A friend points me to this paper by Menzie Chinn, and calls it “a critically important insight.”
I’m not really sure what to think of it. I think it is critically important, but not for the reasons my friend does.
Menzie seems to be saying fiscal multipliers are larger than expected, assuming that the Fed would have no response whatsoever to say a $2 trillion deficit — that is, assuming that the Fed would not respond by raising interest rates. Menzie calls this being “accommodative” of expansionary fiscal policy. (By the same logic, if the Fed didn’t respond to a $0 deficit, or even a surplus, by lowering interest rates, the fiscal multiplier would be especially high, i.e. austerity would be extremely damaging.)
My friend seems to think it’s a safe assumption that the Fed wouldn’t respond to any stimulus, because the Fed can’t lower interest rates any lower than zero, where they are now, though the Fed would like to. A larger fiscal deficit, at a constraining zero lower bound, would simply bring the Fed’s preferred interest rate from somewhere in negative territory up towards the zero lower bound, which would not require raising interest rates, so the Fed’s target interest rates would stay the same. Likewise a fiscal contraction would push the Fed’s preferred interest rate even deeper into negative territory, where the Fed can’t do anything to correct its contintued decline.
Menzie’s argument seems valid to me, but it is not an iron-clad law of physics that deficits are low at the zero-lower-bound on interest rates (ZLB) — it is an if-then statement about the Fed’s reaction function. That’s why it’s so important. Menzie is not saying that the fiscal multiplier is definitely large (though he seems to think so), he’s saying that if the Fed would have no reaction whatsoever to larger or smaller deficits (because it’s at the ZLB), then the fiscal multiplier will be large, according to studies X Y and Z.
But this is just another way of saying the exact same thing that Market Monetarists have been saying about fiscal multipliers for years. MM’s have been saying that if the zero-lower-bound is not binding — that is, if the Fed is not constrained by the zero lower bound because it has unconventional policy tools, like quantitative easing and forward guidance, i.e. it can effectively go negative – then fiscal multipliers will actually be small (or even zero), because the Fed will respond to any changes in fiscal policy, i.e. “neutralize” the austerity or the stimulus.
Menzie’s paper, and Market Monetarists, are saying the exact same thing from two different directions. And they beg the exact same question: what exactly is the Fed’s reaction function? How would the Fed react to fiscal stimulus? Or how would it react to austerity?
If Congress ran a deficit of $2 trillion, for example, would the Fed really have no reaction, as my friend seems to think, or would it pull back on unconventional policy levers like its bond-purchasing program and its forward guidance (or, alternatively, would it pull back on its unconventional policy levers, which never worked anyway, which is effectively the same as doing nothing)?
Whether you think the Fed would pull back or do nothing in response to a $2 trillion deficit ultimately comes down to whether you think the Fed considers its current stance — near-zero interest rates, aa bond-buying program that will last until unemployment falls to 7% or inflation goes to 2.5%, and forward guidance signalling low interest rates through at least 2014 — to be sufficient.
If the Fed considers that stance to be a sufficient response to the current economic environment, then the Fed would probably respond to higher deficits by scaling back its bond-buying activities and its forward guidance — if not actually raising interest rates — which would “neutralize” the stimulus and bring the multiplier way, way down, possibly even to zero.
But if the Fed would like to be doing more than it is right now — that is, if it considers its own current stance inadequate – but for some reason it feels it can’t do more, for whatever reason (political economy of the Fed anyone..?), or if it de facto can’t (but thinks it can), then it might just be “accommodative” of bigger deficits and do nothing in response to even a $2 trillion deficit, as Menzie’s paper seems to suggest and my friend seems to think, in which case the fiscal multiplier might be very large. Likewise, that would mean the Fed’s response to fiscal austerity would be inadequate to correct for falling demand.
So maybe the Fed would respond to higher deficits by keeping interest rates at zero, which would be accommodative, but maybe it would also scale back its bond-buying activities and adjust its forward guidance, which would not be accommodative. Or maybe it would do nothing. It depends on its own opinion of its own job performance, right now, and its ability to effectively steer the economy below the ZLB.
But who can say what the Fed would do, or whether it thinks of its own current stance? This is all very speculative. People comb over Bernanke’s and the FOMC members’ public statements to try and figure out what the Fed is thinking, but when you get right down to it, we really don’t know.
What isn’t speculative though, is the idea that any discussion of whether fiscal multipliers are high or low basically begs the question of what is the Fed’s reaction function. Discussing the one without discussing the other is kind of pointless.
I do agree that this point — that multipliers are large if the Fed is stuck at the zero bound, or small if the Fed is not — deserves a lot more attention than it gets, for numerous reasons, and that when it is internalized by Washington’s policy elite you will be looking at a very different discussion about fiscal deficits. And I also know that despite their differences, Market Monetarists and New Keynesians agree very much on the importance of that point.
But much of Washington, to say nothing of the public, is not even close to having that discussion…