Suppose you believe that Canada (or the US, or wherever), needs a more expansionary fiscal policy now. If so, answer these questions:
1. Would you also recommend a more expansionary fiscal policy at some future time, if Canada ever found itself in the same situation as it is now?
2. If so, why would you want a discretionary change in fiscal policy, rather than stronger automatic stabilisers, that would work both now and in the future?
The first question was rhetorical. I can't imagine anyone answering "No". The second question is a genuine question.
I can think of four main advantages of automatic stabilisers over discretionary fiscal policy:
1. Speed. Discretionary changes in fiscal policy have recognition lags, decision lags, and implementation lags. When we add a fourth lag, between implementation and the maximal effect on aggregate demand, the increase in aggregate demand may come far too late, and may even make things worse if the recession is already over. Automatic stabilisers can eliminate the first three lags. They can even start working before anyone has realised we are in a recession.
2. Expectations. Because people know that automatic stabilisers will kick in if the economy enters a recession, they expect a smaller recession, with less unemployment and disinflation. Those expectations themselves help stabilise the economy. Since people expect a smaller recession, they cut their consumption and investment spending less. Since people expect less disinflation, the real interest rate does not rise as much, so consumption and investment fall less.
3. Stable rules. Because people know in advance how the taxes, transfers, and expenditures will change, instead of having to guess how the government of the day will act, they can make better plans for their saving and investment decisions.
4. Better politics. It is hard to change things in politics, and people know this. If we need a temporary deficit, the right will argue for lower taxes, hoping that it might become permanent. The left will argue for higher government spending, hoping that it might become permanent. But then decisions about short-run fiscal policy get confused with decisions about long-run fiscal policy. What is best for short-run stabilisation might be very different from what is best for long-run fiscal policy. There is nothing inconsistent, for example, in a right-winger wanting low taxes and government expenditure on average, but arguing that government expenditure should be increased in a recession (to take advantage of good deals). Nor is there anything inconsistent in a left-winger wanting higher taxes and government expenditure on average, but arguing that taxes should be cut in a recession (because you can do it more quickly). But, if we are talking about discretionary changes in fiscal policy, which should be temporary but won't be, you won't hear either side making those arguments. Both sides want to work the political ratchet in their preferred long-run direction. When discussing automatic stabilisers, however, both sides would be forced to consider booms, as well as recessions. The right-winger who advocates tax cuts in recessions would be forced to advocate tax increases in booms. The left-winger who advocates spending increases in recessions would be forced to advocate spending cuts in booms.
So, what are the possible disadvantages of strengthening automatic stabilisers instead of using discretionary policy?
1. They only ameliorate. Not. "Automatic stabilisers can reduce the magnitude of fluctuations, but cannot be powerful enough to prevent them, so they may need to be supplemented by discretionary policy." I have used that argument myself many times, but I now realise it's rubbish. Anything discretionary fiscal policy can do could, in principle, be written into the tax and spending codes, and thereby be made automatic. Just specify the circumstances under which you would use discretionary policy, and make it automatic.
2. Moral hazard. Maybe. If we permanently increased the generosity of Employment Insurance and welfare payments, and increased marginal tax rates, that would strengthen automatic stabilisers. But it would also reduce individuals' incentives to work, save, and increase their incomes.The way around that problem would be to make taxes and transfers contingent on aggregate outcomes, not individual outcomes, (so they provide macroeconomic insurance). Canada already has this in part, where the duration of EI payments depends on the unemployment rate in the applicant's local region. But this creates a disincentive to relocate to find work, and should be made contingent on the national unemployment rate. We could de-index the tax/transfer system, except to adjust all taxes and transfers automatically for the 2% inflation target. So real taxes would decrease, and real transfers would increase, if inflation fell below target. The automatic stabilisers would be especially strengthened if this were applied to taxes on capital gains.
3. It's complicated. True. Lots of contracts ignore contingencies which are just too complicated to put into writing. It would be difficult, or impossible, to imagine, let alone define, all the contingencies under which a discretionary change in fiscal policy might be desirable. Which means that there will still be room for some discretionary changes. But on the other hand, we can imagine and define some of those contingencies. Just because we cannot make automatic stabilisers perfect, doesn't mean we shouldn't try to strengthen them.
At the very least, thinking of fiscal policy in terms of automatic stabilisers forces us to think symmetrically, and recognise the long-run government budget constraint. What is done in a recession must be undone in a boom. So don't argue for lower taxes as a cure for the current recession, unless you swear a solemn promise that you will argue for higher taxes when the economy is in a boom. And don't argue for higher government spending as a cure for the current recession, unless you swear a solemn promise that you will argue for lower government spending when the economy is in a boom.
If you want a permanent tax cut and spending cut, fine. If you want a permanent spending increase and tax increase, fine. But that's got nothing to do with the recession.
Follow the macroeconomists' version of the Kantian maxim: act now as if you were following a universal rule, applicable in booms as well as recessions.
