A Fiscal Policy Rule Without Austerity

What will happen about fiscal policy after the tumultuous events beginning in 2010 or so in Europe and the end of Great-recession-era fiscal stimulus in the US? In the US, Paul Krugman and other economists debate the meaning of the CBO’s recent fiscal report, which, as Krugman points out, clearly show a drastic fall in the US deficit—to less than 3 percent of GDP at last check.

This brings us to the main subject of our post: an interesting article that seems to be out in the July issue of the Cambridge Journal of Economics (abstract—rather technical). I happened to run across this new study last week. It may be one of those cases in which an academic article has some implications for macro policy. The authors consider an inflation-targeting fiscal rule: they explore the outcome when government spending is always adjusted upward or downward, depending upon the actual inflation rate, according to an algorithm of sorts set in advance.

Before I go on, I should note the disclaimer that a paper of my own featuring fiscal targets also appeared last month in Metroeconomica, an international journal whose chief editors are based in Austria and Italy. I argue in the paper against deficit targets that restrict spending levels without regard to the strength of the economy. This notion that fiscal policy should aim for budget balance rather than good economic performance is the “Treasury view” lambasted, by the way, in another article in the same journal, penned by Suzanne Konzelman. I will try to outline the article on fiscal targets in terms of what I found in the process of working on my own paper. The post also includes an interactive model of how the rule in my own paper would work in a simplified version of the economy.

I am happy to see various parallels and hope the new piece is indicative of widespread interest in output-stabilizing policy rules, or at least non-austerity rules, and in stock-flow-consistent macro models, including the Levy Institute macro model. The differences between the policy rules and other assumptions in the two papers are numerous. Most importantly perhaps, Matthew Greenwood-Nimmo, the author of the new CJE article, considers a different type of rule. An inflation-targeting rule is the main fiscal policy rule considered in the paper. Inflation-targeting is certainly run-of-the-mill for monetary policy around the world, but as this IMF country-by-country list of fiscal rules now in force indicates, most actual rules simply specify low deficits or low ratios of the budget deficit to GDP.

The new CJE article notes, commenting on a fiscal policy rule from our former Distinguished Scholar Wynne Godley’s work with Canadian Marc Lavoie, that “it seems unlikely that the form of fiscal intervention advocated by Godley and Lavoie…could be fine-tuned to the degree required to achieve a point target in practice, as activating and deactivating public works projects, for example, is likely to generate a somewhat lumpy path of government spending [i.e., one that moved in big steps rather than smoothly]. For this reason, the use of a band target [a range, rather than a specific number] for fiscal policy seems more appropriate.”*

Specifically, Godley and Lavoie’s rule–published years ago in the Journal of Post Keynesian Economics and reprinted in 2012 and in a collection of papers by Godley —called for a level of government spending that would immediately fill the gap between actual and potential output—and hopefully keep unemployment low. In contrast, Greenwood-Nimmo adopts a rule with spending changes in specific amounts that go into force abruptly once inflation exceeds or drops below certain upper and lower bounds or thresholds.

There are numerous other differences, including the assumed institutional setting. Greenwood-Nimmo’s is an international model with two countries. This aspect of the new study brings in concerns about coordinating policy among governments, which are harder to avoid without traditional MMT (chartalist) assumptions of a closed economy, a floating exchange rate, or capital controls.

Also, of course, the new paper uses an inflation objective, as mentioned before. It will be interesting to see how my newest paper, in preparation for the International Post Keynesian Conference in Kansas City does in this regard, as it will contain much more about money and finance than my recently published paper—including the elimination of the assumption of a fixed overall wage level. With broad inflation possible in the new model, things will be more comparable.

Moreover, my Metroeconomica paper dealt only with government (chartal) liabilities. The new conference paper from me will look at the effects of the public-production-cum-capacity-utilization targeting rule in an environment with private debts and money, not just paper money and government debt. This should yield a more truly monetary model.

The rule examined in my paper assumes an adjustment process whereby government spending and production gradually rise when either public or private-sector production are below their respective target levels. The government approaches its targets slowly when it is off course.

Below is a peek at what the adjustment process looks like. For those who have the appropriate browser plug-in (available for free download at this link), the CDF below can be moved with a slider button to show how changes in the policy parameter can transform a cycle into a convergent two-dimensional pathway. Technically, the policy parameter is the weight placed by fiscal policymakers on a term in the policy function that steers the economy closer to the public production target, relative to the corresponding weight for the capacity utilization target. As the slider representing the parameter value is moved to the right, policymakers place more emphasis on the target for the size of the government’s own operations, relative to their target for private-sector output. The CDF shows that the exact policy “setting” matters. (Key to variables in figure: u = capacity utilization; p = public production)
http://multiplier-effect.org/files/2015/02/bifurcation.cdf
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cdf.embed(‘http://multiplier-effect.org/files/2015/02/bifurcation.cdf’, 429, 779);

The CDF shows that the model does not close the output gap as quickly as Godley’s (i.e., immediately), but the assumption of a gradual adjustment of spending to desired levels may meet Greenwood-Nimmo’s criticism of Wynne’s notion that public production could be adjusted so quickly to specific amounts each year to achieve full employment.

Of course, I have blogged in this space about my recently published study before; the intended focus above is on the kudos due to Greenwood-Nimmo for his effort. It should go without saying that there have been many articles over the years addressing the topic of fiscal stabilization in a way that helped the cause in one way or another, and the debate certainly continues. But the 2 studies published last month have several things in common, including the use of fiscal targets to ameliorate economic problems, not as ends in themselves.

FOOTNOTES: *In this foregoing quotation, I have added some hopefully helpful interpretation to Greenwood-Nimmo’s own clear but somewhat technical wording in square brackets. I have used ellipses for a deleted citation.
Also, early technical glitches involving the CDF appear to be fixed at this time. We apologize for the earlier malfunction. Please consider letting us know if you are finding an invisible CDF. -G.H.