Fiscal stabilisation and debt

lizardgossypibomaManagement

Oct 28, 2013 (4 years and 11 days ago)

91 views

Fiscal stabilisation and debt

Simon Wren
-
Lewis

Economics Department and Merton College,
Oxford


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


Summary


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
limitations


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


See
Eggertsson
, 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



Ricardian

Equivalence means fiscal policy
does not work”


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


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
appreciate.


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

WEF Event: Picking Up the Pieces

Macroeconomics, ideology and ivory towers


Eugene
Fama

(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

WEF Event: Picking Up the Pieces

On theory that denies the possibility of deficient
aggregate demand


Keynes

(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

WEF Event: Picking Up the Pieces

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


Theory


fusion of two literatures


Dynamic optimal taxation theory


Schmitt
-
Grohe
, S. and
Uribe
, 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


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

January 2010

WEF Event: Picking Up the Pieces

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
lived
Ricardian

consumers


Taxation is
distortionary
, so any non
-
negative
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


Schmitt
-
Grohe
, Stephanie and
Uribe
,
Martyn

(2007)


Benigno
, P and Woodford, M (2003)



Essentially a tax smoothing result

January 2010

WEF Event: Picking Up the Pieces

Limitations


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,
intergenerationally

selfish
consumers, debt crowds out capital


January 2010

WEF Event: Picking Up the Pieces

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


Blanchard
-
Yaari


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


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


Calibration (annual): K=1,Y=Debt=0.25,
=0.04,p=0.02,
=0


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%


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

January 2010

WEF Event: Picking Up the Pieces

Implications


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

WEF Event: Picking Up the Pieces

How best to achieve gradual and erratic debt
reduction?


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


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
watchdog


See
Kirsanova
, T,
Leith
, C and Wren
-
Lewis, S (2007),
Optimal Debt Policy, and an Institutional Proposal to help in
its Implementation, European Economy Economic Papers No
275


And Sweden, Canada
, Hungary
and others


And Conservative Party policy


January 2010

WEF Event: Picking Up the Pieces