Helicopter Money and the Denial of the Importance of Sound Fiscal Policy

A recent article on VOX has prompted more commentary on Helicopter Money.

In principle, HM should appeal to anyone who believes that more stimulus is needed.  To those of a post-Keynesian mindset, HM is just expansionary fiscal policy; the fact that it is financed by money rather than bonds being of secondary importance.  But those that believe fiscal policy is impotent and it all comes down to monetary policy can view HM as being another monetary tool.

Given that it should appeal to both points of view, it's perhaps odd that it should cause so much argument.  Yet, as someone whose perspective tends to fall in the former camp, I find myself strangely irritated by the approach of many in the latter.  Where additional stimulus is needed, I think debt-financed fiscal expansion is best, but I'd still see HM as a pretty good substitute.  So what's the problem?

I think the issue is that portraying HM as monetary policy looks to me like a pretence and worse, it looks like a rather desperate attempt to defend the idea that monetary policy is sufficient to regulate demand in the economy, regardless of what fiscal policy is doing.  In my opinion, if we think we need HM, that  is an indication that we have got fiscal policy wrong.  Furthermore, it is an indication that when we get fiscal policy wrong, regular monetary policy is not capable of providing anything other than a temporary fix.  Monetary policy enthusiasts like to think of the zero lower bound as a special case where regular monetary policy might be insufficient.  However, they fail to acknowledge that if the fiscal stance is misjudged, attempts by monetary policy to compensate will inevitably end up at the zero lower bound anyway (see here).

So what I don't like about this debate is the way that it is used to avoid recognising how important fiscal policy is.  Fiscal policy is, on the whole, an unwieldy tool for day-to-day management, but it is critical that it is used with a view to its impact on demand, not to managing the public debt.  If this is not the case, monetary policy is stuffed.  It might provide a temporary fix, but only through stoking private sector debt bubbles.  The notion that HM may now be beneficial should be a recognition of this, not an attempt to pretend that monetary policy is still what it's all about.

Why the Inter-temporal Government Budget Constraint Cuts Both Ways

There are some heterodox economists who get very worked up over the notion of the inter-temporal government budget constraint (IGBC).  In my opinion, this is unjustified.  For a couple of reasons.

In the first place, where the constraint does hold, it is in itself little more than an accounting identity and not a limit on policy as we normally understand it.  If there is any kind of non-accounting constraint, it arises for other reasons such as resource constraints or the imposition of other objectives.  Secondly (and I rarely see this mentioned) the IGBC sometimes imposes a strong imperative for the use of active fiscal policy.

The IGBC says that the real discounted value of future primary surpluses is equal to the real value of current outstanding debt (where discounting takes place at the real effective rate of interest on government debt).

With regard to the first point, we can easily see that this condition will hold in a typical SFC model[1].  Such models settle down into a steady state where the real value of debt remains constant, with a primary surplus exactly offsetting the interest charge on outstanding debt.  This is a position which meets the IGBC, so the IGBC must hold for each preceding period as well.

In the typical SFC model, the policy instruments are the level of real government expenditure, the rate of tax and the nominal rate of interest.  The IGBC does not itself limit the choice of these variables.  This is because the models allow for the level of real output and/or the rate of inflation to be determined, with the mix depending on what is assumed about Phillips curve relationships.  Given the policy variables, both of these are relevant for the IGBC.  The level of output determines the tax take and hence the level of primary surpluses.  The level of inflation impacts on the real discount rate.

The upshot of this is that all the IGBC does in this type of model is limit the possible sets of solutions for output and inflation.

The assumptions of different types of model may combine to place more of a constraint on policy.  For a start, if taxes are assumed to be lump sum, then there is no scope for primary surpluses to be determined endogenously.  Even without lump sum taxes, the assumption that real output is supply side determined in the long run (a common, if questionable, assumption) will limit the endogeneity of the tax take.   Additionally, if the model assumptions incorporate a unique natural rate of interest, then it may be that the discount rate used for the IGBC must also be tightly constrained (although this does depend on what is assumed about how monetary policy is conducted).  A typical DSGE model will tend to incorporate these sorts of assumptions and will therefore impose a greater constraint on fiscal policy.

However, this constraint cuts both ways.  The usual message is to say that, given the exogenous output level and natural rate of interest, there is no scope for increased government expenditure now without requiring correspondingly higher taxes later.  But this is not in fact true in all circumstances and, in some cases, expansionary fiscal policy is exactly what is required.

