An Austerian of Last Resort

Brad DeLong and Matt Yglesias have tried playing Bryan Caplan’s “Ideological Turing Test“:

But the ability to pass ideological Turing tests – to state opposing views as clearly and persuasively as their proponents – is a genuine symptom of objectivity and wisdom […] But the beauty of the notion of the ideological Turing Test is that it’s a test.  We don’t have to idly speculate about how well adherents of various ideologies understand each other. We can measure the performance of anyone inclined to boast about his superior insight.

I find fiscal consolidation during a time of high unemployment to be appalling, and I’m going to develop my own (plausible) argument for austerity, but first I don’t think Yglesias’ case is very “strong” at all:

But the solution to this problem can’t be to say “next time congress is going to be way better and less partisan and fiscal stimulus will work out great.” […] But I’d say the best thing to do would be to change the practice of central banks. Give the Federal Reserve an explicit mandate to level-target aggregate economy-wide spending and authorize the Fed to issue helicopter money directly to citizens when necessary to hit the targets. Then there’s no “zero bound”, there’s no question of monetary impotence, and there’s no question of discretionary fiscal stabilization […] Creating a dedicated agency charged with macroeconomic stabilization was a good idea. If it’s failed, we need to fire its leaders and replace them with people who’ll succeed. If it legally lacks the necessary tools, give it the tools. Print money and give it to people.

Or as DeLong puts the old argument:

1. The problem of legislative confusion.

2. The problem of legislative process

3. The problem of implementation.

4. The problem of rent-seeking.

5. The problem of superfluity.

Now Yglesias feels the crisis imperils (5) but validates the first 4. This is inconsistent, however, with his preference for remarkably loose monetary policy (printing cash to hit a nominal target). The Federal Reserve is similarly handcuffed by problems of implementation, legislative deliberative process, and rent-seeking. For one, it is highly idealistic to think it is a “dedicated agency charged with macroeconomic stabilization”. This might be a historically accurate statement – Volcker reigned inflation in a way the political process could not. But there is both an intellectual and political belief that the Fed’s primary purpose is stability of prices and the financial system. As Tim Duy, via Mark Thomarecently put it:

If Kocherlakota is correct and monetary policy can only pursue the dual mandate in the context of financial – and, by extension – macroeconomic instability, then we really need to consider which part of the dual mandate needs to be loosened to reduce the reliance on financial instability. My fear is that if Fed policy makers were asked this question, they would unanimously answer that it is the full-employment portion of the mandate that should be jettisoned.

Duy writes, convincingly, that a central bank can only give us two of: price stability, full employment, and healthy financial system. In a historically conservative institution, it is hard to believe given the choice employment would be prioritized.

This is to say that even if we’re ready to give the central bank total power, come what may, there are crucial questions of deliberation and implementation that need to be answered. More importantly, accommodative monetary policy as we know it is hardly rent-free, as John Aziz argues:

Yet data suggests that the monetary injections via asset purchases are not really trickling down, much less kickstarting strong growth. While money has flowed into stock markets and corporate debt lifting prices from the lows of 2009, real GDP growth in Britain has been deeply depressed since quantitative easing began in 2009, lending to business remains depressedunemployment remains elevated at 7.9%, and M4 growth remains severely weak, even while being boosted directly by quantitative easing. So the wealth effect so far appears to be constrained to the financial economy (to such an extent that it may be an asset bubble rather than sustainable growth).

Is it just a matter of time before the effects of quantitative easing begin to bloom in the real economy, or is the transmission mechanism fundamentally broken? And — perhaps just as importantly — is it possible to have a policy that doesn’t disproportionately benefit the richest?

When the Fed loans money at the Federal Funds Rate a low discount rate, bankers and shareholders make a killing on cheap debt and appreciated assets, without any tangible benefits to the “common man”. To be fair, Yglesias does suggest a form of “helicopter money“, but this policy is again so radical it will inevitably be delayed in policy meetings.

