct of various financial ratios.

They make a small adjustment to the normal debate, which is constructed in terms of ‘dangerous’ public debt thresholds (recall the spreadsheet cheats Rogoff and Reinhart and their spurious 80 per cent limit), by focusing on what they call the “fiscal gap” (as a share of GDP).

The fiscal gap is (from now (time t) to some “terminal period, T”:

… would equal the required increase in the annual primary surplus, as a share of GDP, relative to those projected under current policy that would be needed for the terminal debt-to-GDP ratio to achieve some desired value.


They define various “terminal debt-to-GDP ratio” measures – current debt ratio, the 60 per cent ratio used in the Stability and Growth Pact for the Eurozone, a measure that assumes no existing debt so captures the future only barring aeging society issues, and a measure that builds commitments related to pensions and health care in the future.

Then they calculate what the primary fiscal surplus would have to be to (cutting spending and/or increasing taxation) to reach these different terminal debt-to-GDP measures.

Quite ridiculous really.

It gets more ridiculous again when you consider their sample, which mixes Eurozone countries with non-Eurozone countries and within the latter group, countries with various types of currency pegs/constraints are included.

As I have indicated in the past, any analysis that conflates nations which issue their own currency with nations that use a foreign currency (for example, any of the Eurozone nations) has no credibility when it comes to answering questions relating to the fiscal capacity of the national government.

A Eurozone nation, which uses a foreign currency (the euro) has to raise funds from taxation or debt-issuance in order to spend that currency.

The US, Australia, Japan etc, all of which issue their own currency and their governments spend in in that currency do not have to raise funds from taxation or debt-issuance, although they might for political/ideological reasons, impose voluntary constraints on themselves, which have the effect of requiring them to match fiscal deficits with debt-sales.

But intrinscally, there is no necessity to do that. And these voluntary constraints have a habit of being relaxed quicksmart when circumstances dictate. Note the substantial rise in the proportion of government debt held by central banks since the recession!

That is, central banks have been effectively funding a substantially increased portion of government deficits in many nations without anyone blinking much. Even in the Eurozone where such ‘bailouts’ are apparently banned.

Pragmatism ruled. Thankfully.

I won’t go into the econometric methodology used in the UC-Berkeley Paper, which doesn’t really alter the applicability of the paper one way or another. It is, in fact, pretty standard and one can tear it apart as much as accept its limitations.

Essentially, they have a statistical model linking ‘fiscal shocks’ (changes in government deficits) to changes in various economic outcomes (real GDP, inflation).

They find among other things (using semi-annual data):

1. “the response of output to a government spending shock is larger in a weak economy than in a strong economy and on “average” … government spending generally stimulates output” – WHO WOULD HAVE THOUGHT!

2. “The weak response of the price level to government spending shocks is consistent with the notion that prices may be rigid in the short run and most of the adjustment in the economy happens via quantities and that, generally, inflationary pressure is stronger when the economy operates at full capacity” – GOSH!

3. “We fail to find clear evidence that short- and long-term interest rates increase after an identified shock. If anything, point estimates suggest that the rates may fall” – THERE GOES CROWDING OUT THEORIES!

4. With respect to (3) “This result suggests that markets may view fiscal stimulus as a way not only to accelerate the economy but also to reduce risks associated with a prolonged slump (e.g., self-defeating austerity policies, populist governments, defaults, etc.)” – SO BOND MARKETS DO NOT DEMAND GOVERNMENTS IMPOSE AUSTERITY WHICH WORSENS THE SITUATION. GEE-WHIZ!

5. “we find that after a government spending shock CDS spreads fall in recessions and rise in expansions. The fall could be consistent with the view that by stimulating the economy the government improves business conditions thus averting a larger crisis. In other words, fiscal stimulus in a weak economy may reduce spreads rather raise them” CAN THIS GO ON?

6. “We find that the debt-to-GDP ratio does not rise significantly in response to a government spending shock” – HMM.

In conclusion they say:

In summary, we find that government spending shocks tend to stimulate the economy and to have little adverse effect on a variety of measures of fiscal sustainability. Specifically, estimated impulse responses show that neither interest rates nor debt-to-GDP ratios increase discernably in response to government spending shocks.

Their results, using annual data, are similar. They conclude that “macroeconomic responses to cuts to government spending (recall that IMF shocks are fiscal consolidations) do not appear to lead to beneficial results in terms of reduced borrowing costs or persistently lower debt burdens.”

