Fiscal stabilisation and debt

1. Fiscal stabilisation and debt Simon Wren-Lewis Economics Department and Merton College, Oxford This talk draws heavily on joint work with Campbell Leith at Glasgow University under the ESRC’s World Economy and Finance programme, and also joint work with Tatiana Kirsanova at Exeter University. However neither co-author should be implicated by any views I express here WEF Event: Picking Up the Pieces

2. Summary • Fiscal countercyclical policy • The traditional assignment • Zero bounds • The right type of fiscal policy • Stimulus without raising debt? • Optimal debt policy • The random walk result: its importance and limitations • Fiscal councils WEF Event: Picking Up the Pieces

3. The conventional assignment • Monetary policy • Short term stabilisation of demand consistent with achieving a medium term inflation target • Debt stabilisation or reduction is not an objective • Fiscal policy • To meet some objective for government debt over the medium/long term • Short term demand stabilisation is not an objective • With the occasional exception, this was the consensus among policy makers and academics before 2008/9 • A key caveat was, or should have been, that monetary policy is not constrained by a zero lower bound WEF Event: Picking Up the Pieces

4. Zero bound implies fiscal action • Impact of QE uncertain • Policy makers are unwilling to raise inflation targets or adopt a price level target • Time inconsistency problem • Misinterpreted as debt stabilisation • Damage anti-inflation credibility • Fiscal stabilisation has to step in at the zero bound, and can be very effective • See Eggertsson, G. and Woodford, M. 2003/2004 on all these points • Some fiscal instruments are much more effective than others. WEF Event: Picking Up the Pieces

5. Some fiscal policy myths • “Ricardian Equivalence means fiscal policy does not work” • Temporary increases in government spending raise demand even if consumers are totally Ricardian • In an open economy independent fiscal action gets crowded out through an appreciation • If interest rates are stuck at zero, and the fiscal expansion is temporary, the exchange rate should not appreciate. • Any increase in government borrowing crowds out private borrowing • Even if we deny that prices can be sticky, the zero bound is a fact, and it prevents demand adjustment WEF Event: Picking Up the Pieces

6. Macroeconomics, ideology and ivory towers • Eugene Fama (Professor, Chicago) • The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another. • John Cochrane (Professor, Chicago) • Every dollar of increased government spending must correspond to one less dollar of private spending. WEF Event: Picking Up the Pieces

7. On theory that denies the possibility of deficient aggregate demand • Keynes (1936) General Theory • That it [Classical Theory] reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commanded it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority. WEF Event: Picking Up the Pieces

8. Fiscal expansion without higher debt? • Intertemporal incentives • Anticipated VAT increases – fiscal policy as monetary policy • Tax financed temporary increases in government spending • Will expand demand if consumers are Ricardian • Redistribution from unconstrained to credit constrained consumers • All redistribute, but so does monetary policy WEF Event: Picking Up the Pieces

9. Outside of the zero bound, is the conventional assignment still right? • Given lags, precautionary fiscal expansion may on occasion be warranted • Theory – fusion of two literatures • Dynamic optimal taxation theory • Schmitt-Grohe, S. and Uribe, M. (2004) – sticky prices make an important difference • Keynesian theory (Woodford – social welfare measure of business cycle costs) • (Robust?) Result: If monetary policy unconstrained, optimal fiscal demand management is no demand management • Eser, F, Leith, C and Wren-Lewis, S (2008) WEF Event: Picking Up the Pieces

10. Fiscal policy still has a stabilisation role in changing relative prices • If wages as well as prices are sticky, tax changes can help ‘correct’ the real wage • Leith, C. and Wren-Lewis, S. (2007), 'Counter-Cyclical Fiscal Policy: Which Instrument is Best?', Glasgow University. • Tax changes can offset cost-push shocks • Tax measures may be more efficient at pricking asset bubbles in particular markets than general interest rate changes. WEF Event: Picking Up the Pieces

11. Optimal debt policy: the random walk result • Assume away default risk, and assume infinitely lived Ricardian consumers • Taxation is distortionary, so any non-negative government debt has social costs • Despite this, if a demand shock raises government debt, the optimal response is to live with this higher level of debt • Schmitt-Grohe, Stephanie and Uribe, Martyn (2007) • Benigno, P and Woodford, M (2003) • Essentially a tax smoothing result WEF Event: Picking Up the Pieces

12. Limitations • Assumes time inconsistent policy • Under time consistent policy, optimal policy would involve rapid debt correction • Leith, C and Wren-Lewis, S (2007), Fiscal Sustainability in a New Keynesian Model, Oxford University Discussion Paper No. 310 • Assumes benevolent policy makers • Leith, C and Wren-Lewis, S (2009), Electoral Uncertainty, the Deficit Bias and the Electoral Cycle in a New Keynesian Economy, Oxford University Discussion Paper No 460 • Ignores default risk • With finitely lived, intergenerationally selfish consumers, debt crowds out capital WEF Event: Picking Up the Pieces

13. Debt and long run crowding out: log utility • Ricardian model • No crowding out of capital • 2 period OLG model with zero labour income in second period • More than 1 for 1 crowding out of capital • Blanchard-Yaari • C=consumption, r=real rates, =impatience, =decline in income with age • A=total assets (debt+capital), p=probability of death • Calibration (annual): K=1,Y=Debt=0.25,=0.04,p=0.02, =0 • Implies r=5% • Reduce debt to zero – interest rates fall to 4.8% • Steady state A falls by almost as much as debt, so K rises by just 3.13% • Steady state consumption rises by 1% • Making =3% pa will double the long run impact of lower debt WEF Event: Picking Up the Pieces

14. Implications • The random walk result demonstrates that debt should be a shock absorber and not a target. • The possibility of hitting a zero bound means that we need, in other times, to be gradually reducing debt • Constant debt/GDP objectives not enough • Supported by OLG crowding out • Unless the emergence of default risk premium is a significant possibility, debt reduction should be gradual and erratic. WEF Event: Picking Up the Pieces

15. How best to achieve gradual and erratic debt reduction? • Targets set by governments are likely to be economically and politically sub-optimal • Governments have a temptation to be over optimistic in making fiscal projections • Need Fiscal Councils to • Independently forecast development of government debt • Advise on the optimal timing and speed of debt reduction • Have the political authority to act as an effective public watchdog • See Kirsanova, T, Leith, C and Wren-Lewis, S (2007), Optimal Debt Policy, and an Institutional Proposal to help in its Implementation, European Economy Economic Papers No 275 • And Sweden, Canada, Hungary and others • And Conservative Party policy WEF Event: Picking Up the Pieces