Worthwhile Canadian Initiative 
Nick, I agree that ‘stimulus’ has become politicized and that solutions haven’t been rational.
I would agree that automatic stabilizers should be strengthened, but I don’t think it helps us as much if we don’t structure it into government spending. If we were to have a fund that we actually set aside from government general revenues for things like EI, it would help to add a fiscal brake to the economy during good times. As it is, governments have been counting these automatic stabilizers as ‘surpluses’, leading to cries of ‘overtaxation’ during good times, and ‘overspending’ during bad times by the right wing.
Beyond that, I’m not convinced that infrastructure spending could not be made to be more of an automatic stabilizer. Keep a one year buffer of (shovel-ready) projects during normal times and a pot of money, and link it to BoC forecasts or the overnight rate. Had we triggered infrastructure spending when the BoC rate had first started declining, they would be ready to start right about now.
On moral hazard and EI/UI:
I read about Raj Chetty in a recent issue of The Economist. It seems the usual moral hazard story is the the whole story:
Moral Hazard vs. Liquidity and Optimal Unemployment Insurance
Or here :
http://www.nber.org/papers/w13967
Ooops. Correction to my previous post:
… moral hazard is NOT the whole story …
This has probably been proposed by someone at some point in history, although I wish I could say this is my original contribution to economics. Forgive me in advance if this idea is stupid for obvious reasons but I am student of economics who just loves to shoot the shit.
What about leaving in the hands of an independent central bank the mandate to maintain GDP at it’s natural rate. I know there would have to be some de-trending to distinguish changes in GDP from LRAS shifts versus booms. As a student I know economics is as much an art as it is a science and econometric modelling does not follow a clear set of rule.
I know the BoC already indirectly does this by controlling inflation in the 1-3 percent band. When the economy is getting ‘hotter’ they raise interest rates to keep inflation at bay.
Hopefully fingers crossed if the central bankers were to get this right, would this not largely make the debate of automatic stabilizers a frivilous argument. Obviously people would still lose jobs and require EI and other social assistance but hopefully not on the scale we are and may yet still see.
Nick, I wish I had asked this way back when I took your course!
“So don’t argue for lower taxes as a cure for the current recession, unless you swear a solemn promise that you will argue for higher taxes when the economy is in a boom.
[…]
“If you want a permanent tax cut and spending cut, fine … But that’s got nothing to do with the recession.”
Sure it does. Good policy is good policy, whenever it’s implemented. It just so happens that it’s even more urgently needed when you’re faced with a serious problem.
If you’re grossly overweight, it’s important to improve your diet and exercise so as to reach a healthier size. But while that’s desirable at any time, it’s urgently so if you begin to develop the signs of diabetes. Good diet and exercise are always good ideas, but if you’re showing signs of obesity-related illness, they become urgent.
Sound economic policy is no different.
But Adam if you knew before hand that you were genetically predisposed to obesity/diabetes wouldn’t you want to prevent it or minimize it?
The kernel: So don’t argue for lower taxes as a cure for the current recession, unless you swear a solemn promise that you will argue for higher taxes when the economy is in a boom. And don’t argue for higher government spending as a cure for the current recession, unless you swear a solemn promise that you will argue for lower government spending when the economy is in a boom.
And politicians are so much more short-sighted than these “automatic stablizers” which are eva so efficacious that even God has them in place.
Izit possible that the lower taxes only exacerbate the growing disparity in wealth/income?…a feature that some say (ok it is Tanta) may be the root of the emergence of subprime…and this (chronic-looking, wouldn’t you say?) economic climate.
Izit possible that there is a threshold in that disparity that might make the “automatic” perform as well as the current Trouble Asset Reparations? …the long, very long if you count TAF, and lagging “stabilization”?
Izit possible that the current regime of 70% consumption GDP is over and that any hopes of returning to that “stability” is naive and requires a global rather than national strategy?
Ok the automatic is not working for me, Nick…it iznt all my fault.
Andrew: I tend to agree with your comment.
Patrick: Yes, moral hazard is probably not the whole story with EI at present. But EI (and other tax/transfer policies) would need to be much stronger if automatic stabilisers were sufficient, and this would I think create moral hazard, if it weren’t done right.
Mark: Well, we sort of have that now. It was hoped that my targeting 2% inflation, monetary policy would be a sufficient stabiliser that we wouldn’t need discretionary fiscal policy. And until the recent financial crisis, it seemed to work. But many argue that with interest rates approaching zero, we need fiscal policy to supplement monetary policy for the current crisis.
Adam: OK. I think I see your point. Getting the long-run fiscal policy right may matter more now (not obvious, but it may be true). But that still leaves the short-run question, which was the point I was trying to make (but maybe overstated by saying “nothing to do”).
calmo: some might argue that lower long run taxes and spending are good, others might argue the opposite. But in the long run we have to pay for spending, so you have to move taxes and spending in the same direction. In the short run you can move taxes and spending independently, or in opposite directions, if you want to. So the short run and long run questions are different. If you do want to use short run fiscal policy to help stabilise the economy, why not make it automatic? (If you don’t want to use short run fiscal policy, then the question of making it automatic is irrelevant, of course.)
