Wednesday, August 3, 2011

Fiscal Austerity Requires Monetary Liberality

Over at Cafe Hayek, Russ Roberts takes on Paul Krugman's claim that most studies show fiscal policy tightening will stall a recovery rather than help it:
Unfortunately, Krugman doesn’t provide a link to those “many studies” of the historical record. Maybe he was busy or simply didn’t have room to provide them. But I will just mention that in 1946, federal spending fell about 55% when the war ended. The Keynesians predicted a horrible depression. Yet despite the release of 10 million people into the labor market with demobilization private sector employment boomed and the economy thrived. That’s a great natural experiment. I am eager to read any of the alleged many studies of the historical record.
Like Roberts, I am skeptical about the ability of discretionary fiscal policy to stabilize the business cycle.  His critique, however, is too quick to embrace the popular view that fiscal policy consolidation actually improves the economy.  On this point, Krugman is correct that most of the empirical evidence (e.g. here, here, and here) does not support this view.  What the evidence does show is that in most cases where fiscal consolidation was accompanied by a robust recovery it happened because monetary policy was accommodative.  In other words, a loosening of monetary policy made it appear that fiscal policy tightening was the cause of the economic recovery when in fact it was not.  For example, the much celebrated case of Canada's fiscal retrenchment in the later half of the 1990s coincided with the Bank of Canada dropping interest rates about 5% which supported domestic demand and increased exports via currency depreciation.  For fiscal austerity to work then, monetary policy needs to be accommodating. 

Along these lines, a more general point is that the impact of any fiscal policy action--where expansionary or contractionary--depends on the stance of monetary policy.  Thus, from 2008-2009 when monetary policy was effectively tight the easing of fiscal policy didn't quite pack much of a punch.  Conversely, in late 2010, early 2011 when there was not much fiscal stimulus, but some monetary policy easing under QE2 there was some improvement in the pace of recovery.  Another way of saying this is that an independent monetary policy will always dominate fiscal policy.

So if Russ Roberts is like me and wants fiscal policy consolidation that works he should really be clamoring for more monetary stimulus.  Otherwise he may get more than he bargained for.

Update: Awhile back I did a related post criticizing hard money advocates to which Paul Krugman repliedHere was my response to Krugman.


  1. Although this is marginally off-topic, I have to point out that Roberts is misleading with his WW II demobilzation post. His cheery-picked quotes are without merit. Samuelson was wrong, three years earlier. So what? Does Roberts have a perfect crystal ball? And Truman's economic report was overly-rosy political hype. Go figure.

    Truth is, the troops demobilized over several years - the draft continued well into 1947. Further, the GI bill sent many vets into school, not the workforce. Rosie the riveter went home and had babies - like me, frex, opening up a job or two. Wartime shortages, rationing and high savings rate caused a huge pent-up demand, so growth was pretty much inevitable, since it had-been supply constrained, and that was relieved.

    It's no coincidence that Hayekians and Libertarians focus on the post WW periods to validate their claims. These periods are aberrations. And then they have to misprepresent reality to make their points.


  2. Jazzpumpa,

    The fact that Samuelson's comment was three years earlier does not change the economics behind his remark. It was still relevant.

    True, many women went back to work and GI's went off to school. But somehow, 7.5 million new jobs were created between January 1945 and July 1946. The Keynesians were surprised and embarrassed. It wasn't just Samuelson.

    Growth didn't seem inevitable at the time.

    Happy to learn more about the pace of demobilization. Suggested readings much appreciated.

  3. Well, I have to say that pointing to that one infamous quote - which I have seen numerous times now - and saying - "See how wrong that is!" is 20-20 hindsight, cherry-picking, and pretty shallow. If Samuelson was generally faulty, there should be many quotes to pick apart. I hear crickets.

    Since Roberts is going after Krugman, he ought to take a look at his predictive abilities, rather than dragging up a 70-year idea enunciated by someone else. That is changing the subject.

    Re: demobilization, I just did a quick google search to make sure what I thought I know wasn't off base.

    I came up with these.

    At any rate, it's awfully hard to put a robust economy story together with the real GDP data in a way that makes sense.

    1941-01-01 1371.5 17.1%
    1942-01-01 1623.5 18.4%
    1943-01-01 1887.9 16.3%
    1944-01-01 2040.2 8.1%
    1945-01-01 2016.6 -1.2%
    1946-01-01 1798.2 -10.8%
    1947-01-01 1784.8 -0.7%
    1948-01-01 1864.8 4.5%
    1949-01-01 1854.2 -0.6%
    1950-01-01 2016.5 8.8%

    Negative growth 4 years out of five, starting in '45.


    I'd love to see data on the 7.5 million new jobs.


  4. Also from FRED, PAYEMS series. (All Employees: Total nonfarm)

    Jan 1, 1946 39839
    July 1, 1947 43742

    OK 3.9 million. This would be more impressive, though, if the previous 18 months hadn't seen the loss of about 2 million jobs.

    July 1, 1944 41904.

    The job additions from Jan, 1946 finally totaled about 7.5 million in Jan, 1951 - way on the far side of the 1948-9 recession.

    1951-01-01 47289


  5. Russ -

    I just noticed that your comment was from you, not from David. Keen powers of observation.

    I apologize for referring to you in the third person.


  6. You quote Russ Roberts: "The Keynesians predicted a horrible depression. Yet despite the release of 10 million people into the labor market with demobilization private sector employment boomed and the economy thrived."

    I read this a lot, but it does not entirely correspond with the actual, you know, facts. According to the annual GDP data on the St. Louis Fed web site, real GDP fell from $2,101.7 billion in 1945 to $1,790.7 billion in 1946, with a further decline to $1,774,6 billion in 1947.

    I'm not about to argue that no one predicted a disaster following the war, But I will argue that there was a sharp, steep decline in real GDP immediately following the war. We got over it fairly quickly (large accumulated savings, pent-up demand, and all that Keynesian rubbish), but to pretend that there was not a significant adjustment as federal government spending fell following the war is just wrong.