And just as I don’t think monetary policy is free from the more mundane “old” problems DeLong mentions, I doubt fiscal policy is as ineffectual as we perceive. There are obvious issues of rent extraction, but take the other few which can be, broadly, delineated as issues of legislation, and issues of implementation. While we have seen decapitating (?) gridlock since 2010, it is important to remember Barack Obama had a powerful governing mandate in January 2009. It is important to remember that only after Scott Sumner Brown won in the special election did Democrats loose the necessary supermajority to rule. It is also important to remember that a fair number of Republicans were on board with a good stimulus.

The implicit point he makes, of course, is that ARRA was too weak. Christina Romer, now infamously, wrote a memo arguing for a super-trillion dollar package which Larry Summers squashed fearing legislative backlash. I think he was wrong. If Obama had single-handedly focused on economic and financial stability, Ron Suskind tells us, he could have survived with a robust fiscal stimulus which might have put a serious dent in our output gap. My point is, the travails of fiscal stimulus were not as much at the political level as much as within Obama’s economic team. Or at least the argument could be made.

But, the whole point of this post is that there is an argument for austerity. Unlike other critics of Keynesian policy, like Scott Sumner or Yglesias in his above incarnation, I won’t take for granted particularly accommodative monetary policy. I will try my hand at what I think is the definitely harder argument of a truly hawkish policy: fiscal consolidation and tight money.

The most convincing economic case for deficits during a slump is the miraculous idea that it is self-financing. This is most precisely accomplished by DeLong and Summers (2012). While a few years ago I might have believed arguments that the multiplier, μ, is below 1, I think it is not too generous to assume that it is closer to 1, noting that IMF estimates have converged near or above this value. However, the pivotal nature of the multiplier to any Keynesian argument and the uncertainty in measurement thereof is by itself a red flag in the theory.

But DeLong and Summers (2012) also note the importance of “hysteresis”, or the long-term supply-side effects of unemployment and depression. This is a convincing argument, particularly in terms of forgone research and investment, but I am less swayed by long-term labor market effects of recession. While Summers has argued (even before) that employment of women during WWII had positive effects on female labor force participation, the data are less convincing in the negative direction. I.e., it is one thing to argue that temporarily employing an excluded group increases aggregate supply of labor, and another thing extrapolating that to say that temporarily disemployment an included group decreases aggregate supply of labor.

Their theory is as follows, where Y is income, η is hysteresis, r is the real interest rate, and G is government purchases:

∂Y = ημ∂G

Total revenues, then, increase as:


where τ is the tax share of GDP. We amortize this debt as:

(r-g)(1- μτ)∂G,

where g is the potential growth rate of the economy. (For reference, this is about 0.025 as measured by the CBO).

Because I’m most unconvinced about long-run supply-side effects, I like thinking about it as the minimum η for which it is worth it to borrow, rather than the maximum r, which, in a slightly different arrangement, is:

∀[η > (g-r)(tu-1)/tu]

In the US, Heritage Foundation and OECD estimates of τ are just above and below 0.25. Today, the thirty-year Treasury yield is .0288. Therefore deficits are self-financing as:

∀[η > 0.0114]

Before we even go on, I have two problems with this estimate. One is, that during just the recession, labor share of GDP fell by 2%, inevitably taxed at lower rates than most labor. DeLong estimates an η of 0.035 based on 60% labor share. I think this is an overestimate. According to FRED, it is at 44% and falling. By next recession this will be even lower, especially if the technologists betting on 3D printing get their way. Also, human capital is more concentrated than ever, to the point where discouraged workers are socially important, but economically more useless than ever before. Indeed, unless the recession has caused serious discouragement among America’s educated, I am unconvinced we ought to worry.

Additionally, this model suggests the long-run potential growth rate is at a constant 2.5%. If hysteresis is a real problem, the higher it is (and hence the more valuable deficits become), the more doubtful it is we can assume a constant g. And if g becomes progressively smaller, the requires hysteresis becomes higher. And now we have feedback.

