Guest Contribution: “Monetary Alchemy, Fiscal Science”

Today, we’re very fortunate to have as a guest contributor Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. His weblog can be found here.

The year 2013 marks the 100th anniversaries of two separate major institutional innovations in American economic policy: the Constitutional Amendment enacting the federal income tax, ratified in February 3, 1913, and the law establishing the Federal Reserve, passed in December 1913.
It took some time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy, respectively. It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macro-economy. John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression. Milton Friedman blamed the Depression on the Fed for allowing the money supply to fall.
In subsequent debate, Keynes was associated with support for activist or discretionary policy. The aim was counter-cyclical response to economic fluctuations: expansion in recessions, discipline in booms. (It is a myth that he favored big government generally. He said “the boom is the time for austerity.”) Friedman opposed activist or discretionary policy, believing that government institutions, whether monetary or fiscal, lacked the ability to get the timing right. But both great economists were opposed to pro-cyclical policy moves, such as the misguided US tightening of 1937 at a time when the economy had not yet fully recovered.
After World War II, the lessons of the 1930s were incorporated into all the macroeconomic textbooks and, to some extent, into the beliefs and actions of policy-makers. But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by experiences such as the high-inflation 1970s. As a result, many politicians in advanced countries are repeating the mistakes of 1937 today. This despite conditions that are qualitatively similar to those that determined Keynes’ policy recommendations in the 1930s: high unemployment, low inflation, and rock-bottom interest rates.
The austerity-versus-stimulus debate has been thoroughly hashed out. On the one hand, proponents of austerity correctly point out that the long-term consequences of permanently expansionary macroeconomic policy [both fiscal and monetary] are unsustainable deficits, debts, and inflation. On the other hand, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt/GDP ratios that go up rather than down. With conditions of excess supply in goods and labor markets, as opposed to full capacity and full employment, demand expansion goes into output and employment. Procyclicalists, both in the US and Europe, represent the worst of both worlds: they push in the direction of expansion during booms such as 2003-07 and in the direction of contraction during recessions such as 2008-2012, thereby exacerbating both the upswings and downswings. Countercyclicalists have it right: working in the direction of fiscal and monetary discipline during booms and ease during recessions.
Less thoroughly aired recently is the question whether — given recent conditions – monetary or fiscal expansion is the more effective instrument. This question was addressed clearly in 1937 by Sir John Hicks in a once-famous article titled “Mr. Keynes and the Classics.” The graphical model is known to many generations of undergraduate students in macroeconomics under the label “IS-LM.”
The answer to the question which form of policy is more effective: under the circumstances that held in the 1930s and that hold again now – which are conditions not just of high unemployment and low inflation, but also near-zero interest rates — stimulus in the specific form of fiscal expansion is much more likely to be effective in the short-term than stimulus in the form of monetary expansion. Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero. This situation, labeled by Keynes a liquidity trap, is today called the Zero Lower Bound. In addition, firms are less likely to react to easy money by investing in new plant and equipment if they can’t sell the goods they are producing in the factories they already have. The hoary — but still evocative — metaphor is “pushing on a string.” Meanwhile, fiscal expansion is rendered relatively more effective, in that it doesn’t push up those rock-bottom interest rates and thereby crowd out private-sector demand.
Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries. It is worth trying all sorts of things: quantitative easing, forward guidance, nominal targets. But the effects of each are highly uncertain. That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position. But many economists have forgotten much of what they knew and politicians may not have even heard the proposition.
Introductory economics textbooks have long talked about the Keynesian multiplier effect: the recipients of federal spending (or of consumer spending stimulated by tax cuts or transfers) respond to the increase in their incomes by spending more as well, as do the recipients of that spending, and so on. Again, the multiplier is much more relevant under current conditions than in the normal situation where the expansion goes partly into inflation and interest rates and thus crowds out private spending. By the time of the 2008-09 global recession, even those who believed that fiscal stimulus works had marked down their estimates of the fiscal multiplier (intimidated, perhaps, by newer theories of policy ineffectiveness). The subsequent continuing severity of recessions in the United Kingdom and other countries pursuing contractionary fiscal policies, apparently to the surprise of the politicians enacting them, suggested that multipliers are not just positive, but greater than one, as the old wisdom had it. The IMF Research Department has reacted to this recent evidence and bravely confessed that official forecasts, including even its own, had been operating with under-estimates of multiplier magnitudes.
A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others. Baum, Poplawski-Riberio and Weber (2012) allow the estimate to change when crossing a threshold measure of the output gap. Batini, Callegari and Melina (2012) allow regime-switching, across recessions versus booms. Others that similarly distinguish between multipliers in periods of excess capacity versus normal times include Auerbach and Gordnichenko (2012a, 2012b), Baum and Koester (2011), and Fazzari, Morley and Panovska (2012). Most of this research finds high multipliers – above 1.0 — under conditions of excess capacity and low interest rates, though few have the courage to mention that this is what one would have expected from the elementary textbooks of 50 years ago. Related studies confirm other conditions that matter for the size of the fiscal multiplier in precisely the way the traditional textbooks say, for example that they are lower in small open economies because of crowding out of net exports.
Needless to say, the effects of fiscal policy are subject to substantial uncertainty. One never knows, for example, when rising debt levels might suddenly alarm global investors who then start demanding abruptly higher interest rates, as happened to countries on the European periphery in 2010. (For this reason, the United States would be well-advised to lock in a long-term path toward debt sustainability, even while undertaking a little short-term stimulus.) In the case of stimulus in the form of tax cuts, one never knows how much of the boost to disposable income will be saved by households rather than spent. We are also uncertain as to the magnitude of negative effects of high tax rates, via incentives, on long-term growth. And it is true that monetary policy is much better understood than it was in the past.
Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter. One might even dramatize the contrast by speaking of “monetary alchemy and fiscal science.”
A much-admired 2010 paper by Eric Leeper had it the other way around: it characterized monetary policy as science and fiscal policy as alchemy. It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to the best that modern society has to offer. It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state of economic knowledge and motivated by largely politicians’ desire to be re-elected. (These political realities may be what the author of “Monetary Science, Fiscal Alchemy” had in mind.)
But the ancient alchemists were not in fact stupid or selfish people in general, notwithstanding their search for the “philosopher’s stone” that was to turn lead into gold, of which modern proponents of returning monetary policy to the pre-1914 gold standard are reminiscent. Nor was the alchemists’ problem that the monarchs of their day refused to listen to them. It was rather that the state of knowledge fell far short of what the modern science of chemistry tells us.
The term alchemy could be applied to pre-Keynesians like US Treasury Secretary Andrew Mellon (whose Depression prescription was that President Herbert Hoover should “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system”). It could also be applied to the “Treasury view” in the UK of 1929. (Churchill: “The orthodox Treasury view … is that when the Government borrow[s] in the money market it becomes a new competitor with industry and engrosses to itself resources which would otherwise have been employed by private enterprise, and in the process raises the rent of money to all who have need of it.” ). But in light of all that was learned in the 1930s, it would be misleading to characterize the current state of fiscal policy knowledge as alchemy.


