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Why the Fiscal Multiplier Is Roughly Zero

Why the Fiscal Multiplier Is Roughly Zero

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Many observers have been perplexed
by the slow recovery from
the 2008 recession. In the United
States, Congress passed a nearly
$800 billion stimulus in early 2009,
yet growth remained sluggish. More recently, a shift
toward fiscal austerity does not seem to have noticeably
slowed the rate of economic growth.1 This seems
to go against the textbook Keynesian model, which
says fiscal stimulus has a multiplier effect on GDP;
however, we shouldn’t be surprised that fiscal policy
seems less effective than anticipated. As we’ll see, fiscal
policy ineffectiveness is one byproduct of modern
central banking, with its focus on inflation targeting.
Many observers have been perplexed
by the slow recovery from
the 2008 recession. In the United
States, Congress passed a nearly
$800 billion stimulus in early 2009,
yet growth remained sluggish. More recently, a shift
toward fiscal austerity does not seem to have noticeably
slowed the rate of economic growth.1 This seems
to go against the textbook Keynesian model, which
says fiscal stimulus has a multiplier effect on GDP;
however, we shouldn’t be surprised that fiscal policy
seems less effective than anticipated. As we’ll see, fiscal
policy ineffectiveness is one byproduct of modern
central banking, with its focus on inflation targeting.

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No. 105February 2012
MERCATUS CENTER AT GEORGE MASON UNIVERSITY
 
MERCATUSON POLICY
Why the Fiscal Multiplier IsRoughly Zero
 
By Scott Sumner
M
 any observers have
 been per-plexed by the slow recovery fromthe 2008 recession. In the UnitedStates, Congress passed a nearly $800 billion stimulus in early 2009, yet growth remained sluggish. More recently, a shifttoward fiscal austerity does not seem to have notice-ably slowed the rate of economic growth.
1
This seemsto go against the textbook Keynesian model, whichsays fiscal stimulus has a multiplier effect on GDP;however, we shouldn’t be surprised that fiscal policy seems less effective than anticipated. As we’ll see, fis-cal policy ineffectiveness is one byproduct of moderncentral banking, with its focus on inflation targeting.The traditional “multiplier” approach to scal policy is based on John Maynard Keynes’s observation that con-sumers usually spend a large share of any increase intheir income.
2
Government spending programs and taxcuts put dollars directly into the pockets of consumers,regardless of how effective they are on a cost/benet basis. If consumers spend 80 percent of their extra take-home-pay on goods and services, then other workersand rms will earn additional income. A portion of thatincome boost will also be spent, leading to a
multipliereffect
, whereby total aggregate demand rises by morethan the initial government stimulus. The multiplierrepresents the ratio of the total increase in spending tothe initial increase in government spending.Conservative critics of scal stimulus often point outthat the extra dollars must come from somewhere.
3
If the government borrows funds to boost spending, theninterest rates might rise, which would crowd out privateinvestment expenditures on consumer durables, newhomes, and business ventures. Although crowding outcan reduce the effectiveness of scal stimulus, Keynes-ians correctly note that when interest rates are zero, it isunlikely that additional government borrowing will befully offset by declining private investment, especially if the central bank holds rates close to zero.
4
 
2 MERCATUS ON POLICY SEPTEMBER 2013
Why has the effect of scal stimulus been so meager in recent years? After all, interest rates in the United States have beenclose to zero since the end of 2008. The most likely explana-tion is
monetary offset
, a concept built into modern central bank policy but poorly understood. We can visualize mone-tary offset with the Keynesian aggregate supply and demanddiagram used in introductory economics textbooks. If scalstimulus works, it’s by shifting the aggregate demand (AD)curve to the right. This tends to raise both prices and outputas the economy moves from point A to point B, although inthe very long run, only prices are affected.Now let’s assume that the central bank is targeting ina-tion at 2 percent. If scal stimulus shifts the AD curve tothe right, then prices will tend to rise. The central bankthen must adopt a more contractionary monetary policy inorder to prevent ination from exceeding their 2 percenttarget. The contractionary monetary policy shifts AD backto the left, offsetting the effect of the scal stimulus. Thisis called
monetary offset
.By the 1990s this process was pretty well understood,which is why even many of the so-called New Keynesianeconomists began to lose interest in scal policy as a sta- bilization tool.
5
Instead, the focus shifted to central bankpolicy, and elaborate rules were devised to assist the cen-tral bank in steering the economy toward low ination andstable growth. Perhaps the most famous was the TaylorRule, which called for central banks to adjust interest ratesso as to keep ination near 2 percent and output close topotential output.
6
 If the central bank is steering the economy or, more pre-cisely, nominal aggregates, such as ination and nominalGDP, then scal policy would be unable to impact aggre-gate demand. As an analogy, imagine a child attempting toturn the steering wheel of a car. The parent might respond by gripping the wheel even tighter, offsetting the push of the child. Even though the child’s actions would initially change the direction of the car, ceteris paribus, the parentwill push back with equal force and correct this turn tokeep the car on the road.If monetary offset was well understood by the 1990s,why was there so much support for scal stimulus in therecent recession? It seems that many economists wrongly assumed that the normal monetary offset model no longerheld, due to three misconceptions:1. In early 2009 many economists wrongly assumedthat the Fed was out of ammunition, leaving mon-etary policy adrift, or passive.
7
2. Some economists have told me that the Fed wouldnever attempt to sabotage scal stimulus becausethe Fed also wanted to see a robust recovery.3. Fed ofcials like Ben Bernanke occasionally spokeout against scal austerity, making monetary offsetseem even less likely.
8
By now we know that central banks are not out of policy options when rates fall to zero.
9
And, in a sense, this nevershould have been in doubt. When Japanese interest rateshit zero in the late 1990s, Ben Bernanke (then an academic)dismissed arguments that policy is ineffective at the zero bound.
10
So did Milton Friedman.
11
The best-selling mon-etary economics textbook of 2010, written by former Fedofficial Frederic Mishkin, noted that monetary policy remains “highly effective” when short term rates fall closeto zero.
12
We’ve recently seen the Bank of Japan engineera sharp depreciation of the yen, despite near zero interestrates. This contradicts Keynesian “liquidity trap” models,which suggest that central banks are unable to depreciatetheir currencies once short-term rates fall to zero. It’s safeto say that the “out of ammunition” view of monetary inef-fectiveness has been thoroughly discredited.The other two objections to monetary offset are harderto dismiss. The Fed has been disappointed by the pace of recovery and wishes that aggregate demand had risen at afaster pace over the past ve years. This remains the cen-tral reason why most Keynesians continue to favor scalstimulus. But on closer inspection it seems quite likely thatthe Fed has been sabotaging scal stimulus (and offsetting recent austerity), perhaps without even realizing it.
 
