Four Questions about Fiscal Policy

Earlier this fall, I spent a pleasant few days at the 12th Post Keynesian Conference in Kansas City, including a long chat over beers with Robert Skidelsky. In addition to presenting some of my current work, I took part in an interesting roundtable discussion of functional finance with Steve Fazzari, Peter Skott, Marc Lavoie and Mario Seccarechia. Here is an edited version of what I said.

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We all agree that fiscal policy is effective. If output is too low, by whatever standard, higher public spending or lower taxes will cause it to rise. And we all agree that the current level of public debt has no implications for the feasibility or desirability of fiscal policy, at least in a country like the United States. In the wider world that might be a controversial statement but in this room it is not.

It’s not productive to repeat points on which we all agree. So instead, I want to pose four questions about functional finance on which there is not a consensus. These aren’t questions I necessarily have (or expect to hear) good answers to at the moment, but ones that I hope will be the focus of future work. First, the political economy question. Why does the idea of a government financial constraint have such a tenacious hold on both the policy conversation and the economics profession? What function, what interest, does this idea serve? Second, how confident are we about the level of aggregate expenditure that policy should target? Is there a well-defined level of potential output that corresponds to both full employment and price stability? Third, what is the problem that we imagine fiscal policy to be solving? Is it stabilizing of output in the face of “shocks” of some kind, or is it adjusting the long term trend? And what are the sources for the variation in private demand to which policy must respond? Finally, if functional finance means that fiscal policy replaces monetary policy as the main tool for managing aggregate expenditure, what role does that leave for the interest rate?


1. The political economy question.  We all agree that in a country like the modern United States (or the EU as a whole), public budgets are never constrained by the willingness of the private sector to hold the government’s liabilities. There are a number of routes, both logical and empirical, to reach this conclusion, which I won’t repeat here. And yet both policymakers and academic economists are, with few exceptions, committed to the idea that government does face a financial constraint. I don’t think it’s a sufficient explanation that people are just stupid. I was on an earlier panel with Randy Wray, where he quoted Paul Samuelson describing the idea of a government financial constraint as “religion” that has no rational basis but is nonetheless "scares people ... into behaving the way that civilized life requires." [1] Randy focused, understandably, on the first half of that quote, the acknowledgement that a balanced budget is desirable only on ritual or aesthetic criteria. But what about the second part? What is the civilized life that benefits from this taboo?

The political salience of the balanced-budegt myth has been particularly clear in the debt-ceiling fights of the past few years.  You read John Cassidy in New Yorker: “Every country needs to pay its creditors or face ruin.” [2] This is framed as a statement of fact, but it really describes a political project. Creditors need to threaten countries with ruin if they are going to be obeyed. The threat doesn’t have to be real, but it does have to be believed.

The most important political use of the government budget constraint today is undoubtedly in the Euro area, where it seems clear that a central part of the elite motivation for the single currency was precisely to reimpose financial constraints on national governments. This view of the euro project was forcefully expressed by Massimo Pivetti in a 2013 article in Contributions to Political Economy. As he puts it, the ultimate effect of European countries’ renunciation of monetary sovereignty has been the dismantling of the social democratic order.

What is being liquidated is but one of the most advanced experiences of civil coexistence the world has ever known—in fact, the greatest ever achievement of the bourgeois civilization. ... 

Surrender of national sovereignty in the monetary and fiscal fields subscribed by European governments produced a situation of political ‘irresponsibility’, which greatly facilitated their declining commitment to high employment and the redistribution of income, as well as the priority given to reducing inflation, the gradual dismantling of the welfare state, and the privatization drive. ...  [The euro] is an infernal machine: a machine born out of a deliberate continental project to undermine wage earners’ bargaining powers.

Wolfgang Streeck similarly argues that policies that result in rising debt are not the result of rising demands for redistribution and public services, but rather have been supported by the wealthy, precisely because “rising public debt can be utilized politically to argue for cutbacks in state spending and for privati­zation of public services.” You can find similar arguments by Perry Anderson (in The New Old World), Gindin and Panitch, and others. Financial constraint “disciplines” “irresponsible” policymakers — in other words, it makes them responsive to the interests of owners of financial assets. And I would stress the same fundamental point emphasized by Gindin and Panitch — the interest that counts here is not a direct pecuniary interest, defined within the economic system. It is the interest of wealthowners as a class in the perpetuation of a social order based on the accumulation of private wealth.


