Monday, September 22, 2014

The Love Affair Conservatives Should Be Having

Paul Krugman and Josh Barro are going after conservatives for their "new love affair with Canada". They claim conservatives are incorrect to view Canada's successful fiscal consolidation in the 1990s as evidence of  "expansionary austerity." Here is Krugman:
Canadian austerity in the 1990s was offset by a huge positive movement in the trade balance, due to a falling Canadian dollar and raw material exports...Since we can’t all devalue and move into trade surplus, this meant that the Canadian story in the 1990s had no relevance at all to the austerity debate of 2010.
Actually, the Canadian story is very relevant to the austerity debate of 2010, but not in the way portrayed by most conservatives. For the Canadian story is largely about expansionary monetary policy offsetting contractionary fiscal policy. The Canadian dollar's fall was not some random event, but the result of concerted efforts by the Bank of Canada to counter the drag of fiscal austerity. This is an important story and it is not the first time it has transpired. About fifteen years earlier the Bank of England also used monetary policy to offset fiscal policy. Ramesh Ponnuru and I wrote about it these experiences back in 2012 in The Atlantic:
The Bank of England vividly demonstrated the power of central banks to offset fiscal policy at the dawn of the Thatcher era. In 1981 her government introduced a budget that would sharply reduce the deficit in the midst of a recession. Most economists opposed it on Keynesian grounds, with 364 of them signing a now-famous letter arguing there was "no basis in economic theory or supporting evidence" for it. Yet the Thatcher government implemented its plan and by late 1981 the economy was recovering. The Bank of England at the same time had begun a cycle of monetary policy easing, and the economists had underestimated its effects.
Something similar happened in Canada in the mid-1990s. After running several decades of budget deficits that had led to a debt-to-GDP ratio of 70 percent in 1995, then-Finance Minister Paul Martin introduced a budget plan that began a half decade of reducing the federal budget, largely through cuts in spending. This fiscal tightening led to budget surpluses by the early 2000s. As in the British case, the Bank of Canada eased monetary policy over the same time, offsetting any fiscal drag. The economy performed nicely.
The U.S. economy over the past two years has exhibited the same pattern. Since mid-2010, total federal expenditures, measured in dollars, have trended down. The budget deficit as a share of the economy has fallen more than 2 percent over this time. This fiscal tightening has taken place in the midst of a barrage of economic shocks including the Eurozone crisis, the 2011 debt ceiling talks, and concerns about an Asian economic slowdown that have kept economic uncertainty elevated. Yet nominal spending has been incredibly stable, growing at about 4.5 percent a year. The recovery has been sluggish, but the Fed appears to have kept fiscal contraction and other economic shocks from ending it.
So yes, the Canadian experience was very relevant in 2010. And it became even more relevant in 2013 when budget sequestering further tightened fiscal policy. In fact, the context of the above article was the "fiscal cliff" crisis of 2012 that led up to the sequester. We were arguing back then the Fed, like the Bank of England and the Bank of Canada, had the ability to offset the looming fiscal austerity of 2013. Paul Krugman, on the other hand, was worried the spending cuts would further depress the economy. Here, for example, was an October, 2012 comment by Krugman:
[T]he only reason to worry about the fiscal cliff is if you’re a Keynesian, who thinks that bringing down the budget deficit when the economy is already depressed makes the depression deeper.
Fortunately, the Fed started QE3 and the Evans Rule about that time. We believed that though these programs were far from perfect--they were not properly designed to restore full employment--they had the potential to at least offset the fiscal austerity of 2013 even with a binding zero lower bound (ZLB). As Mike Konczal noted our views would be put to the test in 2013. The year 2013, therefore, would provide a natural experiment of sorts that would test whether monetary policy could offset contractionary fiscal policy at the ZLB. Even Paul Krugman recognized this point: 
On the right are the market monetarists like Scott Sumner and David Beckworth, who insist that the Fed could solve the slump if it wanted to, and that fiscal policy is irrelevant... [A]s Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.
And let's be clear: fiscal policy was tightening. The IMF's cyclically-adjusted government budget balance as a percent of potential GDP showed fiscal policy had been tightening since 2010. It just tightened more so in 2013. This natural experiment would put all the Keynesians, Post-Keynesians, and sectoral-balance theories to the test. Many of these folks made dire predictions about the sequester. There are many I could list, but one predicted it would cost 700,000 jobs over 2013-2014.

