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Monday, November 24, 2008

Is Fiscal Policy the Answer?

Does Christina Romer believe fiscal policy won't work to cure a recession? (No, she doesn't):

Dueling outlooks, Free Exchange: ...At the heart of depression economics, [Paul] Krugman has said, "is the collapse of policy certainties". Or as he put in in a paper on the Japanese liquidity crunch:

The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem.

Virtue is vice; vice, virtue. But this view is not shared by everyone. In a weekend New York Times column on the New Deal, Tyler Cowen writes:

The good New Deal policies, like constructing a basic social safety net, made sense on their own terms and would have been desirable in the boom years of the 1920s as well. The bad policies made things worse. Today, that means we should restrict extraordinary measures to the financial sector as much as possible and resist the temptation to “do something” for its own sake. 

So what's the right approach? Interestingly, Mr Cowen's column cites the work of Christina Romer, the Berkeley economist recently tapped to run Barack Obama's Council of Economic Advisers. He says:

A study of the 1930s by Christina D. Romer, a professor at the University of California, Berkeley (“What Ended the Great Depression?,” Journal of Economic History, 1992), confirmed that expansionary monetary policy was the key to the partial recovery of the 1930s. The worst years of the New Deal were 1937 and 1938, right after the Fed increased reserve requirements for banks, thereby curbing lending and moving the economy back to dangerous deflationary pressures.

Mr Cowen is seeking to use Ms Romer's findings as evidence that little expansionary action should be taken beyond easy money, but I'm not sure the paper reflects that conclusion. For one thing, it is the extraordinary monetary actions that made the difference during the 1930s—the abandonment of the gold standard coupled with massive capital inflow from Europe.

But as importantly, Ms Romer doesn't say that fiscal policy couldn't have worked, just that it didn't. The reason it didn't, as many commentators have pointed out in recent weeks, is that president Roosevelt didn't do a particularly good job of employing it. He was stubbornly resistant to deficit spending, and he threatened to undo the progress made to 1937 with a misguided attempt to balance the budget, throwing the country back into recession.

So yes, monetary policy largely saved the day in the 1930s. It had to, because that's mostly what there was. Of course, aggressive deficit spending combined with monetary easing would almost certainly have prevented the Depression from spanning the whole of the decade.

Fiscal policy is a blunt instrument, and difficult to use in a run of the mill recession. This is no run of the mill recession, however, and it's not clear whether monetary policy has the verve to give the economy the jolt it requires. ...

Romer's colleague Brad Delong offers talking points concerning her nomination to head the CEA:

Talking Points on the Designation of Christina D. Romer as the Candidate to Be Nominated to the Senate for the Post of Chair of the Council of Economic Advisers:

  • World-class expert on the Great Depression: if you want to avoid any of the mistakes made during the Great Depression, she is the one to hire.
  • World-class expert on monetary and fiscal policy: encyclopedic knowledge of their history...
  • A center-left moderate:
    • But these are not moderate times. To be moderate now is to be radical. To be radical is to be moderate.
  • A woman who taught her then-two year old that the answer to the question "Who should be president?" was "Bruce Babbitt."

And, in a recent interview, Christina Romer says:

...The thing I added in this paper was the long-run fiscal side. ... What's very striking is that we had a pretty sensible long-run fiscal view in the 1950s—the budget should be balanced over the medium run, but not each and every year and not in exceptional circumstances. And, policy choices reflected that view-the budget was balanced on average, but not in recessions and not during wars.

But views took an unfortunate turn in the 1960s and '70s. Policymakers started to believe that budget balance was not important even over an extended horizon, and that tax cuts would pay for themselves. And views took another wrong turn in the 1980s, when policymakers added notions such as the starve-the-beast hypothesis that tax cuts would force spending cuts. I think these are wrong turns that we haven't corrected yet—as evidenced by our ever-worsening long-term fiscal outlook. ...

So, balance the budget over the long-run, but do what is necessary to stabilize the economy in the short-run, including running budget deficits. Tax cuts don't pay for themselves, and starving beasts get angry, not thin. Seems reasonable to me.

Update: Eric Rauchway adds:

That Romer article on the Great Depression: Christina Romer, the appointee-designate (or whatever) as director of the president’s Council of Economic Advisors is said to have argued, in her influential article “What Ended the Great Depression?” [JSTOR link], that “expansionary monetary policy was the key to the partial recovery of the 1930s” and therefore, “monetary policy is key.” And indeed Romer does argue this, but contrary to a variety of panicky emails that have shot through my inbox, her argument is not inconsistent with the president-elect’s stated plan for fiscal stimulus. Why?

Romer’s argument goes something like this:

(1) Per E. Cary Brown, and Keynes before him, the New Deal did not provide enough fiscal stimulus to spur recovery during the 1930s—not that it didn’t work, but that it wasn’t tried.

(2) Yet there was significant recovery during the 1930s, both as to economic growth and to job growth.

(3) So we have a mystery: where did the recovery come from? Did it come from the ordinary operations of the economy? No; there was an inflow of money from outside.

(4) Why was there an inflow of money? Not because of the Fed—it wasn’t cooperative. But by stabilizing the banks and devaluing the dollar, Roosevelt’s administration set policy that drew overseas investments into the US.

(5) This money came from overseas at first because of the devaluation, but it came in quantity later because it needed someplace safer to go than a Europe menaced by Hitler. Other countries’ misfortune was America’s good luck. (Which means you can’t necessarily say that there would have been a recovery without the war; the inflow of overseas investment owed partly to the war.)

(6) Romer’s conclusion then is that “the rapid rates of monetary growth were due to policy actions and historical accidents.”

She’s very clear throughout that deliberate policy choices were key, and she thinks the deliberate policy choice of FDR to devalue in 1933/34 was most key.

But there’s nothing particularly prejudicial there against fiscal policy. Nor an argument about the superiority of monetary policy. But an empirical case that owing to planning and luck, monetary policy worked in the 1930s.

And just now we haven’t stabilized the banks quite as the New Deal did in 1933.

    Posted by on Monday, November 24, 2008 at 09:09 PM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (27)


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