Yet millions have been made unemployed and poverty rates have been increased as the Troika or national governments have imposed austerity on many (compliant) Eurozone nations.

And no policy officials who have preached the neo-liberal economic snake oil and created the disastrous economic outcomes have gone to prison for malpractice.

After having established these results, which as the former chair of Barack Obama’s Council of Economic Advisers said contradict the “catastrophically bad advice” that has been given “to countries with high debt to GDP ratios” during the GFC, the UC-Berkeley authors feel the need to get back into the fold somewhat.

They claim that:

It is certainly conceivable … that a significant fiscal stimulus can raise doubts about the ability of a government to repay its debts and, as a result, increase borrowing costs so much that the government may find its debt unsustainable and default.

In the real world, for currency-issuing governments it is inconceivable that this would happen.

Such a government can always repay its debt as long as they are denominated in the currency it issues.

The central bank in such a nation can always control yields on government bonds, if the governments continues to, unnecessarily, issue such liabilities.

Such a government will never find its debt unsustainable and have to default on financial grounds.

And, finally, as noted above, the UC-Berkeley authors also say in closing (the last words are often the most remembered):

… our results should not be interpreted as an unconditional call for an aggressive government spending in response to a deteriorating economy. Indeed, the experience of Greece and other countries in Southern Europe is a grave warning about the political risks and limits of fiscal policy. Bridges to nowhere, “pet” projects and other wasteful spending can outweigh any benefits of countercyclical fiscal policy. Perhaps more importantly, we face considerable uncertainty about how economies will respond to fiscal stimulus programs given levels of public debt rarely seen in recent history, as well as large unfunded liabilities.

First, the experience of “Greece and other countries in Southern Europe” provides no warning about the “limits of fiscal policy” for a currency-issuing government such as Australia or the US.

These nations use a foreign currency and run deficits at the behest of the private bond markets.

But having said that, the lessons from Greece are clear. Fiscal policy is very effective in both directions. Cut public spending and/or increase taxes and you will cut GDP growth.

The greater the fiscal contraction, the worse will be the subsequent recession, other things being equal (including non-government spending).

Second, the ‘fiscal actions’ of the ECB (for example, the Securities Markets Program introduced in May 2010) clearly showed that the currency issuing authority can effectively fund any size deficits at low to negative yields any time it wants even if the designated fiscal authority (the Eurozone Member States) are effectively states in a federation, without their own currency issuing capacity.

So the experience of the Eurozone taught us nothing about the “limits of fiscal policy”. Rather, it reinforced the power of the fiscal policy and the capacity of the currency-issuing authority.

Third, the “Bridges to nowhere, “pet” projects” quip is gratuitous at best. Clearly, these authors were worried about being criticised for departing from the Groupthink too much and so had to finish by leaving the impression that governments who use fiscal deficits to defend their economies just waste money (unlike private sector investors!).

Fourth, the “considerable uncertainty” is all the more reason for governments to make strong statements that they will use their fiscal capacity to do whatever it takes to stop recessions. That will do more to quell endemic uncertainty than the alternative – the talk about government’s running out of cash and not being able to fund pensions or health care or all the rest of it.


While the conclusions of the paper (derived from the statistical results) are clearly not surprising to a Modern Monetary Theory (MMT) proponent, this paper is not a piece of progressive literature.

It is firmly embedded in the mainstream conceptual structure and in the end cannot even seem to accept its own results.

That is enough for today!

(c) Copyright 2017 William Mitchell. All Rights Reserved.

This Post Has 13 Comments

  1. So the World’s top economists may finally be getting to grips with what Keynes said almost a century ago. What next? World’s top economists – “Jackson Holers” – learn to tie their own shoe laces? Jackson Holers learn how to make a cup of instant coffee…..:-)

  2. Have you reached out to the authors with a copy of this post to see if they have a response?

  3. Ralph, unfortunately, it does not seem like economists are actually getting to grips with the problem at all. Rather, they seem to be sleepwalking into uttering MMT-like propositions, and then, if they recognize they are doing this, backtrack as soon as they can. It is quite disheartening.

  4. “and markets know it”

    Well, I guess that usually they don’t…

    Here in Brazil we are facing the old neoliberal fiscal austerity measures, and “the markets” are betting in GDP growth and unemployment decline right now. They are loving it. They believe that fiscal austerity will somehow “fix” the country finances and so bring the economy back to good shape. Risings in government spending would undermine that good future.

    But month after month they are surprised about how their expectations are not met, and GDP is constantly revised downwards.

