Fiscal multipliers at the zero bound in an open economy

Let’s continue our look at debates over UK fiscal adjustment.

Will fiscal policy work in an open economy? The standard view has
been that in a Mundell-Fleming model fiscal expansion appreciates
the exchange rate and hurts the trade balance, thus offsetting
the fiscal policy. The U.S. may be too closed an economy for this
to be a big deal, but for the UK it seems this might apply, at
least if one is operating within Keynesian frameworks.

The recent Keynesian response has cited the “lower bound” as a
reason why fiscal policy still may be effective in an open
economy. But what does this literature really show? Let’s take a
brief tour of it, starting with the August 2012 piece by Emmanuel Farhi and Ivan Werning,
brilliant Harvard and MIT guys. Their piece is clear and
excellent, and it shows what the case for fiscal policy in this
setting looks like. (I don’t read them as offering concrete
advice to current governments and thus I have no criticism of
their paper, which I am pleased to have spent time with.)

Here are a few points:

1. “…the effects of government consumption work through
inflation.” In other words, if you think the BOE has greater
influence over inflation than UK government spending, you do not
need the other results of this paper for macro policy. I get the
point of “the central bank cannot precommit to elaborate
targeting schemes over time,” but that’s not what we need here.
We just need some basic money-induced price inflation to render
monetary policy dominant over fiscal policy, even in this case.
And pretty much everyone thinks the BOE can influence the rate of
price inflation. The rates of price inflation we are getting are
not some kind of strange coincidence.

By the way, even with a so-called liquidity trap, the BOE also
can play QE with the exchange rate, as do the Swiss.

2. The zero bound open economy model predicts that fiscal
tightening leads to exchange rate appreciation (contra the usual
Mundell-Fleming case), yet here is the British pound against the
dollar:

Not an obvious fit to the prediction. There are countervailing
factors, to be sure, but maybe that’s the broader story too.

3. The model in the paper suggests that “current” fiscal policy
won’t much help aggregate demand. Fiscal policy does best the
further away in time it is, provided it does not happen
after the liquidity trap goes away. This makes sense if you view
inflation as the channel for the effectiveness of fiscal policy.
Getting the inflation over with won’t help much, but if it hangs
over people’s heads they will spend more in response. In fact
there is even a problem that the multiplier can be infinite if
fiscal policy is sufficiently well-time and back-loaded.

None of this corresponds with the advice we actually are hearing.

4. The greater the nominal stickiness of prices in the model, the
weaker the Keynesian effects and in the limiting case they
approach zero. Yet we are told (by the policy commentators) that
nominal stickiness is of the utmost importance.

Let’s consider a few other pieces and points:

5. It is common for these papers to rely on squirrely mechanisms
of intertemporal substitution, which in other contexts are mocked
by Keynesians. Consider
Fujiwara and Ueda, a commonly cited paper on fiscal
multipliers and the zero bound:

Incomplete stabilization of marginal costs due to the existence
of the zero lower bound is a crucial factor in understanding
the effects of fiscal policy in open economies. Thanks to
this, government spending in the home country raises the
marginal costs of home-produced goods, which increases expected
inflation rates and decreases real interest rates.
Intertemporal optimization causes consumption to increase, so
that the fiscal multiplier exceeds one. While government
spending continues, the price of home-produced goods increases
more than that of foreign-produced goods. Expecting that two
countries are at symmetric equilibrium when government spending
ends, the home currency depreciates and the home terms of trade
worsen on impact when government spending begins. That shifts
demand for goods from foreign-produced goods to home-produced
ones. The fiscal spillover thus may become negative depending
on the intertemporal elasticity of substitution in consumption.

If a passage like that came from an RBC theorist it would be
mocked, but in support of activist fiscal policy it passes
without critical comment.

6. When it comes to Japan and the Japanese lower bound, the
empirical evidence seems to show that “standard theory” predicts
quite well and the stranger zero bound theories do not predict
well. Here is Braun and
Korber:

We show that a prototypical New Keynesian model fit to Japanese
data exhibits orthodox dynamics during Japan’s episode with
zero interest rates. We then demonstrate that this
specification is more consistent with outcomes in Japan than
alternative specifications that have unorthodox properties….

Those same zero bound Keynesian models predict that economies
should have quite volatile responses to real shocks, yet they do
not:

We also considered specifications of the model that have larger
government purchase multipliers and some which also exhibit
unorthodox predictions for the response of output to labor tax
and technology shocks. We found that these specifications are
difficult to square with the fact that the period of zero
interest rates in Japan between 1999 and 2006 was a period of
low economic volatility. All of the specifications predict the
opposite should have occurred. The specifications with
unorthodox properties also have other problems. They predict
large resource costs of price adjustment which are difficult to
reconcile with empirical evidence that menu costs are small and
they require that households expect the period of zero interest
rates to be counterfactually long.

Need I state the irony that proponents of the relevance of the
zero bound often insist that real shocks simply aren’t making
such a big difference in recent years? That is inconsistent with
the basic model which they otherwise are citing.

7. In these settings (and assuming away all the problems above),
a lot of the effectiveness of fiscal policy, or sometimes all of
it, comes from “beggar thy neighbor” effects. Read Cook
and Devereux for some illustrative cases. Beggar thy neighbor
strategies are criticized and rejected when Germany (supposedly)
does them through its export prowess, but in the context of
fiscal policy they seem to be given a free pass.

8. In fact I could make further points but I believe that is
enough.

The bottom line: A look at this new and
interesting literature shows it does not support the
interpretations which the “policy commentariat” Keynesians are
putting on it and in some regards it even opposes those
interpretations. When it comes to UK fiscal policy, we are seeing
again what I described
last week: exaggeration and a lack of transparency in
argumentation.