Miguel Almunia, Agustín Bénétrix, Barry Eichengreen, Kevin O’Rourke, and Gisela Rua, 2010 “From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons“, Economic Policy 25, no.62, pp. 219-265.
Alan Auerbach and Yuriy Gorodnichenko, 2012a, “Measuring the Output Responses to Fiscal Policy,” American Economic Journal: Economic Policy, vol. 4(2), pp.1-27, May.
Alan Auerbach & Yuriy Gorodnichenko, 2012b, “Fiscal Multipliers in Recession and Expansion,” NBER Chapters, in Fiscal Policy after the Financial Crisis, edited by Alberto Alesina and Francesco Giavazzi (University of Chicago Press).
Nicoletta Batini, Giovanni Callegari and Giovanni Melina, 2012. “Successful Austerity in the United States, Europe and Japan,” IMF Working Papers 12/190, International Monetary Fund.
Anja Baum and Gerritt Koester, 2011, “The Impact of Fiscal Policy on Economic Activity Over the Business Cycle – Evidence from a Threshold VAR Analysis” Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies number 2011,03.
Anja Baum, Marcos Poplawski-Riberio and Anke Weber, 2012, “Fiscal Multipliers and the State of the Economy,” IMF Working Paper 12/286, International Monetary Fund, December.
Olivier Blanchard and Daniel Leigh, 2013, “Growth Forecast Errors and Fiscal Multipliers,” IMF Working Paper No. 13/1, January. Forthcoming, American Economic Review, May.
Steven Fazzari,James Morley, and Irina Panovksa, 2012, “State-Dependent Effects of Fiscal Policy,” UNSW Australian School of Business Research Paper No. 2012-27, April.
Milton Friedman and Anna Schwartz, 1963, A Monetary History of the United States, 1867–1960 (Princeton University Press).
John Hicks, 1937, Mr. Keynes and the Classics: A Suggested Reinterpretation,” Econometrica, pp. 147-59.
Ethan Ilzetzki, Enrique Mendoza & Carlos Vegh, 2011. “How Big (Small?) are Fiscal Multipliers?,” IMF Working Papers 11/52, (International Monetary Fund.) Forthcoming, Journal of Monetary Economics.
Eric Leeper, 2010, “Monetary Science, Fiscal Alchemy,” NBER Working Paper No. 16510.
Christina Romer and David Romer, 2013, “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter,” UC Berkeley, January.
Antonio Spilimbergo, Steven Symansky, and Martin Schindler, “Fiscal Multipliers,” Staff Position Note No. 2009/11, International Monetary Fund.

