Let’s get fiscal!

How to grease the aching wheels of a sickening world capitalist economy?  Let’s get fiscal is the universal cry of economists and policy makers.  The COVID meltdown and impending global recession is forcing authorities to consider fiscal stimulus.

Monetary policy is running out of ammunition and was not working anyway in restoring business investment, productivity and growth even before the virus epidemic. The US Federal Reserve cut its policy rate (the floor for all interest rates) by ½% last week and plans more cuts. It has some room to do so.  The European Central Bank (ECB) may follow this week and perhaps the Bank of England too. But these banks have already got their policy rates near zero, so they don’t have much more to offer. The Bank of Japan has been at zero for years. The Fed cut had no effect at all in stopping the meltdown in global stock markets: all it did was to weaken the US dollar.

So the cry is out for fiscal stimulus: i.e. increased government spending and tax cuts through deficit borrowing on budgets.  The IMF, OECD, World Bank etc are clamouring for governments to take action.  The IMF has offered $50bn in emergency funding.  The stricken Italians announced a $4bn injection, which will mean that the annual budget deficit will break Eurozone fiscal cap rules.  The new UK government presents its budget this week and will surely increase spending even if the ‘golden rule’ of balancing current expenditure with taxes is broken.  The US Congress passed a bill to provide funding for dealing with the virus and there may be more infrastructure plans soon, though the Trump administration has been running significant budget deficits already after its corporate tax cuts.  Even the fiscally prudent German government has announced increased spending.

But will any of this make a difference?  Will running fiscal deficits and increasing spending avoid a global recession or even reduce significantly the impact on jobs, incomes and trade?  That’s certainly what the Keynesians and post-Keynesians (including those in the Modern Monetary School) expect.  Take Paul Krugman, the world’s most popular Keynesian economist.  In his New York Times blog, he tells us that is it time for permanent fiscal stimulus.  Let’s get fiscal!

“I hereby propose that the next U.S. president and Congress move to permanently spend an additional 2 percent of GDP on public investment, broadly defined (infrastructure, for sure, but also things like R&D and child development) — and not pay for it.”  Krugman points out that monetary policy won’t work because the US economy is now in “a liquidity trap, that is, a situation in which monetary policy loses most of its traction, much if not most of the time. We were in a liquidity trap for 8 of the past 12 years; the market now appears to believe that something like this is the new normal.” Funny that he should point this out after initially advocating cheap money getting Japan out of its ‘lost decade’ back in 2000.

Anyway, the point is that “conventional (or even unconventional? MR) monetary policy doesn’t work in a liquidity trap, but fiscal policy is highly effective. The problem is that the kind of fiscal policy you really want — public investment that takes advantage of very low interest rates and strengthens the economy in the long run — is hard to get going on short notice.” So what we also need is “fiscal stimulus, like the one advanced by Jason Furman, basically involve handing out cash — a good idea given the constraints.”  But such ‘helicopter money’ is limited in effect over time as it goes into consumers’ pockets when we need “to invest in the future.”

So Krugman’s answer is to keep “investment-centered stimulus in place all the time. It would cushion the economy when adverse shocks hit.” through permanent budget deficits with spending on infrastructure and emergencies.  No need to worry about rising public debt, even though it is hitting over 100% of GDP in the US and servicing costs are already sucking funds from public services.  You see, interest rates are so low that servicing the debt is no problem.  Even at 100% of GDP and nominal interest rates of 2%, the interest cost is half that of nominal growth (real plus inflation) of 4% in the US economy.  So “in the long run, fiscal policy is sustainable if it stabilizes the ratio of debt to GDP. Because interest rates are below the growth rate, our hypothetical economy can in fact stabilize the debt ratio while running persistent primary deficits (deficits not including interest payments.)”.  So we can run a deficit of 2% to spend on a public investment program without driving up the debt burden.  “My permanent-stimulus plan would raise the debt/GDP ratio to only 150 percent by the year 2055. That’s a level the UK has exceeded for much of its modern history”.  So that’s all right then.

Krugman goes on in the usual Keynesian way that the ‘multiplier’ effect on growth from increased spending would more than pay its way: “the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3 percent higher GDP in bad times — and considerable additional revenue from that higher level of GDP.”

