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Fiscal Policy in the New Normal: IMF Panel

Preview of Fiscal Policy in the New Normal IMF Panel

A cleaned-up transcript of my part of this Bank-Fund Meeting cycle's panel on "Fiscal Policy in the New Normal":

Moderator: Vitor Gaspar. Panelists: Mitsuhiro Furusawa, Brad DeLong, Bill Morneau, Ludger Schuknecht, Arvind Subramanian

My Part of IMF Panel: Fiscal Policy in the New Normal: Cleaned-Up Transcript

Has academic thinking about countercyclical fiscal policy changed recently?

I would not say that thinking has changed. I would say that there is a good chance that thinking is changing. If so, it is as a result of a whole bunch of extraordinary surprises that have hit us all.

Back in 2007 we thought we understood the macroeconomic world, at least in its broad outlines and essentials. It has become very clear to us since 2007 that that is not the case. Right now we have a large number of competing diagnoses about where we were most wrong. We clearly were very wrong about the abilities of major money center banks to manage their derivatives books, or even to understand to understand what their derivatives books were. We clearly did not fully understand how those markets should be properly regulated.

Right now, however:

  • We have people who think the key flaw in the world economy today is an extraordinary shortage of safe assets. Nobody trusts private sector enterprises to do the risk transformation properly. Probably people will not again trust private sector enterprises for at least a generation.

  • We have those who think the problem is an excessive debt load where--I think we should distinguish between debt for which there is nothing safer, the debt of sovereigns that possess exorbitant privilege, and all other debts.

  • We have those who think we are undergoing a necessary deleveraging.

  • We have those who look for causes in the demography.

  • And then there is Larry Summers, as the third coming of British turn-of-the 20th century economist John Hobson. (The second coming was Alvin Hansen in the 1930s.) And the question: just what is Larry talking about?

    • Is Larry talking about the inevitable consequences of the coming of the demographic transition and of the end of Robert Gordon’s long second Industrial Revolution of extremely rapid economic growth?

    • Or is he talking a collapse of the ability of financial markets to do the risk transformation--to actually shrink the equity risk premium from its current absurd level down to something more normal?

If you look at asset prices now, you confront the minus two percent real return on the debt of sovereigns that possess exorbitant privilege with what Justin Lahart of the Wall Street Journal was telling me yesterday is now a 5.5% real earnings yield on the U.S. stock market as a whole. That 7.5% per year equity premium is a major derangement of asset prices. It makes it very difficult for us to use our standard tools to think about what good policy would be...


So it's the Federal Reserve's fault? The Federal Reserve is the only central bank engaged in a tightening right now...


I find myself thinking of Ludger Schuknecht's very powerful and apposite comments about just what, even if you believe--as I do--that there are substantial spillovers for Germany and for the world for Germany to use its fiscal space for expansionary policies right now, the question of how it is supposed to use it--what it is supposed to use it for. The fiscal space is in Germany. The infrastructure needs are in Sicily. This is in the end the political and also the political-economic dealbreaker. It does speak to necessary reforms of the European Union so that things like this do not happen again.

I remember Maury Obstfeld saying once that at the start of the 1990s California and New York had no problem using the United States's fiscal space to transfer 25% of a year's Texas GDP to Texas to clean up the Savings and Loan financial crisis mess. This just was not an issue in American politics or political economy. Texas had bet wrongly on the real estate sector via lax regulation--both at the federal and state level--and financial engineering. It was regarded as a proper use of America's fiscal space to spend money on this and pull Texas out of what was a shallow national but would have been a very deep regional recession. The fact that the Chair of the Senate Finance Committee at the time was from Texas may, however, have had something to do with it.

The American institutions then were, somehow, a better set of institutions for dealing with this kind of crisis. That there was an alignment of interests, and that the prosperity of each would redound to the prosperity of all in the long even if not always in the short run was taken for granted. In fact, perhaps, Europe's institutions today are inferior along some aspects of this dimension than Europe's institutions in the past. Back in 1200, say, the question of how Germany should use its fiscal space, if in fact the desired location of spending was in Sicily, was finessed. A Germany Hohenstaufen princeling would be married to a Viking-Sicilian princess, and she would then bring Sicily along with her into the Holy Roman Empire as her dowry, and Germany--at least Germany's rulers--would have an obvious interest in upgrading Sicily's infrastructure. Admittedly, the German Emperor then decided that he would rather spend time in his palace in Palermo than in Burg Hohenstaufen twenty miles east of Stuttgart.

Somehow, national borders and national communities constrain us in Europe in ways that are not the wisest today...