This post written by Jeffrey Frankel.

13 thoughts on “Guest Contribution: “Monetary Alchemy, Fiscal Science”

  1. Bruce Carman
    The chart at the link above shows the ratio (velocity) of GDP to local, state, and federal gov’t debt having fallen to effectively near 1.0 versus 2.2 in the late ’90s and 2.7 in the ’70s-’80s.
    In terms of private GDP, the ratio (velocity) is at 0.7, having fallen below 1.0 in ’08 and from highs of 1.9 and 1.6 respectively in the ’70s-’80s and ’00-’01.
    Given the levels of public and private debt to GDP, wages, and per capita, gov’t spending from borrowing an equivalent of 10% of private GDP is not contributing to growth of private sector economic activity; it is preventing nominal GDP, profits, asset prices, and private sector demand from collapsing, which it otherwise would do without the unprecedented, balls-to-the-wall deficit spending and pulling demand from the future.
    The banks directing the Fed to print for them $1 trillion this year is not “stimulus” with unprecedented levels of public and private debt to GDP in a debt-deflationary regime; it is for “bank liquidation” and will only result in equity prices being even more overvalued than otherwise, ensuring low or negative returns to equities for another 10+ years hereafter.
    Speaking of equity valuations and GDP, the charts above show the velocity of equity market (S&P 500, which represents ~80% of market capitalization) capitalization to private GDP (inverse of the market cap/GDP) and estimated market capitalization to private GDP. Equity valuations are still at levels of the ’60s and early ’70s secular bull market “peak” and the bubble level of the ’90s, reflecting the low-velocity hoarding effects from concentrated ownership to the top 1-10% of overvalued corporate equity.
    Unprecedented levels of public and private debt and EXTREME wealth and income concentration and hoarding of financial wealth by the top 0.1 to 1-10% of households will not permit growth of private economic activity per capita.
    With equity prices again at bubble-like valuations and reported earnings contracting yoy, the historical precedent is for a 35-50%+ decline in equity prices and another recession to force further private sector debt deflation, this time for non-financial corporations that now have debt/GDP at a record going back to 1929 and Japan in ’89-’95.
    We can’t print reserves and deficit spend our way out of the deep-structural effects of a once-in-a-lifetime debt-deflationary regime. Debt has to be deflated, asset prices correct and remain low to GDP and wages, and wages/GDP rise, or at least cease contracting.

