Richard Murphy is calling for a fiscal stimulus. Tim Worstall rejects this, citing this paper (pdf) by Ethan Ilzetzki, Enrique Mendoza, and Carlos Vegh which concludes that “the fiscal multiplier…is zero in economies operating under flexible exchange rates.”
I’m not convinced by Tim’s reply.
Let’s note, in passing, that this paper flatly contradicts George Osborne’s argument against reversing his spending cuts. He’s claimed that doing so “would plunge Britain into the financial whirlpool of a sovereign debt crisis”. Such a crisis, though, would see sterling collapse. But in Ilzetski, Mendoza and Vegh’s world, fiscal stimulus fails for the exact opposite reason - because the exchange rate rises and so crowds out net exports. They write: “Output does not change because the increase in government spending is exactly offset by the fall in net exports.”
There are two closely related reasons for this. One is what we’re taught in the Mundell-Fleming model. A fiscal stimulus causes investors to anticipate stronger economic growth. Bond yields therefore rise and there is a rise in capital inflows - not the outflow that Osborne fears. The other is that central banks anticipate stronger economic activity and so raise official interest rates, which also raises the exchange rate.Ilzetski, Mendoza and Vegh write (p16):
Central banks operating under flexible exchange rates increase the policy interest rate by a statistically significant margin, with interest rates increasing an average of 60 basis points within the two years following a fiscal shock.
This monetary tightening offsets the fiscal stimulus and so results in that zero multiplier.
Which brings me to why I’m not convinced by Tim’s reply. This monetary policy response to a fiscal stimulus is not an inevitable, inherent feature. It’s perfectly possible that a fiscal stimulus could be accompanied by monetary accommodation. If the Bank of England were to “do a Fed” and pledge to leave Bank rate unchanged for a long time, or if it were to resume quantitative easing and buy gilts, there might well be no rise in short- or long-term interest rates and therefore no rise in sterling, and thus no crowding out of the form Ilzetski, Mendoza and Vegh describe. As this recent paper (pdf) shows, a fiscal stimulus that’s not matched by monetary tightening can work.
Of course, you might have other objections to this. Perhaps it would be inflationary - especially given that our problem is not merely the purely Keynesian one of deficient demand. Or maybe something else is wrong with it.
But this isn’t my point, which is simply that Tim is mistaken to think that the Ilzetski, Mendoza and Vegh paper is a decisive argument against fiscal stimulus. It’s not.