When Austerity Is Self-Defeating

In “Fiscal Policy in a Depressed Economy” (PDF) Lawrence Summers and Brad DeLong try to nail down the center-left’s take on the “macro wars,” attempting to mount a robust defense of fiscal stimulus in the conditions of the Great Recession without overturning the conventional wisdom about the primacy of monetary policy from the era of the Great Moderation.

They say that normally stimulating the economy with discretionary fiscal policy won’t work because the central bank, in order to avoid inflation, will respond to any stimulative impact with higher interest rates. Thus government purchases will “crowd out” private sector activities, which may be good or bad in the long term but either way won’t change the level of economic activity in the short term. But in a period when rates are up against the zero bound and still the economy is depressed, the calculus is different. By simply committing to keep interest rates low despite the expansion in government debt, the central bank can allow an expansion in government purchases to increase the amount of economic activity and not just crowd out private sector investment.

But what about the need to repay the loan later with taxes? Doesn’t that produce growth-slowing distortions? Yes, it does. But they argue that the decision to allow for a very prolonged period of depression also creates economic distortions. For starters, a prolonged recession means a prolonged period of time of below-average investment—a time during which population growth and depreciation mean that a society’s stock of capital goods is declining. Secondarily, when people are employed they’re constantly learning job-relevant skills whereas when they’re unemployed they’re slowly un-learning those skills. Thus not fixing a recession leads to declines in both physical and human capital. They illustrate this dynamic by showing that the CBO has steadily lowered its estimate of the U.S. economy’s “potential output” as the recession has dragged on:

They also mount some provocative evidence that this kind of factor explains why core European unemployment remained so stubbornly high for most of the 1980s and 1990s. They quote Ball (1997) on Europe noting that “countries with larger decreases in inflation and longer disinflationary periods have larger rises in the NAIRU” while “imperfections in the labor market” that tended to take the blame had “little direct relation to change in the NAIRU.” The exception that proves the rule here is that generous long-term unemployment benefits do seem to have NAIRU-boosting properties. But that variable is a mixed bag. On the one hand a labor market policy, but on the other hand an alternative policy response to a prolonged depression.

Their net point is that rather than a tradeoff between short-term pain and long-term gain, we face a tradeoff between the long-term pain of needing to repay a larger stock of debt and the long-term pain of needing to deal with an economy that’s permanently crippled by under-capitalization and deteriation of worker capabilities. They argue that this means fiscal stimulus passes cost-benefit analysis even under very restrained estimates of the fiscal multiplier.