  2. ppcm

    One may find comfort with F. Braudel statement, he was not an economist as defined through classic recognition.
    « A civilization is not one economy but several economies »
    This comfort bears its own limits in time and comparison. Should Old Cato’s principles be demoted so are the analogies with 1937.It remains to be found among the multi layers of theories, the common principles of soundness.
    Let us start with Cicerone « A country is only strong because it has credit » that means solvency. The Western world has gambled its solvency.
    Jumping in memory and time, Mundell diagrams come into mind a Balance of payment, Investment Savings curves I-S curves , supply of money and demand for money L-M curves, real interest rate, full employment.
    A struggling Professor chalk in hands, looking for an answer when trying to move any of these functions above the horizontal line of employment, Fiscal policies, monetary policies exchange rates none of them independently or all together worked as he was outlining the infectious effects of a balance of payment deficit, the lack of private investments the ineffectiveness of the exchange rate policy, of the money supply. The unemployment was stocked at a level below full employment.
    His conclusion « never drive an economy in this situation » the Western world did.
    This diagram was not typifying 1937 but the end of the 20th century and beginning of the 21st century.
    So trials and errors will prevail but one may as well address the moral hazard and culprits of those failures.History is reminding us that soon or later the society will.

  3. Edward Lambert

    There is another thing which has been forgotten about the 1930’s. And it seems forgotten by everyone, even Keynesians.
    In short, the labor share of income sky-rocketed during WWII. This brought down debt and created some inflation. The effect was to “heal” the demand-side of the economy.
    Some economists talk about the big fiscal spending of WWII as the cure in the economy, but what if labor share had not risen? Would the economy have recovered so strong?
    We now have a situation with low labor share of income.
    The true goal of fiscal spending is beyond just jobs, it is creating an environment for rising labor share of income… but nobody says this explicitly, but they should. Are they worried about being seen as promoting a policy leading to a wage-push inflation? But what is the flip-side of wage-push inflation?… wage-pull under-performing economy?
    There is a serious imbalance and we simply need to remember the curative effects from the increasing labor share of income during WWII.

  4. markg

    The analysis of the problem is quite clear, but the solution offered is difficult for those in Washington to understand. He correctly states fiscal is the best option and calls for stimulus. But those in Washington read stimulus has greater spending. Tax cuts are stimulus; but for who? He correctly states “investing in new plant and equipment if they can’t sell the goods they are producing in the factories they already have”. Translation so those is Washington understand: tax cuts for job creators ain’t gonna work. He does go on to explain how stimulus on the demand side will work, but leads with govt spending and hides tax cuts in parenthesis.
    Mr Frankel is correct in saying inflation could be a future problem. I hope he understands the difference between supply shock inflation and demand inflation. Will Washington step up to the plate and take action if inflation becomes a problem? People hate inflation and vote that way. Politicians know this and if they want to keep their jobs they will take action.

  5. joe bongiovanni

    “”Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero. This situation, labeled by Keynes a liquidity trap, is today called the Zero Lower Bound.””
    What we have here is a new liquidity trap – that created by our limited thinking about money.
    I beg that you get out of this traditional view of what might constitute effective monetary policy – into a new one , administered by what we would call state monetarism – a position that would admittedly be manifest only after the state regains the right to issue the nation’s money . The transmission mechanism for combined monetary-fiscal policy becomes the traditional lever, that of Treasury.
    Greenbacks are the proper vehicle for delivering fiscal stimulus as part of a combined monetary – fiscal counter-cyclical policy apparatus.
    The Bill introduced by Dennis Kucinich
    would provide the measure needed to restore a demand-side expansion funded by real money, i.e. without debt(like Greenbacks) and at the same time maintain the government’s proper roles – both to issue the money and to determine its first use.
    We live in both unprecedented and uncertain times. It’s time to take the big look around at what can be done to solve our social and political problems, while keeping the best of what we call capitalism alive.
    It’s a structural-policy adjustment of one word – separation.
    Separate out the PRIVATE banking and finance function from the PUBLIC money-creation function.
    We’re home free.
    For the Money System Common.