Why are we here in this mess? I think on the one hand it is a substantial mystery. On the other hand, back during the Great Moderation we economists plus central bankers plus politicians convinced the press and the public much too well that central banks did and always would have sufficient powers to manage the business cycle. For a generation the press and the public were told, over and over again, that fiscal policy should always and everywhere focus on the classical principles of right-sizing the state, right-directing the state, and right-funding the state--plus automatic stabilizers. This seemed to be the implication of looking back at the 1970s in Latin America and Europe and the 1980s in the United States where the license to use fiscal policy to manage the business cycle was grabbed by governments and used for policies that deranged national savings rates, destabilized national budgets, and imposed significant long-run drags on the growth of economic potential. The extraordinarily harmful "structural adjustment" imposed on America's midwest in the 1980s as a result of the dollar cycle generated by the disastrous Reagan deficits that followed his 1981 tax cut--justified by people like Larry Lindsey primarily for its short-run Keynesian stimulus benefits--still casts a destructive shadow on the American economy today.

As a result, we worked hard to convince and we did convince the press, the public, and the congress to butt out of stabilization policy and focus fiscal policy on more "classical" considerations. Let the central banks--which we believed, well, I at least had believed up to 2010--deal with it for they had sufficient and plenary power to do so.

As John Maynard Keynes said of the Versailles peace treaty: British Prime Minister David Lloyd-George, having bamboozled the old Presbyterian who was American President Woodrow Wilson, found that he was unable, when he needed, to un-bamboozle him in a hurry...


If we want to have a better world, we either need to change the politics to restore the stabilization policy mission to fiscal authorities--and somehow provide them with the technocratic competence to carry out that mission--or give additional powers to central banks, powers that we classify or used to classify as being to a degree "fiscal".

A great deal of the rest of it is the peculiar combination in the U.S. of the emergence of political parties with European-style internal party discipline in the context of a presidential system. When President Obama wants to spend more money for fiscal expansion, every single Republican legislator knows that it must be a very bad thing because the President is of the other party and wants to do it. They reach for whatever economists will tell them that expanding the deficit is a very bad thing.

Remember: back in 1993, the same Republican Party--with many of the same figures in it, albeit today's seniors were then juniors--was just as certain that Democratic President Clinton's desire to reduce the deficit it was a very bad thing. That was something every Republican politician knew should be fought tooth-and-nail. Newt Gingrich has the distinction of having been the most vocal one of the leaders of both of these movements--the claim that Clinton's deficit reduction would kill the U.S. economy in 1993, and that Obama's deficit expansion would kill the U.S. economy in 2009. Why were these very bad things? Because they were advocated by Democrats! Yet we find respected commentators for the Washington Post, the National Journal, the New York Times, and other journalistic outlets that really should and probably do in their heart-of-hearts know better praising our very same Newt as one of the most serious, policy-oriented, and technocratic of Republican leaders--as a statesman.

I look at that. I remember 1993 and 2009. I ask: doesn't anybody else put these two things together? The answer seems to be: no. The United States constitution was built in 1787. At the time it was regarded as state-of-the-art, as a marvel, as including the most forward-looking ideas of what Hamilton called "great improvements" in the science of politics. But look at U.S. governance since the 1980s, and you can no longer say that. Now it appears to be a creaky and outmoded orrery...


The United States had an immense boom in the 1990s. That was in the end financial disappointing for those who invested in it, but not because the technologies they were investing in did not pan out as technologies, not because the technologies deliver enormous amounts of well-being to humans, but because it turned out to be devil's own task to monetize any portion of the consumer surplus generated by the provision of information goods. Huge investments in high tech and communications. Huge amounts of utility generated. Little financial return. $4 trillion of investors' wealth destroyed as assets were revalued. That is something like 8 times the fundamental losses we saw in subprime mortgages and home equity loans made on houses in the desert between Los Angeles and Albuquerque from mid 2006-mid 2008. A 1.5%-point rise in the unemployment rate after 2000 is not nothing--it is a bad thing. But it is not a 7%-point rise. And it is not a failure to close any of the gap vis-a-vis the pre-crisis trend of potential thereafter and a dark shadow over economic growth for a generation thereafter. Yet the fundamental shock from dot-com looks to me 8 times as large as the fundamental shock from subprime.

That tells me that we can deal with such shocks to private sector credit that go wrong: Have them be to equity wealth in the first place, or rapidly transform all the financial asset claims affected into equity on the fly as the crisis hits. Easy to say. Hard to do. We make sure they are diversified. And we do not, not, not, not, not, not let the people in Basle get too clever with their ideas of what reserves and capital structure look like and allow core reserves to be placed in assets that are not AAA even if some ratings agency whose revenues depend on pleasing investment banks has labeled them as AAA.

