Fiscal stabilisation and debt


Oct 28, 2013 (4 years and 8 months ago)


Fiscal stabilisation and debt

Simon Wren

Economics Department and Merton College,

This talk draws heavily on joint work with Campbell Leith at Glasgow
University under the ESRC’s World Economy and Finance programme,
and also joint work with Tatiana Kirsanova at Exeter University. However
neither co
author should be implicated by any views I express here

January 2010

WEF Event: Picking Up the Pieces


Fiscal countercyclical policy

The traditional assignment

Zero bounds

The right type of fiscal policy

Stimulus without raising debt?

Optimal debt policy

The random walk result: its importance and

Fiscal councils

January 2010

WEF Event: Picking Up the Pieces

The conventional assignment

Monetary policy

Short term stabilisation of demand consistent with
achieving a medium term inflation target

Debt stabilisation or reduction is not an objective

Fiscal policy

To meet some objective for government debt over the
medium/long term

Short term demand stabilisation is not an objective

With the occasional exception, this was the consensus
among policy makers and academics before 2008/9

A key caveat was, or should have been, that monetary
policy is not constrained by a zero lower bound

January 2010

WEF Event: Picking Up the Pieces

Zero bound implies fiscal action

Impact of QE uncertain

Policy makers are unwilling to raise inflation
targets or adopt a price level target

Time inconsistency problem

Misinterpreted as debt stabilisation

Damage anti
inflation credibility

Fiscal stabilisation has to step in at the zero
bound, and can be very effective

, G. and Woodford, M.
2003/2004 on all these points

Some fiscal instruments are much more
effective than others.

January 2010

WEF Event: Picking Up the Pieces

Some fiscal policy myths


Equivalence means fiscal policy
does not work”

Temporary increases in government spending raise
demand even if consumers are totally

In an open economy independent fiscal action
gets crowded out through an appreciation

If interest rates are stuck at zero, and the fiscal
expansion is temporary, the exchange rate should not

Any increase in government borrowing crowds
out private borrowing

Even if we deny that prices can be sticky, the zero
bound is a fact, and it prevents demand adjustment

January 2010

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Macroeconomics, ideology and ivory towers


(Professor, Chicago)

The problem is simple: bailouts and stimulus plans
are funded by issuing more government debt. (The
money must come from somewhere!) The added
debt absorbs savings that would otherwise go to
private investment. In the end, despite the existence
of idle resources, bailouts and stimulus plans do not
add to current resources in use. They just move
resources from one use to another.

John Cochrane (Professor, Chicago)

Every dollar of increased government spending must
correspond to one less dollar of private spending.

January 2010

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On theory that denies the possibility of deficient
aggregate demand


(1936) General Theory

That it [Classical Theory] reached conclusions quite
different from what the ordinary uninstructed person would
expect, added, I suppose, to its intellectual prestige. That
its teaching, translated into practice, was austere and often
unpalatable, lent it virtue. That it was adapted to carry a
vast and consistent logical superstructure, gave it beauty.
That it could explain much social injustice and apparent
cruelty as an inevitable incident in the scheme of progress,
and the attempt to change such things as likely on the
whole to do more harm than good, commanded it to
authority. That it afforded a measure of justification to the
free activities of the individual capitalist, attracted to it the
support of the dominant social force behind authority.

January 2010

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Fiscal expansion without higher debt?

Intertemporal incentives

Anticipated VAT increases

fiscal policy as
monetary policy

Tax financed temporary increases in
government spending

Will expand demand if consumers are Ricardian

Redistribution from unconstrained to credit
constrained consumers

All redistribute, but so does monetary policy

January 2010

WEF Event: Picking Up the Pieces

Outside of the zero bound, is the
conventional assignment still right?

Given lags, precautionary fiscal expansion may
on occasion be warranted


fusion of two literatures

Dynamic optimal taxation theory

, S. and
, M. (2004)

sticky prices
make an important difference

Keynesian theory (Woodford

social welfare
measure of business cycle costs)

(Robust?) Result: If monetary policy
unconstrained, optimal fiscal demand
management is no demand management

, F, Leith, C and Wren
Lewis, S (2008)

January 2010

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Fiscal policy still has a stabilisation role in
changing relative prices

If wages as well as prices are sticky, tax
changes can help ‘correct’ the real wage

Leith, C. and Wren
Lewis, S. (2007), 'Counter
Cyclical Fiscal Policy: Which Instrument is
Best?', Glasgow University.

Tax changes can offset cost
push shocks

Tax measures may be more efficient at
pricking asset bubbles in particular markets
than general interest rate changes.

January 2010

WEF Event: Picking Up the Pieces

Optimal debt policy: the random walk result

Assume away default risk, and assume infinitely


Taxation is
, so any non
government debt has social costs

Despite this, if a demand shock raises
government debt, the optimal response is to live
with this higher level of debt

, Stephanie and


, P and Woodford, M (2003)

Essentially a tax smoothing result

January 2010

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Assumes time inconsistent policy

Under time consistent policy, optimal policy would
involve rapid debt correction

Leith, C and Wren
Lewis, S (2007), Fiscal Sustainability in a
New Keynesian Model, Oxford University Discussion Paper
No. 310

Assumes benevolent policy makers

Leith, C and Wren
Lewis, S (2009), Electoral Uncertainty, the
Deficit Bias and the Electoral Cycle in a New Keynesian
Economy, Oxford University Discussion Paper No 460

Ignores default risk

With finitely lived,

consumers, debt crowds out capital

January 2010

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Debt and long run crowding out: log utility

Ricardian model

No crowding out of capital

2 period OLG model with zero labour income in second period

More than 1 for 1 crowding out of capital


C=consumption, r=real rates,
=decline in income with

A=total assets (debt+capital), p=probability of death

Calibration (annual): K=1,Y=Debt=0.25,

Implies r=5%

Reduce debt to zero

interest rates fall to 4.8%

Steady state A falls by almost as much as debt, so K rises by just 3.13%

Steady state consumption rises by 1%

=3% pa will double the long run impact of lower debt

January 2010

WEF Event: Picking Up the Pieces


The random walk result demonstrates that debt
should be a shock absorber and not a target.

The possibility of hitting a zero bound means
that we need, in other times, to be gradually
reducing debt

Constant debt/GDP objectives not enough

Supported by OLG crowding out

Unless the emergence of default risk premium
is a significant possibility, debt reduction should
be gradual and erratic.

January 2010

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How best to achieve gradual and erratic debt

Targets set by governments are likely to be economically
and politically sub

Governments have a temptation to be over optimistic in
making fiscal projections

Need Fiscal Councils to

Independently forecast development of government debt

Advise on the optimal timing and speed of debt reduction

Have the political authority to act as an effective public

, T,
, C and Wren
Lewis, S (2007),
Optimal Debt Policy, and an Institutional Proposal to help in
its Implementation, European Economy Economic Papers No

And Sweden, Canada
, Hungary
and others

And Conservative Party policy

January 2010

WEF Event: Picking Up the Pieces