The problem with this argument is manifold.  First, it assumes that US economic growth can be sustained at 2% in real terms with inflation of 2%.  In a slump, that nominal rate will dive and so the debt to GDP ratio will rise sharply. That could lead to increased debt servicing costs even with interest rates on bonds so low.

Second, there is no evidence that ‘permanent’ deficits work to stimulate the capitalist economy.  Krugman advocated such a policy for Japan and Japan has run permanent deficits for 20 years, but Japan has failed to sustain real GDP growth – indeed it was entering yet another slump just before the epidemic hit. Will increased government spending save the airlines, energy companies and other travel-based operations from collapse. How will it stop the dramatic fall in the oil price, leading to a collapse in investment in shale and energy companies across the world?

Some argue lower fuel prices will boost consumer spending, as would government cash handouts to households.  But if you are told not to travel, cheaper pump prices are not going to do much.  And what is also forgotten is that two-thirds of transactions in a modern capitalist economy are business to business, not business to consumers.  So what matters is the investment and trading decisions of businesses.  If your company sacks you because of a slump in profits, having a cash handout from the government is unlikely to stimulate you to buy more things and services.

Krugman advocates an extra 2% points of government investment through deficit financing. If implemented, that would take government investment to GDP in the US to about 5% – a post-war high. And yet business and real estate investment is 15-20%.  If that were to fall by 25% in a slump, the downward impact would be double Krugman’s stimulus package.  So unless there was a huge shift from capitalist to state investment, such deficit spending would be insufficient to reverse or avoid a slump in capitalist investment. Only China has ever adopted such a sufficiently large use of government investment in an economy and succeeded in reducing or avoiding a slump – as it did in 2008-9.

Krugman and most Keynesians only ever talk about fiscal stimulus in the G7 economies. Is it feasible to expect all those so-called emerging economies to resort to fiscal stimulus?  The global trade and investment slowdown has already hit emerging economies, several of which have slipped into outright slumps. Emerging markets face a serious “secular stagnation” problem. Growth in almost all cases has been far lower in the last 6 years than in the 6 years leading up to the Great Recession. And in Argentina, Brazil, Russia, South Africa and Ukraine, there has been no growth at all. Emerging markets (EMs) that in 2019 grew less than developed markets were Brazil, Uruguay, Turkey, South Africa, Ecuador, Mexico, Saudi Arabia and Argentina. EMs that barely outgrew developed markets were Russia, Nigeria and Thailand. Running huge budget deficits in these countries is condemned by the likes of the IMF and would probably induce a massive run on national currencies by foreign investors.  Instead governments there are imposing more austerity measures.

Most important, it is not correct to assume that the Keynesian multiplier (the ratio of the unit increase of real GDP from a unit increase in real government spending) is high at all.  There are many studies that put it at below 1 i.e. a 1% pt rise in government spending adds less than 1% pt in real GDP growth.  Just see all these studies:

https://voxeu.org/article/fiscal-multipliers-during-european-sovereign-debt-crisis

https://voxeu.org/article/fiscal-multipliers-and-fiscal-positions-new-evidence

https://voxeu.org/article/government-spending-multipliers-and-business-cycle

https://voxeu.org/article/world-war-ii-america-spending-deficits-multipliers-and-sacrifice

As I have argued in previous posts, the key to restoring economic growth is investment and that depends on profitability.  In a predominantly capitalist economy, raising the profitability of capital has a much higher impact on growth (the Marxist multiplier) than government spending (the Keynesian multiplier).  http://gesd.free.fr/carch12.pdf.  Indeed, more government spending based on more debt or taxation can threaten the profitability of capital.  The blockage to government spending may not be from high and rising public debt when interest rates are near zero; but the blockage to business investment may well be from high and rising corporate debt when profitability of capital is low and falling.

Monetary easing has failed, as it has done before.  Fiscal easing, if adopted, will also fail.  A recession wipes out weaker capitalist companies and lays off unproductive workers.  The cost of production then falls and those companies left after the slump have higher profitability as the incentive to re-invest.  Capitalism can only get out of a recession by the recession itself.