If I remember correctly, think that Axel Weber tells this story. It begins with him claiming that once at Davos he was invited to a policy by mistake, people having confused Deutsche Bank with Deutsche Bundesbank--a thing he claimed happens more often than one might think. So he found himself sitting on a panel with a number of bankers, all of whom talked about how (a) their issue departments had made immense profits and successfully shed all the risk involved in creating risky financial derivatives because their model was originate-to-distribute, while (b) their risk-management departments had become profit centers because they were squeezing remarkably large margins over Treasuries via the AAA-rated securities that they were holding as reserves. Axel pointed out that the twenty largest major money center universal banks were both the twenty largest issuers of structured financial derivative products and the twenty largest purchasers. And there he was: the only central banker there, saying that what you have done is trade risk that your issue departments understands for issues that you know nothing about, that only your competitors' issue departments understand, with no net diversification of the risk outside the large money center universal bank community at all.

If I have the story right, he then said that this was a dangerous situation. Of course, he had no idea how dangerous it was. Barry Eichengreen, Alan Taylor, and Kevin O'Rourke think that once the run on the shadow banking system was underway this was the largest shock relative to the size of the market financial markets have ever experienced. Joachim Voth might dispute that, and say that given the small size of the market in the sixteenth century the state bankruptcies of the borrower from hell Felipe II Habsburg of Spain may have been, relatively, larger.

We could have avoided this. If we had done our surveillance sufficiently deeper, we would have seen that this might be coming...


I do think we have the tools to keep private sector debt overhangs from turning into massive catastrophes that require extraordinary large scale fiscal intervention and that can truly and disastrously damage the world economy. In the United States in the late 1980s we had five years of lax surveillance of primarily the Texas but also the rest of the savings and loan industry enforced by rent-seeking lobbying--the infamous "Keating Five" senators, , and many others. Thus the S&Ls were given five years to gamble for resurrection, and their gambles went disastrously wrong. Yet it was not that huge a deal in the context of the world economy. The key is the surveillance--to make sure that risks are not concentrated and, where they are, are equalized.


When should you use fiscal policy to expand at full employment? When you can see the next recession coming, it would be the moment to try to see if you could push the next recession further off. Or it it would help you prepare you to fight it. Using some of our fiscal space would open up enormous amounts of potential monetary space to fight the next recession, if it succeeded in raising the neutral interest rate--and if a large enough fiscal expansion does not raise the neutral interest rate, we do not understand the macroeconomy and should simply go home.

OVERVIEW: The global recovery has been anemic and future prospects have dimmed. Monetary policy has been stretched to extremes with quantitative easing and zero interest rates, yet investment remains subdued and deflationary pressures linger. Waning productivity, growing income inequality, and the longer-term implications of shifting demographics have led to repeated markdowns of medium-term growth potential. Should there be a pivot toward new ways of thinking about fiscal policy in a “new normal” of prolonged slow growth, in terms of both its countercyclical role and its effectiveness in boosting productivity and catalyzing longer-term inclusive growth?

Moderator: Vitor Gaspar is Director of the Fiscal Affairs Department at the International Monetary Fund. Prior to joining the IMF, he held a variety of senior policy positions in Banco de Portugal, including most recently Special Adviser. He served as Minister of State and Finance of Portugal from 2011– 2013. He was head of the European Commission’s Bureau of European Policy Advisers from 2007–2010 and director-general of research at the European Central Bank from 1998 to 2004.

Mitsuhiro Furusawa is Deputy Managing Director of the International Monetary Fund. Mr. Furusawa joined the IMF after a distinguished career in the Japanese government, including several senior positions in the Ministry of Finance in recent years. Immediately before coming to the Fund, he served as Special Advisor to Japanese Prime Minister Shinzo Abe and Special Advisor to the Minister of Finance. Brad DeLong:

Brad DeLong is a Professor of Economics at the University of California, Berkeley, a research associate of the National Bureau of Economic Research, and a blogger at the Washington Center for Equitable Growth. DeLong served as U.S. Deputy Assistant Secretary of the Treasury for Economic Policy from 1993 to 1995.

Bill Morneau is Canada’s Finance Minister. Previously, he led Morneau Shepell and was Pension Investment Advisor to Ontario’s Finance Minister. He is a former chair of the C. D. Howe Institute. He holds an MSc from the London School of Economics and an MBA from INSEAD.:

Ludger Schuknecht is Chief Economist at the German Ministry of Finance, and head of the Directorate General Fiscal Policy and International Financial and Monetary Policy. In his previous position as Senior Advisor in the Directorate General Economics of the European Central Bank, he contributed to the preparation of monetary policy decision making and the ECB positions in European policy coordination.

Arvind Subramanian is the Chief Economic Advisor to the government of India. He was Assistant Director in the Research Department of the IMF, served at the GATT, and taught at Harvard University's Kennedy School of Government and at Johns Hopkins School for Advanced International Studies. In 2011, Foreign Policy Magazine named him one of the top 100 global thinkers.