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Paul Krugman on Fiscal Stimulus [UPDATE]
Posted by: Jon Henke on Sunday, January 20, 2008

I intend to write a post examining the merits, problems and complexities of fiscal stimulus soon. Among other things, I seriously question (a) whether it can be effective when we are potentially entering a housing bubble bust driven recession< (b) what effect fiscal stimulus would have while we are still at full employment - to the extent that it increased consumption, wouldn't it simply be inflationary - and in general, (c) whether fiscal policy, practically speaking, is a sufficiently delicate tool to achieve its objectives. As happened in 2001, it's very likely that a recession will become an ex post facto rationalization for policy goals (corporate/populist welfare, inequality, tax cuts) that have relatively little to do with the economic object of fiscal stimulus.

I want to get to that soon. In the meantime, I've been reading on the subject and I kept finding myself reading Paul Krugman's past observations on the subject of fiscal stimulus and/or the optimal response to recession. I haven't yet read what he's written about potential responses to any forthcoming economic downturn, but it's worth reading what he has written in the past.

Paul Krugman, December 2000
Cheney's remarks were those of a vulgar Keynesian — a believer in the now- discredited doctrine that taxes and spending should be routinely twiddled in an attempt to "fine-tune" the economy. Decades of experience shows that this is a bad idea, that when governments try to fight garden-variety recessions by cutting taxes or increasing spending they almost always get it wrong. By the time Congress has finished negotiating who gets what, and puts the new law into effect, the recession is usually past — and the fiscal stimulus arrives just when it is least needed.

Fiscal pump-priming has its place; it's appropriate in the face of deep and persistent slumps. But otherwise we should make budgets for the long run, and let the Fed deal with short-run problems by adjusting interest rates. It's disturbing that Mr. Cheney seems unaware of this basic policy rule.
Paul Krugman, August 2001
Can we pump up the economy with additional tax cuts or temporary public spending? Not safely; those huge future tax cuts have created a grim long-term financial outlook, and any further tax cuts would make the outlook even grimmer.
Paul Krugman, September 2001
What about fiscal policy? Some liberals have recently made common cause with the Bush administration, arguing that the economic slump is a reason to put aside promises to protect the Social Security surplus. But those liberals are making a big mistake.

Even on the straight economics of the case, it is by no means clear what good it would do to give up on protecting Social Security. By and large, the spending decisions that Congress will make over the next few months won't have much impact on the economy until late next year at the earliest. Even pessimistic analysts think that a recovery will already be under way by then.

Furthermore, responsible behavior can be rewarded — and irresponsible behavior punished — quite quickly. In 1993, in the face of a still-sluggish economy, Robert Rubin and Larry Summers urged Bill Clinton to commit himself to fiscal discipline. Such a commitment, they argued, would help keep long-term interest rates down and would do more to stimulate the economy, even in the short run, than any attempt to pump it up with deficit spending. And they were vindicated by events.
Paul Krugman, September 2001
The conventional wisdom among economic analysts is that fiscal policy is not necessary to deal with most recessions, that interest-rate policy is enough. In other words, they believe that stabilizing the economy is properly the job of the Fed, not the Treasury Department. But the possibility of fiscal action always stands in reserve.
Paul Krugman, October 2001
Basically, monetarists wanted to get the government out of the business of short-term economic management. First and foremost this meant rejecting the use of fiscal policy — discretionary tax cuts or spending increases — to fight recessions.

By and large this was an argument that the monetarists won on the evidence. Few economists now accept [Milton] Friedman's further view that even monetary policy should be placed on cruise control. Alas, it turns out that a stable money supply is no guarantee of a stable economy. But almost all economists now agree with the position that monetary policy, not fiscal policy, is the tool of choice for fighting recessions.
And finally, Paul Krugman in May 2003, when the Fed Funds rate was 1.25%.
[D]o I need to point out that the case for fiscal policy to create jobs rests mainly on the fact that the economy is near a liquidity trap? If the interest rate were currently 5 percent, we'd all say that the Fed needs to cut more, while the Treasury and the Congress should focus on long-term fiscal responsibility. It's the Fed's possible ineffectuality that makes us reach for another tool.
The Federal funds rate today is 4.25% - not far at all from 5%.


