EMBARGOED BY BROOKINGS UNTIL 1 PM EDT March 22, 2012:

PRESENTATION: AS PREPARED FOR DELIVERY: Fiscal Policy in a Depressed Economy

J. Bradford DeLong and Lawrence H. Summers

March 23, 2012

We are here to say that, as a matter of arithmetic, in a depressed economy like the present, if a long deep recession casts even a small shadow on future potential output, with interest rates in the range at which the U.S. has been able to borrow, there is a substantial likelihood that expansionary fiscal policy right now would be self-financing, and an overwhelming likelihood that it would pass a benefit-cost test.

Since the start of 2007, CBO has repeatedly and substantially marked down its estimates of potential output a decade hence. For each percent that output falls below potential for a year, the CBO mark down its estimate of the long run potential of the economy by 0.2%.

The CBO is not an outlier among forecasters.

If higher output this year raises potential output in the future by a fraction η because it reduces the shadow cast by the downturn through discouraged workers, lost skills, broken organizations, and missing investment on future productivity, then boosting government purchases now, in an environment with a policy-relevant net-of-monetary-policy-offset Keynesian multiplier μ, boosts future real GDP by the multiplier times some hysteresis coefficient η. That means that in an environment with a tax rate τ, the flow of future total tax collections are boosted by τημ.

The extra debt incurred by a temporary government purchases expansion ΔG in an environment with a policy-relevant net-of-monetary-policy-offset Keynesian multiplier μ and a tax rate τ is (1 - μτ). If the government maintains a stable debt-to-GDP ratio then the cost of amortizing this extra debt is (r - g)(1 - μτ), where r is the real interest rate at which the Treasury borrows, and g is the long-term growth rate of the economy.

If:

r < g + τημ/(1 - μτ)

then we simply cannot do a benefit-cost calculation for expansionary fiscal policy. It is self-financing. There are no costs. No future tax increases are needed to amortize the extra debt, because economic growth does it on its own.

It is, rather, austerity that requires future tax increases.

For a multiplier μ = 1.0, a hysteresis shadow-cast-by-the-recession coefficient η = 0.1, a growth rate g = 2.5%/year, and a tax share τ = 1/3, this critical value of r becomes:

r < 7.5%

The long-run Treasury borrowing rate needs to be above 7.5%/year in real terms--above 9.5%/year in nominal terms--for fiscal expansion to be a bad deal.

For a multiplier μ = 0.5, a hysteresis shadow-cast-by-the-recession coefficient η = 0.05, a growth rate g = 2.5%/year, and a tax share τ = 1/3, (6) becomes:

r < 3.75%

The long-run Treasury borrowing rate needs to be above 3.75%/year in real terms--above 5.75%/year in nominal terms--for fiscal expansion to be a bad deal.

Note that this applies only to a depressed economy, and only as long as the monetary authority cannot or will not--but in any case does not--carry out the government's full stabilization policy mission all by itself.

If the self-financing condition fails, there is a benefit-cost calculation to do. Write down the net effect of expansionary fiscal policy on the present value of future output:

ΔV = [μ(1 + η(1 + ξτ)/(r-g) - ξ(1 - μτ)]ΔG

with ξ being the national income lost from raising an extra dollar of revenue from future taxes.

The last term is the burden placed on the economy from the taxes needed to amortize the additional debt.

The second term is the extra future production because lessening the current downturn lessens the destructive shadow cast on the economy in the long run. This middle term plausibly doubles or triples the benefits of expansionary policy above those of higher output from the multiplier μ in the present period alone. (9) tells us that, for a multiplier μ = 0.5, an η = 0.05, τ = 1/3, g = .025, and an r = 6%, expansionary fiscal policy passes its benefit-cost test as long as raising $1.00 in extra tax revenue through distortionary taxes reduces national income by less than $10.00.

In this depressed-economy framework at least, you have to get far out toward the edge of the parameter space in order for expansionary fiscal policy to flunk its cost-benefit test.

Does this prove too much?

No.

In normal times the logic of Taylor (2000) that stabilization policy should be left to the monetary authority still holds. It is only in extraordinary times, like now, that this argument has force.

In normal times expansionary fiscal policy as a stabilization policy will flunk its benefit-cost test. In normal times the multiplier μ will be close to zero. Perhaps the monetary authority will have a view about how the economy should evolve in a way that is consistent with long-run price stability, will not want its elbow joggled by others, and will thus take anticipatory steps to offset any effect of expansionary fiscal policy on output. Perhaps the monetary authority will watch fiscal expansion raise output, disapprove of the resultant increase in inflation, and then offset it by creating an equal and opposite output gap later. Either way the policy-relevant multiplier μ is zero. Either way, expansionary fiscal policy as stabilization policy has only costs and no stabilization-policy benefits.

In a depressed economy, however, there is less increase in inflationary expectations following from higher output, and less reason for the monetary authority to fully offset the effects of expansionary fiscal policy.

Hence our conclusions.

How could this argument go wrong?

The fear is that expansionary fiscal policy will lead to a collapse in confidence in the government, and a spiking of interest and inflation rates to previously-unseen values.

But since austerity appears, for what we see as reasonable parameter values, at least as likely likely to erode the government's fiscal room to maneuver than temporary expansion, this seems backward. if the logic of this argument is correct, then it is a failure to engage in expansionary fiscal policy right now--a failure to speed recovery and so reduce the long-term shadow cast on future productivity by the downturn--that is the real threat to long-run fiscal stability.

Sovereign debt crises can be triggered by rises in spending due to expansion. They can also be triggered by falls in growth and taxes due to austerity.