This is not, of course, something that Paul Krugman would either ever say nor mean, that fiscal policy just won’t work as a macroeconomic policy. Yet it’s something that can be derived – with caveats – from what he’s just said.
To set the scene here. We’ve, largely enough and for the Lord’s Sake don’t get hung up on details here, two sets of macroeconomic policies. One is monetary, the other fiscal. Monetary talks about the quantity of money floating around, the interest rate which determines how the narrow money supply – that central bank money and cash etc – translates into the wider money supply of credit and bank accounts etc. We’ve a recession, cut the interest rate, more of that central bank money becomes the wider money supply that greases the economy upwards. Yes, I know, but please, don’t sweat the details here. We’ve inflation so throw the system into reverse by raising interest rates. Or printing more cash and dumping it from helicopters, or, well, monetary policy like QE and so on. Fiscal is talking about the size of the government deficit really. How much is government spending, how much is it raising in tax, what’s the difference between the two? We’re in a recession, government spends more and gooses up that economy, but it doesn’t raise taxes. It’s the increase in the deficit, funded by borrowing, which does the goosing. We’ve inflation, government taxes more than it spends, runs a budget surplus, this tames matters.
Yes, really, I know, gargantually simple to the point of being wrong. But useful for us here.
In theory theory either monetary or fiscal policy will work. There are those who much prefer one or the other and that’s an interesting difference. For it does tend to be those who would like less, or at least not more, government who prefer monetary policy, those who would generally like more government, or at the very least not less, who prefer fiscal. The reasons for this should be pretty obvious. If we’re to expand government spending in a recession, it’s easy enough to slip in a permanent plan for spending more. As opposed to what theory theory says should just be a one time bolus of more spending to get out of the recession.
This explanation has an Occam’s shaving kit simplicity in that it explains both sets of preferences. Those who don’t want more government prefer not to allow politicians to succumb to that temptation, those desirous of more think giving in to that desire is just great.
All of the above is just background, which is why the detail doesn’t matter. At which point we come to a rather solid argument against fiscal policy. One offered by Scott Sumner. Which is that fiscal policy will never work. Not in the Obama sense, when he went looking for shovel ready projects to spend $800 billion on and found nary a one. Rather, because independent central banks are independent. That independent central bank will have monetary policy, all that from interest rates through to QE, set up for what it thinks the correct policy is. Given the circumstances of the economy we’re going to have this much demand, we either need to goose it or damp it, therefore rates should be – .
Along come the politicians and they decide to splash out on some spending. Maybe it is proper bolus stuff, good on ’em. Maybe it’s whatever pork barrel they think they can get away with, perhaps that smuggling in of a permanent program under the guise of recession fighting. That changes – let’s assume that this is true at least – demand in the economy. Which means then central bank – which is independent recall – now changes interest rates and other monetary policy to meet those new circumstances. The central bank will always act to offset fiscal policy – fiscal policy doesn’t work.
Now, you can argue that this isn’t symmetrical, that when interest rates are zero the central bank can’t do anything and thus we must have fiscal policy. That would be – is in fact – Krugman’s argument and it’s a decent one. I myself think it wrong, for whatever little my opinion on matters macroeconomic is worth (not a lot to be honest) for I look at QE and all this over the past decade and see that it has worked. We are able to make monetary policy work at the zero bound.
I’m even open to the idea that it works less well than fiscal policy but given how extreme I am over the size of government (we should be having perhaps 25% of what we do have) I’m entirely happy to put up with that relative ineffectiveness in return for not having new permanent programs smuggled in.
Which brings us to Krugman again. For, absent that zero bound qualification there (again, note, PK think that’s the important part) this is what he’s saying here:
OK, here’s the point where being a card-carrying economist gets me into a bit of trouble. The proper answer about the job-creation or -destruction effect of a trade policy – any trade policy, no matter how well or badly conceived – is basically zero.
Why? The Fed is currently on a path of gradually raising interest rates, because it believes we’re more or less at full employment. Even if tariffs were expansionary, that would just make the Fed raise rates faster, which would in turn crowd out jobs in other industries: construction would be hurt by rising rates, the dollar would get stronger making U.S. manufacturing less competitive, and so on. So all my professional training wants me to dismiss the jobs question as off-base.
An independent central bank does indeed offset other policies. So, all we’re arguing about is when this is so, not whether it is possible, not even whether it happens. I, and Scott Sumner, would say always. Others would say only most of the time. But there’s no one out there capable of both walking and farting at the same time who is going to say never.