Time for Expansionary Fiscal Policy?

While it appears that Quantitative Easing has reached its limits and the FED intends to implement a strategy of gradual exit, there is less clear what available options exist for stimulating the economy.

That austerity is not the way to go it’s quite clear for most of us. There are increased evidences of its failures when applied, see the case of peripheral European economies (also, read The Failure of Austerity Measures in Portugal), while the academic studies hardly find evidences of its stimulating effects (except maybe for the isolated cases of Denmark and Ireland in early 1980; read the earlier post on Can Austerity Be Expansionary?).

Thus a reasonable alternative for many is an expansionary fiscal policy. This is what DeLong and Summers discuss and propose in their new paper “Fiscal Policy in a Depressed Economy”. While they support in general the view that only monetary policy should be used for stabilization purposes (my note: I hope that this does not include Quantitative Easing), according to them, in a zero lower bound situation, with cyclical unemployment and excess capacity, an expansionary fiscal policy might be self-financing.

What the paper does not answer to, or it answer in an unconvincing way, is the issue of the debt constrained economies which is present in most of the Western world. Following their argument, this expansionary fiscal stimulus would be self-financing, but in the real world the government might find that it is not (fully) self-financing. What would imply this, a rising debt? What is the stimulus is run for several years? In the end, if the fiscal-stimulus is not self-financing it might lead to additional taxes or debt, both with negative effects on the economy. But we should also note that the case of negative effects of debt would be more negatively felt by small open economies than the United States.


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