So how did this natural experiment at the ZLB turn out? The economy did not collapse and 700,000 jobs were not lost. Real GDP maintained stable growth and over 4 million new jobs have been created so far in 2013-2014 period. More importantly, the one variable both fiscal policy and monetary policy directly affect, aggregate nominal spending, did not collapse in 2013-2014.This experiment indicates, then, that monetary policy can offset fiscal policy at the ZLB.

Conservatives should be having a love affair with this outcome. It shows that government spending can be curtailed without adverse consequences for the economy if monetary policy provides an offset. It is the same story that unfolded in Canada in the mid-1990s and the United Kingdom in the early 1980s. Conservatives need to embrace this view and run with it. It implies a reduced role for fiscal policy in stabilizing the economy.1 Some conservatives have embraced it, but most have not and continue to draw the wrong lessons from these experiences. If they want to make a convincing argument against an activist fiscal policy this is it.

P.S. Unfortunately, the many voices who were predicting doom and gloom because of the sequester have gone silent. No mea culpas from them. Their silence speaks volumes. Others, instead, point to the continued absence of full employment, but this is simply a moving of the goal posts. The original argument made by Market Monetarist was only that an offset was possible. We did not claim QE3 and the Evans Rule would restore full employment. We argued that would require something bolder like a NGDP level target.

Update: I was asked for evidence showing the Bank of Canada (BoC) explicitly eased policy in the mid-to-late 1990s. Below is a figure of their target policy interest rate corridor from a BoC report in 1998. It shows a sustained path of lowered policy interest rates--roughly 500 basis points!-- through early 1998. Here is a link to how the BoC manages its target.

1Okay, I have endorsed a NGDP-level target-based helicopter drop which is technically fiscal policy. The proposal is outlined here. The main reasons for my endorsement is to incentivize the Fed to act properly and provide insurance against central bank incompetence. This is a pragmatic proposal.


  1. David, Krugman hits right and left, always, so he always has a fall-back position. His argument really boils down to the liquidity trap, and given MP IS interest rate policy, unless fiscal policy is expansionary, we´re doomed!

  2. David-

    I have been talking about you over at Marcus Nunes'. My latest post is about tax cuts and QE. An idea of yours, but I put some spin on it. Called USE-ME. Take a look

  3. I think Krugman and Konzcal were wrong to call 2013 a test of MM. Not that I don't think Monetary Policy can offset fiscal policy and vice versa over a period of time, but I don't think 2013 gave us a good test of it. By almost all economic measures except unemployment we had an expanding economy going into 2013 that didn't falter in 2013, but showed fundamental signs of slowing. We had house prices bottom at the beginning of 2012 and start a strong rebound. We hit a 30 year low in the debt service as % of disposable income in 2012 which stalled out in 2013. I think we should have expected the same growth in industrial and commercial loan activity (or even better) from QE measures, but the growth in this loan activity slowed in 2013. personal consumption expenditure also slowed in 2013 relative to 2011 and 2012. Real estate loans dropped in 2013 after growing in 2012. GDP declined for the first time since 2009 in Q4 of 2013.

    Taking all the underlying fundamentals into account when looking at 2013 I see an economy that is expanding, but at a slower pace than it was prior to 2013. I don't really see how that is a victory for any policy.

    I think K & K were over-zealous to suggest the sequester would result in huge and immediate contraction in a growing economy and MM's were over-zealous to declare victory where the fundamentals don't seem to support it.

    I am not an economist by any means, but as an interested observer the only victory I see for 2013 is the disproving of both economic philosophies if they are based on the declarations of their most famous representatives.

  4. TravisV here from TheMoneyIllusion comments section.

    Cliff Asness’s influential forecasts need to be critiqued / rebutted by a Market Monetarist……

  5. Konzcal, finally, has a response to the results of the "natural experiment." He recognizes that fiscal tightening began well before 2013, but his numbers show that GDP growth actually slowed right at this time, contra to your claim. The difference is that he used a 4 quarter average over previous 4 quarter average. What do you make of this? Can you explain why one measure of growth is more appropriate than another?