2. Next, I think we need to interrogate the notion of potential output more critically. The assumption of almost the entire functional finance literature — including my own work — is that there is a well-defined level of aggregate expenditure that policy should be targeting, which corresponds to full employment and full utilization of society's resources. In the standard formula, once we see rising inflation, we know that this target has been reached and there should be no further expansionary policy. In this respect, there is no difference between functional finance and mainstream policy thought. The difference is about the tools used, not about the goal. Most importantly, both policy orthodoxy and functional finance assume that neither inflation nor employment is affected directly by macroeconomic policy, but only via the level of output. So output, inflation and employment can be treated as three indicators for a single target. [3]

It is not obvious, though, why the goals of full employment, price stability and steady output growth should always coincide. Now, in practice it may be that they generally do, or at least are close enough that this is not a big problem. One thing Arjun and I do in our paper is examine this question directly. We compute a number of different measures of the output gap from 1953 to the present. We compare output gaps based on the deviation of current output from trend, the level of unemployment, the level of inflation, and the change in inflation, as well as a measure combining unemployment and the change in inflation that corresponds to the Taylor rule. The interesting thing is that these different measures perform very similarly. The output and unemployment measures fit especially closely, with a simple correlation coefficient of 0.94.  In other words, the Okun relationship between output and unemployment is very stable, and the Phillips curve relationship between output or employment and inflation is also fairly stable. So the statement “When output is above trend, you will see rising inflation; when output is below trend, you will see high unemployment” does in fact seem to be a reliable generalization. (See figure below.)

The figure shows measures of the difference between current output and potential based on (1) trend GDP, as computed by the BEA; (2) the deviation of unemployment from its long-term average; (3) the average of the deviations of unemployment and inflation from their long-term averages; (4) the average of the deviation of unemployment from average and the year-over-year change in inflation; and (5) the year-over-year change in inflation. 

But even if these measures agree with each other for the US over the past 60 years, that doesn’t mean they will agree in other times and places. And in fact, we see that the inflation-change measure does not agree with the others for the post-2007 period, suggesting a much smaller negative output gap. (This is because inflation has stabilized at a low level, rather than continuing to fall.) And even if these measures do generally agree with each other, that doesn’t mean they are right, or that interpreting them is straightforward. In particular, we should ask if hysteresis might not be a more general phenomenon, and that the inflation that comes with output above potential isn't better thought of as an adjustment cost. This brings me to the next question.


3. Is aggregate demand only an issue in the short run, or does it matter in the long run as well? In other words, is the problem to be solved by policy deviations of output around a trend that is determined on the supply side, or is the trend itself the object of policy?

If the former, shouldn't we have a more positive theory about what these "shocks" are that policy is responding to. This has always struck me as one of the weirdest lacunae in mainstream macro. The entire problem of policy in this framework is responding to these shocks, so you would think that a central question would be where they come from, how large they are, whether there are identifiable factors that affect their distribution. But instead the existence of these vaguely defined "shocks" is just the unquestioned starting point of analysis. Now obviously there are reasons for this. Shocks, by definition, are changes in the state of the world that are not due to rational optimization, so if that's your methodology, then "shocks" just means "things I have nothing to say about." (And I have a sneaking suspicion that there is a logical inconsistency between the existence of unanticipated shocks and the idea of intertemporal equilibrium. But maybe not.) But on our side we don't have that excuse. We shouldn't limit ourselves to showing that changes in the government budget position can offset changes in desired private spending. We should try to explain why desired private spending varies so dramatically.

And what if demand matters in the long run, thanks to hysteresis (and what I call anti-hysteresis) in the laborforce, and Verdoorn-Kaldor changes in productivity growth? [4] In that case these questions are even more urgent. And we also have to face the political question that was banished from respectable macro in the 1980s: What is the desirable tradeoff between output and inflation? More broadly, if we can't take a given path of potential output as given, how do we define the goals of macro policy?


4. What is the role of interest rate policy in a functional finance framework, given that it is no longer the primary tool for adjusting aggregate expenditure? On Thursday’s panel, we had three different answers to this question. Arjun and I say that if for whatever reason the public debt to GDP ratio is a concern for policymakers, adjusting the policy interest rate is in general sufficient to stabilize that ratio at some desired level. Peter Skott says that if we have some idea of the optimal long-run capital-output ratio (or perhaps more precisely, the optimal choice of technique), the interest rate can be set to achieve that. And Randy says that we shouldn’t worry about the debt-GDP ratio and that business investment decisions are not very responsive to the interest rate, so its main consequences are distributional. Since there is no social interest in providing a passive, risk-free income to rentiers, the nominal interest rate should be set to zero permanently.


[1] The quote is from an interview with Mark Blaug:  "I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires."

[2] The title of the piece is "Why America Needs a Stock Market Crash."

[3] This isn’t strictly correct, since an important component of functional finance in its modern UMKC form is a job guarantee or employer of last resort (ELR) policy. But given the stability of the Okun relationship, employment and output can safely be treated as a single target in practice. The problem is the relationship of employment and output, on the one hand, with inflation, on the other.

[4] As late as the 1980s, people like Tobin took it for granted that the reason that inflationary or deflationary gaps would not continue indefinitely, was that aggregate supply would adjust.