STIMULUS OR STYMIED?: THE MACROECONOMICS OF RECESSIONS
- CARLO COTTARELLI (International Monetary Fund)
- PAUL KRUGMAN (Princeton University)
- VALERIE A. RAMEY (University of California-San Diego)
- HARALD UHLIG (University of Chicago)
"But in general as much as possible we favor a gradual approach to fiscal adjustment—it should not be front-loaded. We have done this for two reasons. First, we feel that the fiscal multiplier is pretty large under current circumstances, essentially output right now is demand-determined. In principle, it would be preferable to postpone fiscal adjustment altogether until some future time in which there is too much private-sector demand rather than implementing it at a time when there is not enough private-sector demand.
The second reason why we favor a gradual approach to fiscal adjustment is called “too much of a good thing”. It is possible that if you tighten fiscal policy up front with multipliers in their current range, you end up with a decline in GDP growth so large as to be counterproductive, to cause not a decline but an increase in interest rates as markets become worried about the decline in GDP. This involves some degree of market local irrationality or short-sightedness. Markets see that when you tighten fiscal policy there is a temporary deceleration of growth but then eventually growth picks up again. There is some econometric evidence that in 2011 markets were focusing very much on the short-term dynamics of output, and the short-term was that there was too much tightening that was actually counterproductive because it was associated with an increase in interest rates.
We have argued that gradual adjustment should be accompanied by a continuing use of monetary policy to support economic activity because there will be a cost of even gradual fiscal tightening...So this is essentially our view of what fiscal policy should do: gradual fiscal adjustment, as much as possible, accompanied by relaxed monetary conditions for as long as necessary, and structural reform."
More seriously, it is really quite remarkable how far the Fund has come (as I have previously chronicled here, on the myth of "credibility" and here, on multipliers). They have got a lot of stick for this, but surely it is commendable that they are prepared to admit the flaws in their ealier analysis (which was, in any case, never nearly as bad as, say, the European Commission and European Central Bank) rather than double down on their mistakes, as others have done?