Monetary Alchemy, Fiscal Science

The year 2013 marks the 100th anniversaries of two separate major institutional innovations in American economic policy: the Constitutional Amendment enacting the federal income tax, ratified on February 3, 1913, and the law establishing the Federal Reserve, passed in December 1913.&

It took some time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy, respectively. It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macro-economy. John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression. Milton Friedman blamed the Depression on the Fed for allowing the money supply to fall. [Tools of fiscal policy used by governments, in addition to tax rates and tax deductions, are spending and transfers. Tools of monetary policy used by central banks include interest rates, quantities of money and credit, and instruments such as reserve requirements and foreign exchange intervention used in various (non-US) countries.]

In subsequent debate, Keynes was associated with support for activist or discretionary policy. The aim was counter-cyclical response to economic fluctuations: expansion in recessions, discipline in booms. (It is a myth that he favored big government generally. He said “the boom is the time for austerity.”) Friedman opposed activist or discretionary policy, believing that government institutions, whether monetary or fiscal, lacked the ability to get the timing right. But both great economists were opposed to pro-cyclical policy moves, such as the misguided US tightening of 1937 at a time when the economy had not yet fully recovered.&

After World War II, the lessons of the 1930s were incorporated into all the macroeconomic textbooks and, to some extent, into the beliefs and actions of policy-makers. But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by experiences such as the high-inflation 1970s. As a result, many politicians in advanced countries are repeating the mistakes of 1937 today. This despite conditions that are qualitatively similar to those that determined Keynes’ policy recommendations in the 1930s: high unemployment, low inflation, and rock-bottom interest rates.

The austerity-versus-stimulus debate has been thoroughly hashed out. On the one hand, proponents of austerity correctly point out that the long-term consequences of permanently expansionary macroeconomic policy [both fiscal and monetary] are unsustainable deficits, debts, and inflation. On the other hand, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt/GDP ratios that go up rather than down. Procyclicalists, both in the US and Europe, represent the worst of both worlds: they push in the direction of expansion during booms such as 2003-07 and in the direction of contraction during recessions such as 2008-2012, thereby exacerbating both the upswings and downswings. Countercyclicalists have it right: working in the direction of fiscal and monetary discipline during booms and ease during recessions.

Less thoroughly aired recently is the question whether — given recent conditions - monetary or fiscal expansion is the more effective instrument. This question was addressed clearly in 1937 by Sir John Hicks in a once-famous article titled “Mr. Keynes and the Classics.” The graphical model is known to many generations of undergraduate students in macroeconomics under the label “IS-LM.”&

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The answer to the question which form of policy is more effective: under the circumstances that held in the 1930s and that hold again now - which are conditions not just of high unemployment and low inflation, but also near-zero interest rates — stimulus in the specific form of fiscal expansion is much more likely to be effective in the short-term than stimulus in the form of monetary expansion. Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero. (Flat LM curve.) This situation, labeled by Keynes a liquidity trap, is today called the Zero Lower Bound. In addition, firms are less likely to react to easy money by investing in new plant and equipment if they can’t sell the goods they are producing in the factories they already have. (Steep IS curve.) The hoary — but still evocative — metaphor is “pushing on a string.” Meanwhile, fiscal expansion is rendered relatively more effective than in normal times, in that it doesn’t push up those rock-bottom interest rates and thereby crowd out private-sector demand.

Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries. It is worth trying all sorts of things: quantitative easing, forward guidance, nominal targets. Even if the short-term interest rate channel is inoperative, such steps may work through other channels: long-term interest rates, credit channel, risk premia, expected inflation, asset prices, commodity prices or exchange rates. But the effects of each are highly uncertain.

That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position. But many economists have forgotten much of what they knew and politicians may not have even heard the proposition.&

Introductory economics textbooks have long talked about the Keynesian multiplier effect: the recipients of federal spending (or of consumer spending stimulated by tax cuts or transfers) respond to the increase in their incomes by spending more as well, as do the recipients of that spending, and so on. Again, the multiplier is much more relevant under current conditions than in the normal situation where the expansion goes partly into inflation and interest rates and thus crowds out private spending. By the time of the 2008-09 global recession even those who believed that fiscal stimulus works had marked down their estimates of the fiscal multiplier — intimidated, perhaps, by theories of policy ineffectiveness. (These are some of the same theories that predicted that a tripling of the monetary base over five years, or a near-doubling of M1, should double or triple the price level !)

The subsequent continuing severity of recessions in the United Kingdom and other countries pursuing contractionary fiscal policies, apparently to the surprise of the politicians enacting them, suggested that fiscal multipliers are not just positive, but greater than one, as the old wisdom had it. The IMF Research Department has now reacted to this recent evidence and bravely confessed that official forecasts, including even its own, had been operating with under-estimates of multiplier magnitudes.

A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others. Baum, Poplawski-Riberio and Weber (2012) allow the estimate to change when crossing a threshold measure of the output gap. Batini, Callegari and Melina (2012) allow regime-switching, across recessions versus booms. Others that similarly distinguish between multipliers in periods of excess capacity versus normal times include Auerbach and Gorodnichenko (2012a, 2012b), Bachman and Sims (2012), Baum and Koester (2011), and Fazzari, Morley and Panovska (2012). Most of this research finds high multipliers under conditions of excess capacity and low interest rates. Gordon and Krenn (2011) and Shoag (2012) have the same implication. Related studies confirm other conditions that matter for the size of the fiscal multiplier in precisely the way the traditional textbooks say, for example that they are lower in small open economies because of crowding out of net exports. (Perhaps due to fear of sounding old-fashioned, few of these studies have the courage to mention that these are the findings that one would have expected from the elementary textbooks of 50 years ago.)

