Stimulus or Austerity?. Presentation for THE PRESIDENTIAL ELECTION OF 2012 Hiram College, November 16-17, 2012. Uğur Aker Prof. of Economics Hiram College. Source: http:// www.dallasfed.org/research/swe/2005/swe0502.pdf. How To Deal With Recessions. Do nothing. Use monetary policy.
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THE PRESIDENTIAL ELECTION OF 2012
Hiram College, November 16-17, 2012
Prof. of Economics
Length of time to get back to “full employment” may be “too long.”
Pervasive bankruptcies may devastate communities.
If government services are dependent on public revenues, the pain on the population will be exacerbated.
Borrowing by firms and individuals during a recession becomes very difficult, closing another door to weather the blow.
The need for a “lender of last resort” to insulate
banks from runs and inevitable bankruptcies that
freeze the whole financial system, caused the
establishment of the Fed, US Central Bank.
Central Banks increase or decrease the amount
of money in the system and as a result, lower or
raise the short term interest rate.
During recessions Central Banks increase the amount
of money in the system and lower the short term
In mild recessions this approach seems acceptable to
spur consumption and investment spending.
During expansions that trigger inflation, raising interest
rates is the policy response of the Central Banks.
Keynesian answer to the Great Depression was to
counter the drop in consumption and business investment
spending by having government to increase spending
and decrease taxes.
The ensuing deficit and the increase in national debt was
supposed to be reversed during boom times.
In fact, the concern was that as the economy grew and
tax rates remained constant, tax collections would exceed
spending and there would be a “fiscal drag.”
Keynes wanted an accommodative monetary policy to
accompany a fiscal stimulus. By keeping the interest
rates constant, the fiscal stimulus would not crowd-out
private sector spending.
Governments found this approach very appealing
politically and utilized it son and off since WWII.
The different price experience in the 20th century
compared to the 19th century can be ascribed to the
activist government practices.
The preferred approach to business cycle research is using
Dynamic Stochastic General Equilibrium models.
DSGE models use random demand or supply shocks to alter
the economy from its full employment path.
Demand shocks are drops in spending by consumers,
businesses, government, and foreigners on our exports.
Supply shocks are any increase in the economy-wide costs
A complementary approach concentrates on the response of
the Federal Reserve. To counter the rising inflation of the
booming economy, the Fed increases interest rates and slows
down the economy. The higher interest rates reduce the
spending on the output and recession occurs.
In spite of the stimulative effects of Reagan tax cuts and
military spending increases, the overnight interest rates
were pushed up to close to 20% by the Fed and the economy plunged into two back-to-back recessions.
GDP growth in the United States in the early-1980s. The short recession at the start of the decade, followed by a brief period of growth and the deeper recession in 81–82, have led to this period being characterized as a W-shaped recession.
Percent Change From Preceding Period in Real Gross Domestic Product (annualized; seasonally adjusted); Average GDP growth 1947–2009
Source: Bureau of Economic Analysis
Over-leveraged, heavily indebted economies face risk of
default. The indebtedness can be either to domestic or
external lenders. The debt can be sovereign or private.
When default risk rises, banks holding the debt as assets
become vulnerable and bankruptcies are imminent.
Bank bailouts and injections of money to counter the freezing
of credit may soften the blow.
Central bank money injection lowers the interest rate and
should spur borrowers to take loans and engage in spending.
At the same time, the banks are flush with reserves and should
be willing to part with their excess reserves.
If neither the borrowers nor the banks are fulfilling their
normal functions and the injection of money already lowered
the interest rate to zero (liquidity trap), the only tool the
government has left is fiscal policy (stimulus).
If inflation is not increasing, then the expected burdens of
the stimulus are not in the horizon.
Inflation will increase the nominal interest rate and will
allow the Central Bank to utilize its monetary policy further.
Inflation will also signal pressure on resources, or expansion
of the economy.
In the past, studies covering the period after WWII, did
not necessarily provide uncontestable results. A sizable
group claimed to come up with multipliers less than one.
That means for one dollar spent by the government the
income of the economy increased by less than one because
other sources of spending dropped.
For instance, in February 2009, in a short note entitled “Voodoo
Multipliers,” Robert Barro claimed that stimulus will have a
multiplier of 0.7-0.8.
About the same time, Mark Zandi published his multipliers.
He claimed that unemployment insurance, food stamps, and
infrastructure spending all had multipliers of greater than 1.5.
Alesina and Ardagna show instances where the multiplier is
negative: reducing government spending actually increases
output. The transmission mechanism is through the fall in
interest rates due to a reduction in risk. Tax increases do not
give the same results.
Auerbach and Gorodnichenko find fiscal tools to be more
effective in recessions than in expansions. According to
their calculations, reducing taxes during recessions do not
budge the total output; increasing military spending does.
Christiano, Eichenbaum, and Rebelo find multipliers to be
around one when the federal funds interest rate is positive
but they are about three when liquidity trap is existent.
In October 2012, IMF declared that fiscal multipliers were
two to three times higher than thought just a couple of years
ago. That meant the negative impact of austerity on the
economy was larger than previously thought.
A common objection to the deficits and piling of the debt is
the extra burden the future generations will carry to pay down
the debt. This cost to the future generation has to be weighed
against the sacrifices of the present generation.
If the unemployment rate is 50% higher than normal, is it
worth the future generations to pay extra taxes to have their
parents and grandparents employed with all the psychological,
economic, and social benefits?
And if the real interest rate is zero or negative, why doesn’t the
government borrow to spend on high return projects? The children
will benefit mightily.
Alesina, A. and S. Ardagna, The Design of Fiscal Adjustments,
NBER Working Paper #18423, September 2012.
Auerbach, A. and Y. Gorodnichenko, Measuring the Output Responses
to Fiscal Policy, NBERWorking Paper #16311, August 2010.
Christiano, L., Eichenbaum, M., and S. Rebelo, When is the
Government Spending Multiplier Large? NBER Working Paper #15394,
Rose, F., “The Art of Immersion: Why Do We Tell Stories?” Wired, 03.08.11
Shermer, M., “Patternicity: Finding Meaningful Patterns in Meaningless
Noise,” Scientific American, November 25, 2008
Voltaire, Candide, 1759
Keynes, J.M., The General Theory of Employment, Interest, and Money, 1936
Del Negro, M. andF. Schorfheide, “DSGE Model-Based Forecasting,”
Federal Reserve Bank of New York Staff Reports, No. 554,March 2012
Reinhart, C. M. and K. S. Rogoff, This Time Is Different: Eight Centuries of
Financial Folly, Princeton University Press, 2009.
Barro, R., “Voodoo Multipliers,” Economists’ Voice,
www.bepress.com/ev, February, 2009