Megan McArdle adds some good points about fiscal stimulus...
[Stimulus rarely works unless it is massive and very rapidly applied, and if it is massive and very rapid, it usually has much larger problems.

The difference between tax cuts and spending is irrelevant in theory. In practice, because so few people pay significant income tax, it has distributional effects. Since rich people seem to save more money than poor people, this blunts the effect of the stimulus. On the other hand, spending is generally much more distortionary than tax cuts, because the government picks what the money is spent on. One more reason not to like fiscal stimulus packages.

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Previous Comments to this Post 

Business cycles are inevitable, and I think we’re in for some pain ahead. But with debt at 70% of GDP and our current account in deficit by so much, I don’t see the wisdom in a fiscal stimulus. However, I’m not sure lower interest rates are the key either — private debt is so high, I’m not sure how much more debt we can sustain. We may need a period of stagflation or even deflation to compensate. I know most gloom and doom predictions are wrong, but I think we’re in for something that will make 1991-92 look very mild by comparison.
Written By: Scott Erb
Of course a stimulus package will work! The main problem seems to be the housing market, and I am certain that, like me, many others will take their $500 rebate and buy a new house, rejuvenating the housing market and thus averting a recession.
Written By: timactual
URL: http://
Many like me will take the money and stick it in the bank to help compensate for the coming tax hike. When the Bush tax cuts expire, my taxes will go up. That’s the coming tax increase. Bush will be blamed.
Written By: MarkD
URL: http://
The world stock markets took quite a dive on Monday.

I wonder what is in store here for Tuesday.
Written By: tkc
URL: http://
"But with debt at 70% of GDP"

Very low by international standards.

"our current account in deficit by so much"

Shrinking as exports grow and imports are reduced by the weak with a recession, imports will be reduced even more while exports may not be effected as much. (If other economies are truly un-yoked from the US)

I’m typing this in Vietnam where all of our suppliers are really happy that China’s currency is rising along with costs...hey, wasn’t China unstoppable?

BTW, they are also complaining about the difficulty of finding workers as industrial parks open in the North - while its not good news for our suppliers, its good news for the world economy as convergence occurs and people become richer . Shipments from Vietnam factories are headed to Taiwan, Korea, and Japan - as the old exporters become the new importers. And its not just cheap countries that get those exports - a Coscto just opened in my city in Taiwan doing booming business with a lot of Made in USA products.

One thing about a recession that might be good - a culling here in Asia where there is serious overcapacity in many industries fueled by easy credit.
Written By: Harun
URL: http://
"But with debt at 70% of GDP"

Very low by international standards.
Not very low. It’s rather mainstream of industrialized states, which means world credit markets have a lot of debt. But you can’t call it "very low."
"our current account in deficit by so much"

Shrinking as exports grow and imports are reduced by the weak with a recession, imports will be reduced even more while exports may not be effected as much. (If other economies are truly un-yoked from the US)
Yes, the dollar has been overvalued, and right now a mixture of a weaker dollar, an infusion of foreign capital into the US (sovereign wealth funds, etc.) and an American recession is the way this rebalances. This already has had an impact, the deficit has gone from about 6% of GDP to 5% of estimated 2008 GDP.
Written By: Scott Erb
Not very low. It’s rather mainstream of industrialized states, which means world credit markets have a lot of debt. But you can’t call it "very low."

So now you’re saying 70% is high by historical standards? LOL. Its a low number and completely within reason.

Also, about the current account deficit, I think you left out the "rising exports" from your lists, and instead grasp at "sovereign wealth funds." What are you, some kind of populist worried about the Japanese owning pebble beach?
Written By: Harun
URL: http://

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