Needless to say, the effects of fiscal policy are subject to substantial uncertainty. One never knows, for example, when rising debt levels might suddenly alarm global investors who then start demanding abruptly higher interest rates, as happened to countries on the European periphery in 2010. (For this reason, the United States would be well-advised to lock in a long-term path toward debt sustainability, even while undertaking a little short-term stimulus.) In the case of stimulus in the form of tax cuts, one never knows how much of the boost to disposable income will be saved by households rather than spent. We are also uncertain as to the magnitude of negative effects of high tax rates, via incentives, on long-term growth. And it is true that monetary policy is much better understood than it was in the past.

Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter. One might even dramatize the contrast by speaking of “monetary alchemy and fiscal science.”

A much-admired 2010 paper by Eric Leeper had it the other way around: it characterized monetary policy as science and fiscal policy as alchemy. It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to the best that modern society has to offer. It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state of economic knowledge and motivated largely by politicians’ desire to be re-elected. These political realities may be what the author of “Monetary Science, Fiscal Alchemy” had in mind.
But the ancient alchemists were not in fact stupid or selfish people in general, notwithstanding their search for the “philosopher’s stone” that was to turn lead into gold (of which modern proponents of returning monetary policy to the pre-1914 gold standard are reminiscent). Nor was the alchemists’ problem that the monarchs of their day refused to listen to them. It was rather that the state of knowledge fell far short of what the modern science of chemistry can tell us.
The term alchemy could be applied to pre-Keynesians like US Treasury Secretary Andrew Mellon (whose Depression prescription was that President Herbert Hoover should “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system”). It could also be applied to the “Treasury view” in the UK of 1929. (Churchill: ”The orthodox Treasury view … is that when the Government borrow[s] in the money market it becomes a new competitor with industry and engrosses to itself resources which would otherwise have been employed by private enterprise, and in the process raises the rent of money to all who have need of it.” ). But in light of all that was learned in the 1930s, it would be misleading to characterize the current state of fiscal policy knowledge as alchemy.


Miguel Almunia, Agustín Bénétrix, Barry Eichengreen, Kevin O’Rourke, and Gisela Rua, 2010, "From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons."& Economic Policy, 25 (62), pp. 219-65.

Alan Auerbach and Yuriy Gorodnichenko, 2012a, "Measuring the Output Responses to Fiscal Policy,"& American Economic Journal: Economic Policy, vol. 4(2), pp. 1-27, May.

Alan Auerbach and Yuriy Gorodnichenko, 2012b, "Fiscal Multipliers in Recession and Expansion,"& NBER Chapters, in Fiscal Policy after the Financial Crisis, edited by Alberto Alesina and Francesco Giavazzi (University of Chicago Press).

Rüdiger Bachmann and Eric Sims, 2012, "Confidence and the transmission of government spending shocks,”Journal of Monetary Economics vol. 59, no.3, pp.235-249. NBER WP No. 17063, May.

Nicoletta Batini, Giovanni Callegari and Giovanni Melina, 2012. "Successful Austerity in the United States, Europe and Japan,"& IMF Working Paper& 12/190, International Monetary Fund.

Anja Baum and Gerritt Koester, 2011, “The Impact of Fiscal Policy on Economic Activity Over the Business Cycle - Evidence from a Threshold VAR Analysis,” Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies no. 2011,03.

Anja Baum, Marcos Poplawski-Riberio and Anke Weber, 2012, “Fiscal Multipliers and the State of the Economy,” IMF Working Paper 12/286, International Monetary Fund, December.

Olivier Blanchard and Daniel Leigh, 2013, “Growth Forecast Errors and Fiscal Multipliers,” IMF Working Paper No. 13/1, January. Forthcoming, American Economic Review, May.

Steven Fazzari, James Morley, and Irina Panovksa, 2012, “State-Dependent Effects of Fiscal Policy,” UNSW Australian School of Business Research Paper No. 2012-27, April.

Milton Friedman and Anna Schwartz, 1963, A Monetary History of the United States, 1867-1960 (Princeton University Press).

Robert Gordon and Robert Krenn, 2011, “The End of the Great Depression 1939-41: Policy Contributions and Fiscal Multipliers,” NBER Working Paper No. 16380.

John Hicks, 1937, "Mr. Keynes and the Classics: A Suggested Reinterpretation,” Econometrica, pp. 147-59.

Ethan Ilzetzki, Enrique Mendoza & Carlos Vegh, 2011. “How Big (Small?) are Fiscal Multipliers?,” IMF Working Papers 11/52 (International Monetary Fund.) Forthcoming, Journal of Monetary Economics.

Eric Leeper, 2010, “Monetary Science, Fiscal Alchemy,” NBER Working Paper No. 16510.

Christina Romer and David Romer, 2013, “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter,” UC Berkeley, January.

Daniel Shoag, 2012, “The Impact of Government Spending Shocks: Evidence on the Multiplier from State Pension Plan Returns,” Harvard Kennedy School.

Antonio Spilimbergo, Steven Symansky, and Martin Schindler, "Fiscal Multipliers,"& Staff Position Note No. 2009/11, International Monetary Fund.;

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