Specifically, we can consider what happens if there is a permanent fall in the natural rate of interest (or at least a fall that everyone expects to be permanent), something that in Keynesian terms we might interpret as an increased propensity to save.  The DSGE response required of the central bank is a reduction in actual interest rates in an attempt to bring these in line with the lower natural rate.

This has consequences within the IGBC.  As the current level of debt is given, then a reduction in the long-term discount rate requires a reduction in future real primary surpluses.  If we assume that long-term  surpluses are to remain the same, then what is required is a short-term period of expansionary fiscal policy.

The IGBC plus the other assumptions of DSGE dictate that something  like this is required.  Monetary policy alone is inadequate.  This raises the question of what happens if the government declines to respond and instead decides to pursue a policy of austerity.  In fact, the only solution in the model [2] involves a period of deflation with the nominal interest rate hitting the zero lower bound.  This gives a period of higher real interest rates which increase the real value of outstanding government debt until it is equal to the future surpluses discounted at the new lower rate.

New Keynesian economists will generally recognise the need for fiscal policy when monetary policy is constrained by the zero lower bound.  They are usually only thinking of scenarios where there are temporary drops in the natural rate of interest that appears in their models.  But there are other possibilities, such as a permanent fall in the natural rate, that monetary policy can never deal with alone even unconstrained by the lower bound.  These situations require a fiscal policy response and the IGBC shows us why.

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[1] Not necessarily in growth models which may be dynamically inefficient.

[2] That I can see, at any rate, but I'd be interested if anyone knows differently.

Fiscal Policy in Neo-Fisherite Versions of New Keynesian Models

This post is intended to enable me to explain in a bit more detail something I have been describing in an exchange with Stephen Williamson on his blog.

The context is how fiscal policy might impact on the results of models of interest rate changes, particularly in the impulse response on output.  I have in mind here a model based on John Cochrane's, which I've looked at before.  The two main equations are a New Keynesian IS curve and Phillips curve.  There are also assumed to be lump sum taxes and single period government bonds, so there needs to be a government budget constraint which determines the evolution of the stock of bonds.  The three equations in y (output), π (inflation) and b (the real end period value of the stock of bonds) are:

(1)          y_t = E[y_t+1] . ( β . i_t+1 / E[π_t+1] )^-σ

(2)          π_t = E[π_t+1]^β . y_t^κ

(3)          b_t = b_{t-1 .} i_t / π_t - τ_t

where i is the interest rate and τ is the level of real lump sum taxes.

Here, monetary policy is an interest rate peg with i as the policy tool - we have no central bank reaction function.  We want to consider the impact of a 1% cut in this rate, announced five period in advance.  In the first instance, we will assumes that fiscal policy involves keeping τ constant.

The results of this are shown below (showing deviations from starting values).

Inflation starts to decline immediately and eventually reflects the drop in nominal interest rates.  This means that, prior to the actual rate cut, real interest rates are higher, which implies that output rises.  Once actual nominal rates are cut, real rates are lower and output declines again.

This change results in a temporary increase in the real stock of bonds.  This happens because real rates have risen and real rates are a key factor in determining how the stock of bonds changes over time.

So I want to consider an alternative fiscal policy rule; one where the level of taxes, τ_t, is adjusted to prevent b_t ever rising above b₀.  We therefore need a fourth equation which is:

(4)          τ_t = GREATER OF { τ₀ } OR { b_{t-1 .} i_t / π_t - b₀ }

Adding in this equation gives us the results shown below (b_t = b₀ for all t, so I have not included it in the chart).

Under this fiscal policy rule, both output and inflation drop sharply on the announcement, and then both rise until the actual rate change takes place.  These paths clearly satisfy equations (1) and (2) for every period where there is no surprise.  Output is rising when inflation is lower than nominal interest rates; inflation is rising when output is below its equilibrium level.  Equations (3) and (4) selects this equilibrium path from multiple others that would also satisfy (1) and (2) (although I cannot be sure that there are no other alternative paths that would satisfy all four equations).

Note on parameters.  I have used Cochrane's values of β = 0.97 and κ = 0.2, (as well as assuming a τ₀ equal to 20% of y₀).  These parameters suggest time periods in the order of a year, so we are talking about changes announced five years in advance.  If we adjust the parameters to reflect shorter periods (like a month), then announcing five periods in advance has a more limited impact (although still the same pattern).