Another issue with employing Keynesian arguments towards deficit spending is that Americans have, recently, not saved during “good times”. Deficits, in other words, are common not only in bust, but also boom. The argument that austerity sets a bad precedent for future recession is at least somewhat tempered by our inability to run a surplus during good times.

Now, people will be quick to note that our growth rate might usually be higher than the deficit, i.e. that we run a structural surplus. But this means America is becoming a bank, and why should we believe it is the most efficient? There are certain projects of such scale – massive infrastructure and education – that perhaps requires governmental coordination. But why should we let our government become a hedge fund?

Of course, confidence in the American government is so high that Bill Gross believes it is the safest asset. One might say it is foolish not to capitalize on such low rates. Again, it is hard to argue that the private forces cannot allocate capital more efficiently. If high rates are what is hurting investment, the central bank can always lend to banks for free overnight.

Indeed, if cost of capital was actually a problem, there’s a great chance the economy is booming. Rates are low because our huge trade deficit forces foreigners to buy Treasuries, banks have excess reserves, corporations are not investing, and consumers are not borrowing. The argument that government should be a leveraged broker because it can sell bonds with low yields doesn’t apply in time of prolonged stagnation.

There is also a more philosophical argument. It is imprudent to run deficits without a plan of paying them off. While a stable debt-GDP ratio is fine, one of the freedoms of low debt levels are the chance to run huge deficits when necessary. We don’t know when our next real (supply) shock will be. We don’t know the next time we will need to ramp up expenditures not for Keynesian stimulus, but for real reasons such as deteriorating infrastructure and education. These are not “shovel-ready” and a Federal Reserve of San Francisco study found that in the medium-term highway projects might actually cost us. (Positive effects are kind of evident in the first years, but only pick up six to eight years later):


We might say there is a fragility associated with debt.

Alright, arguing that austerity might actually be good is exhausting. Especially without the option of easy money policies. Maybe I should have tried before R-R blew up…

  1. Sam Gray said:


    First, I’m a big fan of your blog, but I’m stongly skeptical of your statements that monetary policy leads to any rent seeking.
    You say, “When the Fed loans money at the Funds Rate, bankers and shareholders make a killing on cheap debt and appreciated assets, without any tangible benefits to the ‘common man.'”

    Since the Fed cut rates to near zero in mid-December of 2008, bank stocks have significantly underperformed relative to broader market indices (I used the iShares Dow Jones US Financial Sector, ticker:IYF, to see this). Wouldn’t your hypothesis have predicted abnormally higher returns? If not, where is the rent seeking?

    I’m also strongly skeptical that macroeconomic stabilization leads to financial instability. It’s fashionable nowadays to talk about the Fed’s current policies as somehow “inflating the next bubble,” but I have yet to hear a coherent explanation why.

    • Thanks for the kind words… Fixed the typo – entertaining, indeed! My subconscious talking?

      Yes, my hypothesis would have predicted abnormally high returns, but relative to other sectors but to the counterfactual in which interest rates were significantly higher. Additionally, it’s not just bank returns, but stocks in general, which benefit from Fed policy, but are disproportionately owned by a few percent. Again, helicoptering money seems to be a fair fix.

      As for your last point, I’d direct you to the Tim Duy link above as well as this Economist article,

      Jeremy Stein, of course, makes another case for tighter policy.

  2. Sam Gray said:

    Oh, and you have a big (but delightfully entertaining) typo in reference to the special election to fill Ted Kennedy’s senate seat. It was Scott Brown, not Scott Sumner, that joined the Senate and deprived Democrats of their fillibuster-proof majority. But oh, how wonderful it would have been if your statement were correct…

  3. ‘When the Fed loans money at the Funds Rate….’

    It’s banks that lend at the FFR, to each other.

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