When monetary and fiscal stimulus do not work, there are two possibilities. Either the stimulus is not enough – you increase it – or you look for explanations as to why they do not work as they were supposed to. May be, something else is at work. There are people – Krugman and DeLong, to name just two – who think that if stimulus does not work, it simply was not enough. They want the Federal Reserve to get even more unconventional and the Obama government to run up a bigger deficit. There are those who argue that, may be, there are some reasons why even such an unprecedented stimulus did not work. Either it was wrongly applied or that the disease required a different remedy. Raghuram Rajan and Thomas Hoenig argued that way and the former is facing some stiff pushback now in the blogspace. See here and here, for example. For good measure, see Krugman’s speech too.
One of the commentators on the DeLong post calls Raghuram Rajan a one-trick pony. That is, he did not do anything meaningful post-2005 after he warned of wrong incentives and risks in the financial system. I am not sure what else others have done.
The commentator had cited evidence from the Raghuram Rajan Committee report on the ‘Road map for financial sector reforms’ to prove his case that Raghu was a one-trick pony. I was not writing a blog then and hence did not comment on that report in a blog. But, I dug through emails that I had shared with my friend and I had expressed disappointment at that report, for its orthodoxy. It also omitted to mention the role and the importance of financial literacy. Otherwise, liberalised financial sector could play havoc with the rest of the economy. Information and incentives asymmetry is higher between vendors and consumers in this sector. But, in mitigation of the Committee, one could say that they wanted to start at the extreme end to arrive at the middle, given India’s political economy. Anyway, that is a digression.
The problem with more and more stimulus is that we enter into the realm of the unknown and hence, as Raghuram Rajan mentioned in a subsequent piece, it is about risk management.
Similarly, let me concede that I have been a votary of ‘expansionary austerity’ – i.e., the belief that austerity could restore confidence and credibility in policy and thus prove to be expansionary. This ‘Free Exchange’ blog post makes an important point and that, I admit, is a valid angle:
Britain counted on “confidence” to lift the economy amid austerity and has been sorely disappointed, despite an accommodative central bank. The literature on expansionary austerity suggests that it’s not an impossibility, but that it nearly always occurs in countries where high debt levels have produced high interest rates. [More here]
There are some academic papers cited in support of the argument on the limitations of expansionary austerity. I have not read them. They can be seen here and here. Bradford DeLong advocates the US government borrowing more because it is in a position to borrow more as the ‘market’ has not protested. After all, the 10-year nominal Treasury yield is below 3.0% when the headline inflation rate is 3.6%.
My problem with this argument is how do we know that the market is correct? Many of these folks have argued, in other contexts, that financial markets are not efficient. After all, just about three years ago, the yield on the 10-year Greek sovereign paper was trading at 20-40 basis points above the yield on the German 10-year government paper. Japan is still able to borrow at around 1% for 10 years. Was the market pricing in the risk of Greek debt correctly then? Or, is it pricing Japanese debt correctly now?
So, I probably err on the side of those advocating making haste slowly at the minimum when stimulus does not work, instead of advocating more stimulus. At the same time, I realize that this debate is impossible to settle. That is the beauty and frustration of economics, given the impossibility of constructing counter-factual scenarios.