The Frustrating Fiscal Stimulus Debate

The final session of the American Economics Association conference I attended was a very popular throwdown between Paul Krugman and UCSD’s Valerie Ramey on the subject of fiscal stimulus.

It was, I thought, a frustrating affair that well summed up the dialogue of the deaf that proceeds in this debate. Krugman advanced basically two key arguments on behalf of stimulus. One is the argument from sectoral balances. The recession was associated with a huge move toward private sector de-leveraging, indicating a clear need for public sector leveraging to avoid the creation of a gigantic output gap. Logically the only alternative strategy would be a huge boost in net exports but it’s not possible for the large developed economies to all simultaneously increase net exports. The second is the empirical evidence from Europe. Krugman then goes on to say that this is a specific argument about a specific kind of situation in which there’s a large output gap and no monetary policy offset.

Ramey in response has time-series data from throughout the twentieth century which points to low multipliers for government spending—multipliers below one.

But this is overwhelmingly drawn from periods when Krugman would concede that fiscal policy multipliers ought to be low, because with interest rates not constrained by the zero bound the Federal Reserve is ultimately controlling the level of aggregate demand. Ramey then has an interesting look at World War II where she argues that essentially the entire reduction in unemployment can be accounted for by conscription. So we’re left with the conclusion that we could sharply reduce unemployment by conscripting young people (youth unemployment is above average, we note) and sending them to fight in a war but this would be unlikely to raise welfare.

To me this and other versions of the academic debate actually suggests that there’s actually a fair degree of consensus on the issue. If you listen carefully to Krugman, he’s saying that fiscal stimulus will almost never be a good idea. And if you listen carefully to Ramey, she’s saying that when economic slack exists fiscal policy can reduce it. In off-topic remarks, Krugman said he thinks there’s a lot of slack in the economy right now and Ramey said she thinks there’s very little slack in the economy right now. Ramey also ended her presentation with a strong call for free market health care reforms, while we know from Krugman’s columns that he’s a strong advocate of the Affordable Care Act and other efforts to bring the United States into closer alignment with Canadian health care practice. So there’s a lot of disagreement here about economic policy but relatively little actualy disagreement about macroeconomics.

My sense is that we could get a lot clearly about where people really stand by actually posing the policy questions squarely. Would a large temporary income tax cut offset by a small permanent cut in Social Security benefits be a good idea? Or how about reducing America’s debt:GDP ratio by taxing dividend income at the ordinary income tax rate?

I think if we tried to jog researchers out of basic left-right political alignments we might get a little bit more clarity on what everyone thinks the real issues are. I get the overwhelming impression that with a few exceptions the issue is basically that right-of-center economists (like right-of-center people) generally think the existing level of government spending is too high and that additional government spending is likely to be wasteful—the equivalent of conscripting soldiers to fight in an unnecessary war—while left-of-center economists have the reverse view.