  6. Blissex

    «This question was addressed clearly in 1937 by Sir John Hicks in a once-famous article titled “Mr. Keynes and the Classics.” The graphical model is known to many generations of undergraduate students in macroeconomics under the label “IS-LM.”»
    Hicks reneged on that paper realizing that it was a poor betrayal of Keynes’ work, and the IS-LM graphical model has been demonstrated to be based on inconsistent logic…

  7. ReformerRay

    Yes, our current conditions is very similar to the Great Depression but one difference is very important. The Great Depression did not have a huge trade deficit sucking economic activity from the domestic economy. We know that the U.S. trade deficit averaged 5.3% of GDP for the period 2004-2008 and 3.6% for the period 2010-2011. What we don’t know is whether consumption and investment would have declined without the trade deficit. We do know that any increase in consumption and investment stimulated by the trade deficit DID NOT INCREASE DOMESTIC PRODUCTION.
    Does the trade deficit remove enough production activity from the U.S. to account for the inability of the various stimuli to kick-start the economy?

  8. JBH

    Ray: You are on the right track, more than you know. The merchandise trade deficit is hollowing out middle-income jobs and has stunted manufacturing feeder industries causing multiplier damage beyond the raw deficit numbers. Jobless recoveries are a consequence of what has happened to trade. The sequence of rising joblessness (months to get back to pre-recession peak) began with the ’82 recession. Joblessness has sequentially worsened ever since mostly because of trade. Payroll employment won’t regain its 138 million peak until mid-2015! The latest recession laid open a host of additional factors. Joblessness is now on steroids. These include: household deleveraging with another 5 years to go, the Reinhart Rogoff effect now that trillion dollar fiscal stimulus has pushed debt up into the Reinhart Rogoff region, the anti-business attitude and regulatory strangle of the administration, a step-function increase in uncertainty (Bloom et al index) that’s dampening growth, bank regulatory capital constraints on well-run tier-2 banks where the monetary transmission mechanism is broke, and Fed policy which has crossed the threshold from salutary to harmful via unintended consequences already (e.g. slashed retiree interest income) and to come (e.g. eventual stagflation). I don’t know of a single paper empirically addressing the long-term (30 years now) damage of the dynamics of widening trade deficits, offshoring of manufacturing vitality, and jobs. Economics is stuck in the comparative statics world of David Ricardo’s nearly 200-year old work and you are pointing that out.

  9. ReformerRay

    JBH says economics is stuck. I am not sure what it is stuck on or why but something is amiss.
    A textbook that influenced many was International Economics by Krugman and Obsfeld. I grew up on the Third Edition, 1993. The phrase “trade deficit” appears only on one page (according to the appendix) and that sentence refers to the second part of the book where finance issues appear. There is no discussion of a possible connection between a trade deficit and Gross Domestic Product despite the use of the trade balance as one of the three components added together to calculate GDP. The model used by Paul Samuelson to discuss trade (JAE, Summer, 2004)assumed balanced trade. Apparently, economists educated recently in the U.S. have not been given the tools needed to think about what 36 years of a trade deficit has done to the U.S. economy.

