January 22, 2009

The Fiscal Stimulus: Catch 22

Writing about web page http://krugman.blogs.nytimes.com/page/2/

Paul Krugman has made the following point: for the United States, one dollar added to the federal debt by new public spending will save three dollars' worth of jobs. This is despite the fact that the Keynesian multiplier for the United States is only about 1.5. Why? Because every job saved will generate tax revenues that should offset some of the implied increase in the federal deficit.

There's a couple of assumptions in that. One is that interest rates won't change much, which makes sense because right now they are on the floor and likely to remain there. Another is that, oddly enough for a guy that won the Nobel prize for contributions for trade theory, Krugman doesn't mention foreign trade. That makes sense because the United States ratio of trade to GDP is only 10% (exports) to 15% (imports).

The same idea should work for Britain. But it is much less favourable, because we are more heavily taxed and also have a much more open economy. Unless I misled several generations of first-year students, the Keynesian multiplier for an economy with direct and indirect taxes and foreign trade is 1/(1 - c(1 - t1) + t2 + m) where c is the marginal propensity to consume (say 0.6 in the short run), t1 is the direct tax rate (say 0.25), t2 is the indirect tax rate (say 0.15 since Darling's VAT reduction), and m is the import propensity (say 0.25). That gives us a Keynesian multiplier of 1/0.95 which for present purposes is about 1.

Let's assume that interest rates stay low, and the exchange rate stays where it is. Then, every extra pound of public spending generates about one pound of effective demand for goods and services. But then, each extra pound spent will bring back 40p to the Treasury in direct and indirect tax revenues, raising the national debt by only 60p. That makes 60p of new indebtedness the price we will pay to create one additional pound of GDP.

Think about jobs. In the UK economy each person employed generates about £50k of GDP. We are currently losing around 100,000 jobs a month from the economy; to be conservative let's put that at a round million jobs over the next year. To save those million jobs should take a fiscal stimulus of £50 billion a year, starting now, but it will add only £30 billion to our national debt, because if those jobs can be saved there will be a clawback to the Treasury of £20 billion in tax revenues.

There are some catches.

Catch 1. The government is proposing a stimulus of £20 billion over the next two years. Oh – and it hasn't even started yet. Jobs are being lost now. A fiscal stimulus doesn't work instantaneously. Fixated on blaming the banking sector for what is about to happen (in addition to what has happened already), the government is still trying to revive lending rather than to revive spending directly. 

Catch 2. Britain, unlike America, can't ignore the rest of the world. The reason exports don't figure in the Keynesian multiplier is that they're outside our economic system: if our export markets are falling off the same shelf as us, that will have an adverse multiplier effect that works against the multiplier effect of our own public spending.

It is critically important for small open economies like the UK to have a fiscal stimulus that is coordinated internationally. We all make up each others' export markets! If every country would stimulate demand at the same time, and in the same proportion, the trade balance effects would be neutral, but the collective stimulus would be far more powerful. Every country would see a double bonus, the first coming from its own public spending, and the second coming from the public spending of its trading partners, reflected in exports.

Catch 22. The European Union was constituted on the assumption that the problem of deficient demand had been solved. Coordination was needed only for monetary policy (so we have a European Central Bank) and to ensure fiscal restraint (so the Eurozone is supposedly governed by the deflationary rules of the Growth and Stability Pact). There's no mechanism to coordinate a European fiscal stimulus!

So it's up to the G8 and the G20. Let's think about that.

Generations of students of international economic history have learned that a major part of the Great Depression was the failure of international coordination. Our ability to coordinate a response to the greatest economic challenge since the Great Depression is being tested now. Until recently, we thought we knew how to avoid bank runs. Then we had the first major run in 150 years. We also thought we knew how to avoid a major recession. I was about to write: "Watch this space." Depressingly, I'm not sure you need to.

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I am a professor in the Department of Economics at the University of Warwick. I am also a research associate of Warwick’s Centre on Competitive Advantage in the Global Economy, and of the Centre for Russian, European, and Eurasian Studies at the University of Birmingham. My research is on Russian and international economic history; I am interested in economic aspects of bureaucracy, dictatorship, defence, and warfare. My most recent book is One Day We Will Live Without Fear: Everyday Lives Under the Soviet Police State (Hoover Institution Press, 2016).

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