    I don’t know what methodology the paper employed to arrive at that conclusion (that “markets may view fiscal stimulus as a way (…) to accelerate the economy”), but probably it was one of that rational agents models, that are useless, as we all know.

  5. “There has always been evidence of the effectiveness of fiscal policy and the ineffectiveness of monetary policy.”

    These ‘economists’ believe that monetary {and fiscal?} policy has been effective?

    “The global pivot to fiscal consolidation that was enshrined in the Toronto G-20 communique was wildly premature. It put a ton of pressure on monetary policy to support demand. Too much pressure. It slowed the global recovery. It was actually a pretty well-coordinated move, just in the wrong direction.
    And I think that there was a second failure. In the face of a set of fairly common shocks-the slow global recovery, the premature fiscal pivot-G-3 monetary policies diverged a bit too much.
    The Fed famously and controversially did QE2 back in 2010. That was the right call, for the U.S. and for the world. The global recovery was weak: it needed more, not less policy support.
    The problem wasn’t that the Fed acted. It was that the other major central banks didn’t.
    The BoJ didn’t really start to ease until early 2013.
    The ECB didn’t do quantitative easing until 2014, though the LTROs (long-term loans at fixed rates to European banks) did provide some balance sheet expansion in 2012. Indeed, monetary conditions inside the eurozone tightened significantly in 2011 and the first part of 2012 even as the eurozone was doing a major fiscal tightening-helping to create the double dip recession.
    At the end of the day, the rest of the G-3 followed the Fed-the ECB’s balance sheet is now bigger than the Fed’s, and Japan’s balance sheet expansion is much more aggressive than anything the Fed did.
    But the other large advanced economies followed the U.S. with a lag.”

  6. Dear Postkey (at 2017/08/30 at 1:25 am)

    The ECB began QE in May 2010 with the Securities Market Program interventions, before the US Federal Reserve. The LTRO was not the first action taken.

    The SMP saved the Euro from collapse.

    best wishes

  7. Dear Bill,

    “The ECB began QE in May 2010 with the Securities Market Program interventions, before the US Federal Reserve. The LTRO was not the first action taken.

    The SMP saved the Euro from collapse.”

    Does this mean that monetary policy was ‘effective’?


  8. Dr NRL

    The ‘right type’ of fiscal policy is required?

    These are the findings of Prof R.A. Werner.

    “(8) Notice that this conclusion is not dependent on the classical assumption of full employment. Instead of the employment constraint that was deployed by classical or monetarist economists, we observe that the economy can be held back by a lack of credit creation (see above). Fiscal policy can crowd out private demand even when there is less than full employment. Furthermore, our finding is in line with Fisher’s and Friedman’s argument that such crowding out does not occur via higher interest rates (which do not appear in our model). It is quantity crowding out due to a lack of money used for transactions (credit creation). Thus record fiscal stimulation in the Japan of the 1990s failed to trigger a significant or lasting recovery, while interest rates continued to decline.
    (9) The finding suggests that Japanese fiscal policy has been ineffective during the 1990s (but also the prior and subsequent decades, as tests show), because it was not supported by monetary policy. Ironically, this ineffectiveness finding may provide a strong case for using fiscal expenditure policy as an effective avenue for stimulating the economy, especially in times when bank credit is stagnating – fiscal policy, that is, which is appropriately coordinated with suitable monetary policy. The need for coordination of fiscal and monetary policy has been emphasised previously by economists such as Lerner (1943), Wray (2001), but also Schabert (2004).33 “

  9. Dear Postkey (at 2017/08/31 at 6:32 pm)

    Hardly. It was a clear ‘fiscal’ intervention. Basically telling private bond dealers that if they funded the Member States growing deficits then they could make a profit soon after by selling the assets back to the central bank.

    In effect, the ECB was just funding fiscal deficits. If they had not done that then the specific nations involved would have become bankrupt.

    best wishes

  10. Oh My! From the St. Louis Fed’s post:
    “The other view suggests that government spending may “crowd out” economic activity in the private sector. For example, government spending might be used to hire workers who would otherwise be employed in the private sector. As another example, if the government pays for its purchases by issuing debt, that debt could lead to a reduction in private investment (due to an increase in interest rates). In this case, the $1 increase in government spending leads to an increase in GDP of less than $1 because of the decline in private investment. Therefore, the government spending multiplier is less than 1.”

    Since we know that government issuing debt does not lead to an increase in interest rates, this “other view” should be discarded, as should this person’s tenure as an economist at that Fed Bank!!!!

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