Cochrane, Fiscal Policy, Interest Rates and Neo-Fisherites Again

John Cochrane's latest paper has raised a few eyebrows, due to some of the distinctly post-Keynesian ideas which seem to have crept into his recent thinking.  His focus is specifically on a world with interest on reserves, but his analysis involves a very significant role for fiscal policy.  This comes down to a point Cochrane has made before about the idea that private sector expenditure can be seen as the counterpart of a demand by the private sector for holdings of public debt.  This concept underlies some important ideas in post-Keynesian economics.

Cochrane considers a model with no government expenditure other than transfer payments and, for the most part, with government debt all of single period maturity.  His main equation (slightly restated here) is:

                                P = D_-1 . ( 1 + i_-1 ) / E(s)

where P is the price level, D is the nominal value of government debt* and i is the nominal interest rate on that debt.  So the top part of the expression is the level of debt left at the end of the previous period plus the interest thereon.  E(s) is the expected real value of current and future primary budget surpluses, discounted at the household rate of time preference.  Because Cochrane assumes no government expenditure, this is basically the expected value of the future net tax burden.

So what this equation amounts to is a statement that the current equilibrium price level is the ratio between the nominal amount of government paper outstanding, divided by the total real value of tax liabilities that will have to be paid using that paper.  The idea here is as follows.  Households expect to have to pay a certain amount of taxes in the future and they hold government debt to cover this.  If the value of the debt they hold is greater than the value of the taxes they expect to pay then, even with consumption smoothing, they can afford to increase current consumption.  This would push up prices, reducing the value of the debt, until the equilibrium price is reached.

So we have here the idea that the real value of the overall government debt is being driven by the future tax liability, and that the price level then depends on the nominal amount of debt available to cover this real value.  This might be said to be essentially a Chartalist position.  But it is also possible to analyse this in terms of backing.  In this view, the value of the debt is driven by the backing of the real value of the expected future tax receipts.  Within this model, these could be said to be just alternative ways of looking at the same thing.

Amongst other things, Cochrane uses his model to look at the relationship between the interest rate and inflation.  One feature of this is easy to see from the above equation.  The growth in the nominal value of government debt depends directly on the nominal interest rate.  If the interest rate is increased by 1%, with no change in expected real primary surpluses, the price level needs to grow at an additional 1% to compensate.

This result should not be a great surprise to post-Keynesians.  In a simple Godley & Lavoie model with only short term debt, they also show how an increase in the interest rate would be expansionary (section 4.5.1).  There are certainly differences between the assumptions in these models, but in essence the reason is the same.  An increase in interest rates transfers nominal value from public to private sector.  If this results in the private sector holding more government debt than it wants it will try to spend to get rid of the excess.

We can see that in Cochrane's simple model, when we have perfectly flexible prices, the price level would rise immediately.  So a rise in nominal interest rates would lead to an immediate inflation, with no temporary deflationary period - the neo-Fisherite result.  I have pointed out before that this is a much less likely result with anything other than single period debt.  This model actually provides a good way of showing this again.

Let's assume instead that government debt also includes some longer term bonds, previously issued at a discount and maturing in the current period.  We now need to write our equation as:

                                P = [ DS_-1 . ( 1 + i_-1 ) + DL ] / E(s)

where DS is the nominal value of the short term debt and DL is the redemption value of the longer dated bonds.  Because these longer bonds were already in issue, their payout is not impacted by any change in the current interest rate.  It is immediately obvious that a 1% increase in the current interest rate now translates into a less than 1% increase in the equilibrium price level.  But if inflation rises by less than the nominal interest rate, the real interest rate has risen which will have real effects.  In fact, the only way that flexible prices could eliminate any real effect is if the price level falls in the period in which the increased interest rate is set.  So we get an initial deflationary period, and only thereafter can inflation increase.  This effect with longer dated debt is also illustrated in Godley and Lavoie (section 5.7).

Cochrane's methodology is clearly mainstream and he excludes many things heterodox economists might consider important.  Nevertheless many of the results he derives are consistent with post-Keynesian analysis.  Cochrane tends to be very dismissive of those who consider themselves Keynesians, but I've been increasingly wondering whether he isn't a closet Keynesian himself.  I hope that at some stage he will be able to come to terms with this.

* Cochrane uses the redemption value of discounted debt as his variable.  I have used issue value, because it helps illustrate my point. 

His B = my D. ( 1 + i )