Can (and has) monetary policy offset fiscal consolidation?

Can fiscal policy increase or reduce demand?  Whatever one thinks of the current stance of fiscal policy, most of us thought the last three years had settled this argument. Of course it can.  But – at least for those economists who argue about these things on blogs and twitter – the Chancellor reopened it with his speech to the CBI earlier this month. The Chancellor argued:

What’s more, without allowing inflation to climb even further above target, a fiscal stimulus three years ago would simply have been offset by less supportive monetary policy, with no net impact on demand. With the independent MPC judging that the risks to inflation and output are evenly balanced, the same is true today.

Let’s leave aside the rather odd reference to “fiscal stimulus” three years ago; of course, what the government actually implemented was what the IMF described as “large and frontloaded fiscal consolidation”, consisting initially mostly of very sharp reductions in public investment and some tax increases (in particular the VAT cut). So what the Chancellor is saying here is:

if we hadn’t cut public investment/raised taxes so much, inflation would have been higher, so the Bank of England would have had to run tighter monetary policy, so growth wouldn’t have been any higher.  And the same is true today – if we were to slow fiscal consolidation, for example by restoring some of the large public investment cuts, the MPC would just tighten monetary policy, and it wouldn’t help growth.

In other words, the fiscal multiplier – the impact of changes to fiscal policy on real GDP – is zero. And just to make clear that I’m not misinterpreting the Chancellor’s words, my old friends at @ToryTreasury doubled down, spelling it out as follows:

[the] expected net impact of looser [fiscal] policy is zero

This is notable, because back in March the Prime Minister claimed, falsely, that this was the view of the independent Office of Budget Responsibility.   The Prime Minister subsequently was forced to backtrack, saying that there was no contradiction between his views and those of the OBR; in other words, that the expected net impact of looser fiscal policy [on growth] is positive.

Now the Chancellor appears to be saying that he disagrees with the OBR after all.  Of course, this is not at all the same as the PM misrepresenting the OBR’s views; the Chancellor’s perfectly entitled to disagree with the OBR if he wants.  But if he does, he really should come out and say so; and explain why he disagrees not only with the OBR, but the IMF and pretty much every serious independent economic forecaster.  We may all have slightly different views, but no-one believes that the fiscal multiplier, under current circumstances in the UK, is zero. Nor does anyone else who actually analyses the data agree; I am not aware of any empirical analysis which suggests that fiscal consolidation in the UK has had no impact on growth. 

Nor, of course, is the Chancellor’s statement remotely consistent with his behaviour in practice – if monetary policy was fully offsetting the depressing impact on output of austerity, he wouldn’t have had to invent the ever growing list of (so far, largely ineffective) schemes designed to boost demand without increasing the (officially measured) deficit – Funding For Lending, Funding for Lending 2, or Help to Buy.  Nor do central bankers themselves think they can offset the impact of misguided fiscal policy, as the most powerful central banker in the world, Ben Bernanke, said just two weeks ago:

with short-term interest rates already close to zero, monetary policy does not have the capacity to fully offset an economic headwind [deficit reduction] of this magnitude.

But we’re economists – who cares if it doesn’t work in practice? Maybe it works in theory, which is what really matters!  This was the theme of the twitter debate sparked off by the Chancellor’s speech: see the Storify version here. 

And there are indeed respectable economists – theoreticians rather than empirical economists, for the most part – who think that this might be the case. As Britmouse points out, the Chancellor’s proposition is just what has been described as the “Sumner Critique”; that an inflation targeting central bank will fully offset the impact of changes to fiscal policy. Britmouse thinks the MPC would do just that, in response to, say, an increase in public investment financed by borrowing. Here Britmouse tries to explain it, in words of one syllable, to me and Prateek Buch: 

Now there isn’t anything actually wrong with this explanation; it is reasonable to think that in general, the MPC will respond to looser fiscal policy with tighter monetary policy.  But in order for this to actually fully offset the impact of fiscal policy on growth – as Britmouse implies but doesn’t actually say – then monetary policy and fiscal policy need to be perfect substitutes. In other words, the impact of fiscal and monetary policy on both real output and inflation must be identical.

To see this, suppose that the MPC thinks that the extra public investment will boost real GDP by 1%, and the CPI by 1%. Given the inflation target, it will then need to tighten monetary policy so as to fully offset this impact on the CPI.  So the CPI will return to target – the net impact will indeed be zero. But what’s the impact on real GDP?  It could be zero. But this will only be the case if the monetary tightening required to reduce the CPI by 1% also reduces real GDP by 1%. 

This seems implausible in general – it’s certainly not what any standard empirical macro model will say.  But it is particularly implausible now.  When output is way below trend, increased public investment increases real GDP because labour and capital which would otherwise be unemployed is put to work.  It is, as many of us have repeatedly argued, likely to be particularly effective when interest rates on government debt, real and nominal, are at historic lows, so it is highly implausible that it would crowd out private investment; and when real wage growth is negative and there is ample labour market slack.  It might or might not also increase inflation by giving previously unemployed people money to spend, and eventually bidding up prices for labour, which in turn will eventually impact on prices. While the risk of this being a big deal seems pretty small, for exactly the same reasons, it will surely have some impact. 

By contrast, what does “monetary tightening” mean in current circumstances?   With interest rates at the zero lower bound, the only monetary policy instrument the Bank has used over the past three years is quantitative easing (QE). So, if we accept the logic of the tradeoff, the real choice over the last year has been between QE and austerity.  But the impacts of quantitative easing are hotly disputed and highly uncertain, as the Bank itself has found.   Many would argue that – after the first round of QE in 2009 – subsequent additions to QE have had little or no impact, given the continued weakness of the banking sector and the consequent impairment of the monetary transmission mechanism (precisely the arguments the Treasury has used to justify the introduction of schemes like Funding For Lending).  In which case, obviously, there would have been no monetary offset to fiscal policy changes.   See Frances Coppola’s excellent blog for a discussion of the possible impacts, positive, negative and perverse, of QE. 

But even if we take the Bank’s published work at face value, then the tradeoffs between growth and inflation are likely to be substantially worse for QE than for public investment.  The Bank’s research suggests that – while different models produce very different results – QE might produce a roughly similar peak impact on growth as on inflation.  And that is based on analyses of the first round of QE  – the tradeoffs are likely to have deteriorated since then.  By contrast, recent work by NIESR for the TUC, using our macroeconomic model NiGEM, which is quite similar to that used by the Bank and the OBR for policy simulations, found that a plausible borrowing-funded investment programme might have a peak impact on output about twice as large as its impact on inflation.

So even taking at face value the proposition that the MPC would have attempted, quite possibly ineffectively, to fully offset, via QE, the inflationary impact of looser fiscal policy, we would have ended up with higher output (and without higher inflation). And we would have been considerably more confident in the positive impacts of fiscal policy, especially public investment, than we would have been of the impacts, positive or negative, of quantitative easing. So, to answer Britmouse’s question, yes: deficit-financed capital spending, from both a theoretical and empirical point of view, makes perfect sense in current UK macroeconomic conditions.  Its impact would have been significant, positive and predictable; the monetary offset, uncertain both in form and impact.

In short, the view that fiscal policy can’t do anything is obviously wrong in practice. But it doesn’t make a lot of sense in theory either.