Stimuli and sterling

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.

Comments

[Lisa]

Really interesting analysis

[Luis Enrique]

Might the zero lower bound be at work here? There may be room for anticipated growth to rise significantly before reaching a level for which zero is the 'right' rate, let alone higher.

[BenP]

We saw central bankers and investors God like abilities to 'anticipate' the future a few years ago, my recollection was that didn't turn out too well for them. Has something changed?

[Keith]

Oh dear the right are grasping at any straws in their holy crusade to find any excuse to cut tax for the wealthy by slash and burn spending cuts all over the place. Very tedious. Lets all check in our mental faculties and repeat 1931 again and again and again. Lets recall Reichs Chancellor Brüning at once, President Hoover and Macdonald. Oh if only they were dead rather than walking among us as undead. Economic Vampires seem immune to the cross and holy water these days.

[Ralph Musgrave]

The whole distinction between monetary and fiscal is hogwash. The only purpose it serves is to keep ten thousand economics commentators employed.

Any monetary or fiscal implement ON ITS OWN is distortionary. For example interest rate adjustments work only via entities that are reliant on loan finance rather than equity finance. You might as well boost an economy via entities whose names begin with the letters A-L and ignore the “M-Zs”. I.e. Chris is right: accompany fiscal stimulus with monetary stimulus.

As regards Arnold Kling’s point (Chris’s final link above), namely that recessions can raise NAIRU because the PATTERN of supply and demand is changed, if this idea were operative you’d expect to see construction workers finding difficulty finding alternative employment. (Construction was the main victim of the recession because of the excess investment in property prior to the crunch). In fact there are two studies which show that former construction workers in the US have no more difficulty finding alternative work than others.

[Recusant]

Oh Keith, I don't know where you got the idea that Hoover conducted a slash and burn approach to government spending: he did the opposite. I suppose it is all part of the great mythology of the Thirties Depression, the one that says that Keynsian stimulus spending saved the US. The precise opposite is what the evidence shows.

[Gareth]

"This monetary policy response to a fiscal stimulus is not an inevitable, inherent feature"

This is a hand-wavy response. Your argument is predicated on the MPC being either incapable or incompetent, i.e. either:

a) they have determined that the current level of AD necessary to meet the inflation target is too low, but they deliberately choose not do anything about it (by QEasing).

b) they have incorrectly determined the level of AD necessary to hit the target (and hence chosen to do nothing), and would have missed the inflation target absent any fiscal stimulus to boost AD.

Which do you pick?

(A) is plausible if the MPC think they cannot boost AD at the ZLB. But that is not what the MPC are saying. Merv King says time and again, "We have a range of tools, but we don't think we need to use them now." [paraphrasing] Is he they lying? Is he hobbled by the hawks? The hawks were saying prior to last month that they thought the level of AD was *too high*.

(B) is plausible only if the Treasury are better at forecasting inflation than the Bank, and that they have a different forecast right now. Is that the case? I haven't seen it.

Osborne clearly does not think the MPC are incapable of boosting AD at the ZLB; he has called for QE (+auto-stabilizers) as his "Plan B" since the beginning. And there is no indication he thinks they are incompetent.

[anon]

Agree with Gareth. If the success of fiscal stimulus is predicated on the monetary authority doing the right thing (ease money--but not too much, lest inflation/nominal growth overshoot its target), then you might as well forgo fiscal stimulation entirely and compensate by doing more monetary easing. Fiscal stimulus is quite expensive in the long run; monetary stimulus is not.