MERCATUS CENTER AT GEORGE MASON UNIVERSITY 3
To see why monetary offset continues to be operative,consider the sorts of statements continually made by Fedofcials. We never hear them explicitly say they’ll sabo-tage scal stimulus, but we do hear them say they will cali- brate the level of monetary stimulus to the health of theeconomy. For instance, the recent Evans Rule commits theFed to hold interest rates close to zero until unemploy-ment falls to 6.5 percent or core ination rises above 2.5percent.
13
Because scal stimulus would presumably makethis happen sooner, it would also, ipso facto, cause the Fedto raise interest rates sooner than otherwise. Thus scalstimulus would lead to tighter money over time. Of course,that doesn’t necessarily fully offset the effects of scalstimulus, but it’s an explicit admission by the Fed that if the scal authorities do more, they will do less. An even better example occurred in late 2012, when theFed took several steps to make monetary policy moreexpansionary, including adoption of the Evans Ruleand additional
quantitative easing 
(QE), or injections of  bank reserves through bond purchases. Why did the Fedtake such bold steps? Some Fed ofcials pointed to thelooming scal cliff, which was widely expected to leadto steep tax increases. A possible spending sequesterwas also lurking in the background. Fed ofcials weredetermined to do enough stimulus to keep the recovery going, despite headwinds from both scal austerity andrecession in Europe. And so far it looks like they’ve succeeded. Job growthduring the rst six months of 2013 was running at over200,000 new jobs per month, which is actually faster thanthe pace of 2012. That’s not to say that a much sharperdrop in government spending wouldn’t have some impacton measured GDP; after all, the Fed’s policy initiative wascalibrated to reect the sort of scal austerity that they expected in late 2012. Much greater austerity would havea short-term effect on growth, but over longer periods of time, the Fed sets the agenda. The Fed’s ability to producealmost unlimited amounts of at money, without running up large budget decits, ultimately makes monetary pol-icy much more powerful than scal policy.Because Fed officials continue to stress the risks of excessive austerity, the monetary offset argument seemscounterintuitive to many economists. Many will ask,“Surely you don’t think Ben Bernanke would offset s-cal stimulus?” But this isn’t really asking the right ques-tion. The question that should be asked is, “Will BenBernanke do what is necessary to keep nominal spend-ing on a path consistent with low ination and stablegrowth?” which is roughly the Fed’s mandate. (Actually,the mandate speaks of ination and employment, but jobs and growth are closely linked.) The real questionis whether the central bank will do its job, regardless of what is happening on the scal front.When viewed this way, estimates of scal multipliers become little more than
forecasts of central bankincompetence
. If the Fed is doing its job, then it willoffset scal policy shocks and keep nominal spending growing at the desired level. Ben Bernanke would deny engaging in explicit monetary offset, as the term seemsto imply something close to sabotage. But what if hewere asked, “Mr. Bernanke, will the Fed do what it canto prevent scal austerity from leading to mass unem-ployment?” Would he answer “no”? Another debate revolves around the Fed’s willingness toengage in unconventional monetary stimulus. They doseem somewhat uncomfortable with doing large amountsof QE. In my view, this is the best argument against mon-etary offset. The Fed might be afraid to use these moreextreme measures to offset scal austerity, even if they’d be willing to use conventional tools (such as cuts in short-term interest rates) if those were still available. And yet we continue to hear Fed ofcials talk of cutting  back on QE as the economy strengthens. This impliesthat they will do more QE under conditions of auster-ity than they would if scal policy were more expan-sionary. Perhaps without even fully understanding theirrole in this complex policy game, the Fed has acted very much like a central bank that was determined to keepthe recovery proceeding at a steady pace but would backoff whenever ination or growth seemed to be accel-erating. That policy stance almost inevitably leads tomonetary offset and largely explains why the recovery continues at a modest pace, despite an increase in scalausterity during 2013.What role does this leave for scal policy? What wouldan effective scal stimulus look like? It turns out thatscal policy could play a role, but only through supply-side channels. Return to the AS/AD diagram discussedabove. If policymakers were able to increase aggregatesupply, then the Fed would be under no pressure to offsetthe effects with tighter monetary policy. That’s becausesupply-side tax cuts actually tend to lower the inationrates and raise growth. A good example is a cut in theemployer-side of the payroll tax, which would encour-age hiring but would not boost wages or prices. Indeed,the cost of labor from the firm’s perspective woulddecline, whereas workers would see no change in take-

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