Micro and Macro Benefits Should Stay Separate

Recent posts by Mark Thoma and Michael Roberts have spurred me to think more about how to evaluate fiscal policies at the zero lower bound. Both Thoma and Roberts make arguments that because crowding out is less severe at the zero lower bound, certain government investments become much more desirable. For Thoma, this policy is increased infrastructure investment, whereas Roberts focuses more on investments in environmental policy. As such, Roberts asks: “how do we more generally evaluate the costs and benefits of public policies in a depressed economy?” This post will be an attempt at answering that question. My core thesis is that while government investment can be more desirable at the zero lower bound, it is no more desirable when the economy is at the zero lower bound than when it is not.

Why is the zero lower bound important anyways? One argument against fiscal policy is that government spending can crowd out private spending, leaving net expenditure unchanged. This can happen through two ways. First, it can happen through direct channels -- when the government builds a new school, this may crowd out a private school that was built in the region. Second, there is an interest rate channel. To finance the new spending, the government has to borrow from financial markets, crowding out private borrowing and thereby attenuating any positive effect of fiscal policy. However, when the economy is at the zero lower bound, private investment is typically weak and interest rates are low. These conditions mean that government spending will likely result in “crowding in” as multiplier effects stimulate more activity. This was the major argument behind the  DeLong and Sumner paper about fiscal policy at the zero lower bound. Therefore government investment spending carries a “double dividend” at the zero lower bound; it boosts output, long run growth, while also avoiding crowding out effects.

I see two major problems with this argument. First, it ignores the Sumner Critique about monetary policy offset. If monetary policy controls the nominal growth path of an economy, then there’s no point in trying to get more aggregate demand with government investments. Any multiplier effect will just be canceled out by the monetary authority passively tightening in response. While we haven’t seen as much tightening in the U.S. economy, we have seen this process work in reverse. Even as the government has severely tightened fiscal policy, signs of aggregate demand have held surprisingly steady. A comparison with Europe -- a continent going through a similarly savage bout of austerity -- leads us to conclude that monetary policy still has a wide latitude in determining aggregate demand even at the zero lower bound. Japan’s recent spike in growth has also shown that monetary policy can have an effect even after a long period of zero rates. This contradicts the assumption made in the DeLong and Summer paper that assumes monetary policy becomes powerless at the zero lower bound, means that any multiplier effects of government investment are minimal. Therefore multiplier or “crowding in” effects do not serve as a sound basis for evaluating government investment.

Now suppose for some reason that the monetary authority has imperfect credibility and cannot pull the economy out of the zero lower bound. Does government investment become more attractive as a result? Still no. This is because the proper benchmark is not the absence of government spending, but rather the next best government spending option. When considering all these investment proposals, we should remember that the government could always spend its money on “firework shows” or “alien defenses”. This (inefficient) policy scheme would capture all the multiplier expenditure effects with none of the long run growth effects. But as a result, the dividend of using government investment are no greater at the zero lower bound than when interest rates are positive.

Some others have made the even more radical argument that the zero lower bound means aggregate supply reducing policies, such as more stringent environmental regulations, can actually have macro benefits at the zero lower bound by increasing inflation. However, a look at forecast data in Japan around the time of the tsunami and in the U.S. around the time of the Libyan oil shocks shows that adverse supply shocks are, well, adverse. Output doesn't rise in response to supply shocks -- even at the zero lower bound.

So where do we end up? While the “double dividend” hypothesis might be a strong political argument for government investment, the core, apolitical economic analysis suggests that the zero lower bound does not make investment more desirable than usual. As a result, focus needs to be directed towards identifying the efficiency costs of low investment, not low output -- focus on the Harberger triangles, not the Okun gaps.