  10. JBH

    Ray: To follow up. The economics profession is stuck on (thoughtlessly wedded to) Ricardo’s theory of comparative advantage. This is a static theory of immense importance and influence. Yet it is silent on the dynamics of how the trade deficit is eating the heart of the US economy (manufacturing) over time. The profession is frozen in time on this, just as it has been ignorant on the topic of debt. There are only 4 references to debt in the General Theory, all trivial. Yet debt is precisely what brought the economy down in 2008, and the burgeoning debt is the gravest issue we face today. Hyman Minsky, as well as a number of others, laid out the dynamics of debt in refereed articles and (in Minsky’s case) in books. But the reigning paradigm ignored Minsky. In his justly famous Structure of Scientific Revolutions, Thomas Kuhn lucidly explained why this happens not just in economics but in all sciences. The trade chapter on dynamic comparative advantage has yet to be written. You cannot leave out this topic and expect the rest of conventional theory to hold. Economics is plagued not just by omitted variables, whole chapters of the book are missing! Hence when conventionally trained economists make a statement about the system (e.g. all we need is more fiscal stimulus to close the output gap), they can at times be very wrong (e.g. wrong on wanting more stimulus today).

    The necessary condition for the survival of a society is that it run a surplus. A domestically created surplus is the foundation upon which, transformed via invention and investment into new capital, the potential resides. Trade and fiscal deficits are anti-surplus. In their present size, and at this moment in time, the two are causally related and act with synergistic ill effect. The deficits are degrading potential – present and future – in proportion to the size of the debt to which they add. And this degradation is ramping up in a nonlinear worsening way.

  11. ReformerR

    Thanks JBD. While no one is looking, let’s have a little seminar on Comparative Advantage. I believe it is a valid theory only after the fact, when trading partners who formerly produced each of two products in both nations and now behave differently and specialize in only one of the alternative products. The specialization creates the opportunity for a greater volume of the two products to be created. The next step is crucial and not often discussed. The assumption is that the extra product is shared between the two countries. Barter would do it. But both nations would have to agree on the metric – how many of one product is equal in value to X number of the other product. But why talk about barter? Barter is not what happens. Instead, both nations must sell their product on the open market. If they are able to do so, we can say that Comparative Advantage is a description of reality. Question – how many times does this happen compared with the number of times a specialized producer sells in a new market forcing out of business local non-specialized producers? When two nations produce near balanced by-lateral trade, it is likely that Comparative Advantage exists. When two nations produce unequal by-lateral trade it is likely that an export has arrived from a specialized producer without a corresponding successful specialization taking place in the receiving county.
    The above is a lot of words to make my point. To put is simply, I think a large trade deficit in by-lateral trade is evidence something is happening that is not properly described as Comparative Advantage. I call this the “selling requirement” for Comparative Advantage.
    Let’s compare different ways of trashing Comparative Advantage. Ian Fletcher lists 7 dubious assumptions of Comparative Advantage. You suggest it is a static view when a dynamic perspective is needed. Could you elaborate on your perspective please?. And tell me how you rate in importance the various objections – Assumptions; Selling requirements; Static.
    What substitute theory is needed? Or do we just assume that we need to work towards balanced trade so that our theories and models which assume balanced trade will no longer be irrelevant?

  12. Ron Abate

    What if a large part of the problem is the huge increase in government paying people not to work. There apparently has been a huge increase in income distribution. An interesting podcast on this subject is as follows:
    In addition, the zero interest rate policy of the Fed is killing retirees. I have reduced my household budget by 30% and keep squeezing. Dropped my tennis membership at a country club. No longer have a once a week house cleaning. Doing it myself. Got rid of my gardener. Doing it myself. Good exercise. Taking vacations every other year. Haven’t bought any new clothes in two years. Only eat out on special occasions, not twice or thrice a week as before.
    As for fiscal stimulus, it seems to me our one trillion dollar annual fiscal deficits for as far as the eye can see is fiscal stimulus on steroids.
    Seem to me that worked real well in Japan. The Japanese did exactly what Krugman advised in 1993. They built bridges to nowhere, paved over most of the country that wasn’t needed for agriculture, built airports that sit idle and now they have government debt at 235% of GDP. That worked so well we need to follow them over the same cliff.

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