The current mess is in large part due to a sort of perfect storm of largely preventable market failures. Maybe we should think of effective regulation as a sort of automatic stabilizer instead of an impediment to free markets. The alternative we’re experimenting with now is not so much fun.
Maybe the level of generalization is obscuring our differences…Nick’s and calmo’s.
calmo believes that the import of “increase taxes” is taking money from the rich and giving to the poor…a measure that needs to be done as the marbles continue to roll into the rich corner, not the poor one; a measure that is resisted by the pretty rich who have the gall to declare that this is the infamous crowding out that removes money and all its glorious multipliers from the economy…and not the preventative measure that keeps the poor, manageable –not desperately and threateningly poor.
I’m hoping that the increasing disparity is a feature of BushCo or at most a feature of the GOP’s influence over the last couple of decades…and not a feature of Marx’s capitalism or some close approximation.
Nick believes “But in the long run we have to pay for spending, so you have to move taxes and spending in the same direction.” skipping over the wealth gradient and all the (political) fuss (from pgl’s correction “tax deferments” to Mankiw’s “unfair burden on the rich”) associated with “tax cuts”. The US repatriation of foreign earned income a few years ago allowed corporations to pay <6% taxes, instead of the 35%…a comparable tax break for workers was not to be found…and this loss of tax revenue would be felt by the poor needing gov services –or funded by those who can still squawk about the beauty of tax cuts and the horror of higher taxes.
For Nick it is not important who “we” is in the long run, nor that currency revaluations and worse, are glaring counter examples to that “in the long run we have to pay for spending”. Nick even likes “some” (and I B so embarrassed wrt MThoma with whom I have “some” relationship.), not declaring even as much as “some wealthy” or “some struggling”…but this is alienating Nick from the real (political) dimension of taxes: re-distribution.
Automatic stabilizers –some long term legislation with the durability of Constitutional Amendments, strike me as proxies for control that are obviously missing now, but whose implementation (disregarding the admission that we are currently somewhat unstable) appears to be a lack of confidence in the future non-automatic stabilizers. Pre-emptive and projective accusations –so don’t tell your children or grandchildren.
Get ready for another horse whipping, American taxpayer. Apparently, Obama and his administration looked bank bondholders in the eye and has blinked.
The idea is that the taxpayer has to pay for the toxic assets making Citi and BA insolvent, thus bailing out bank bondholders and, incredibly, even equity shareholders. The number is huge. A trillion dollars or more.
Just the sheer number will blow up any plans Obama has to move the American economy into the 21st century.
There’s absolutely no reason to do this other than to bail out the wealthy and powerful people who rule Wall Street and, obviously, Washingto D.C.–no matter who was elected as President.
What needs to be done is to nationalize these two broken banks, move the toxic assets to a warehouse, and then take your sweet time assessing their true value. You don’t force the taxpayer to swallow some huge, imagined value up front, in order to balilout investors.
Then, once the economy recovers, you can re-capitalize the national banks into several (as in “not too big to fail”) private banks. And at that time, you will have a fair idea of what these assets are worth.
As a country we’ve already done this before. It’s not new. This is the technique used to clear out the bankrupt S&L industry in the late 1980s and early 1990s. Nationalization wasn’t the word used, it was Resolution Trust Company. But nationalization it was.
Bring back Bill Seidman. Geithner can be the big boss where the buck stops, but let someone who doesn’t care what bankers think of him do the dirty work.
Sorry. Thought I was posting a different thread. Ooops.
Beezer: pity, it sounded like a fun comment 😉
calmo: I’m not sure I’m following everything you say here, but let me try.
Taxes do 3 things: pay for government spending; redistribute income; and (if we move taxes up and down in short-run booms and recessions) help stabilise aggregate demand and reduce fluctuations. In the long run (which means “on average over the business cycle”) taxes have to be big enough to pay for government spending (and you can include transfers to the poor either as negative taxes, as macroeconomists think of them, or as spending, if you must). So any short run fluctuation in taxes, up and down, must cancel out on average.
Nick,
my main concern here is that we could end up doing the wrong thing at the wrong time. What happens if we are facing a sudden change in the long-run terms of trade, and so have a real loss of purchasing power to distribute. We will respond to the change in relative prices with something that may well excerbate the inflationary shock without doing much to encourage the structural adjustment that is needed.
reason: I think that’s a legitimate concern. If there’s long-term shift in relative demand, it doesn’t make sense for the government to try to offset it permanently (though maybe it could ease the adjustment). But if we see declines in total demand (so nearly all industries see falling demand), that’s when you want to increase AD.