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Monday, April 21, 2003

Committed to Being Irresponsible

Brad Delong has posted the latest information on the US Deficit ( here ) but I'm afraid the smart money says we're all missing something here. Reading the comments there lead me to recommend the following paper by none other than Gauti B. Eggertsson, and appropriately enough entitled "Committing to being Irresponsible"


This paper explores the peculiar credibility problem that a zero bound on the short-term nominal interest rate, the liquidity trap, poses to monetary and fiscal policy. We present a rational expectations model in which the zero bound on short-term nominal interest rates is binding due to deflationary shocks. When the zero bound is binding the Central Bank best achieves its objectives by generating inflation expectations to lower the real rate of interest and stimulate aggregate demand. A discretionary Central Bank that is independent from fiscal policy, however, cannot credibly commit to inflation. The result is a liquidity trap that is characterized by excessive deflation and a negative output gap. This deflation bias is the opposite of the inflation bias analyzed by Barro/Gordon (1983) and Kydland/Prescott(1977). Turning to fiscal policy, our model implies that if the Central Bank is independent then Ricardian equivalence holds and deficit spending, i.e. tax cuts and debt accumulation, has no effect. Our proposed solution involves reducing the independence of the Central Bank. If fiscal and monetary policies are coordinated, Ricardian Equivalence fails, and the government can credibly commit to future inflation by deficit spending. As a result it lowers the real rate of return, curbs deflation and increases output. Finally we address what coordination of fiscal and monetary policy might entail in practice. We review the applicability of our model to the current situation in Japan. We then discuss the extent to which the successful policies pursued in Japan during the Great Depression can be rationalized by our model.

Now remember not everybody working in the White House is completely stupid, there is a real deflation threat, and if they said they were going to create a temporary scare and then announce 'sorry folks only kidding', no-one would believe them, now would they? So if you want to commit to being irresponsible then you have to be credible, and what better actor to convince the world the US government is totally irresponsible than George W. (I never have been able to understand why he didn't get the Oscar for Elmer Gantry).

I have been trying to flag this since Mankiw was appointed. I don't believe the looming inflation story for a minute (my whole ageing population analysis goes out of the window for one. Of course I wouldn't mind being proved wrong since a bit of nice steady inflation would be a lot preferable - there I am a Keynesian at heart - the trouble is I'm not convinced). If I had been Paul Krugman I wouldn't have take a fixed rate mortgage. (Unless, that is, he's also an insider working-up the act. Of course I'm joking but it's a wonder Mickey Kaus and company haven't got round to thinking this one up, probably they're not paranoid enough yet). However once you start along this road you could read Greenspan and Volcker as joining in the act.

Or again, you could read all those internet Iraqui oil/euro conspiracy theories as just Karl Rove inspired spin to keep the Europeans happy with a rising euro while the US Treasury quietly lets the dollar fall.The trouble is, once you start to read economic policy like a game, you just don't know where to stop, now do you?

The government ran up a deficit of $252.6 billion in the first six months of the 2003 budget year, nearly twice the total for the same period a year earlier. The latest figures, released Friday by the Treasury Department, highlighted the government's deteriorating fiscal situation. Record deficits are forecast this year and next. The total deficit so far this fiscal year, from October through March, was higher than the Congressional Budget Office's forecast for a deficit of $248 billion. The shortfall was $131.9 billion in the 2002 first fiscal half. Revenue slipped 6.1% to $825.2 billion from the year-earlier period, reflecting lower tax revenue from the listless economy. Individual income-tax payments dropped 6.8% to $372.1 billion. Corporate tax payments plunged 43% to $44.6 billion, reflecting in part the impact of business tax cuts enacted last year and weaker profits, the CBO said. Federal spending climbed 6.6% to $1.08 trillion from a year earlier. The biggest spending categories were Social Security, at $249.3 billion; programs of the Health and Human Services Department, including Medicare and Medicaid, $246.5 billion; military, $180.9 billion; and interest on the public debt, $160.6 billion. For the entire 2002 budget year, which ended Sept. 30, the government ran up a deficit of $157.8 billion, ending four consecutive years of surpluses...
Source: Associated Press

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