Fiscal policy in a depressed economy

Brad DeLong and Larry Summers has a new paper out titled ‘Fiscal Policy in a Depressed Economy‘. It’s full of greek letters, but it’s conclusion is quite clear: Short term fiscal stimulus works and is arithmetically worth doing, even when taking account of the debt issue. I won’t quote the paper (you should go read it), but I’ll post three graphs, which I think sums up their argument nicely.

First, we have the real interest rate at which the government can borrow. What we see is that the real interest rate is negative, thus ensuring that if the investment the government undertakes has a positive return, it’s worth doing:

Picture 41 Fiscal policy in a depressed economyNext, the fiscal multiplier, i.e., if the government spends $1 how much of that dollar will get spent. Think of it as if the government builds a bridge. Then the government pays the workers directly, but then the workers use their wages to buy goods and services, etc.

Picture 73 Fiscal policy in a depressed economyFinally, we have the U.S. employment-to-population and unemployment ratio:

Picture 5 Fiscal policy in a depressed economyThis is essential. In “normal times” (where short-term rates aren’t up against the zero lower bound), fiscal stimulus can crowd out investment (by raising interest rates). This is not the case in a depressed economy, which is in a liquidity trap. As a matter of arithmetics, short-term and medium-term stimulus is worth doing, because the multiplier is substantial and a sell-off in government bonds is unlikely. Thus (part of) the conclusion:

Our analysis simply demonstrates that additional fiscal stimulus, maintained during a period when economic circumstances are such that multiplier and hysteresis effects are significant and then removed, will ease rather than exacerbate the government’s long run budget constraint.

I’m not doing the paper justice as I haven’t talked about monetary policy, reservations, limitations, etc. — so go read it.