How to Stop Deflation with Fiscal Policy: Past Lessons for the Future

How to Stop Deﬂation with Fiscal Policy: Past Lessons for the Future

Eric M. Leeper University of Virginia

November 2020 Hoover Institution Virtual Series Macro Policies

I Can we distinguish monetary from ﬁscal policy? 1. both issue interest-bearing “safe” liabilities 2. in “dollars” whose supply government controls 3. ultimately backed by primary budget surpluses 4. price level must clear both money & bond markets I Variation in expected surpluses alters rate of exchange between nominal govt liabilities and goods I this is the price level I Price level always determined by both MP & FP I In thinking about P, key distinction between policies is who controls the levers I ﬁscal authority controls the backing that gives liabilities value I monetary authority controls composition of liabilities public holds Two Examples of Joint Policies

1. Incoherent policies: European efforts to hit inflation targets I MP interest rates negative & large asset purchases I long-term bond yields also negative I inflation chronically below target I FP chronically tight, retiring debt I makes sense only if believe FP irrelevant for inflation 2. Coherent policies: U.S. recovery from Great Depression I abandoned convertibility to gold I created genuinely nominal government debt I MP at ZLB I FP expansionary, financed with new nominal bonds I FDR convinced people debt expansion unbacked European Monetary Policy (pre-Covid)

I Negative policy interest rates 1. Euro Area: since June 2014 2. Sweden: since February 2015 3. Switzerland: since December 2014

I Increases in central bank assets since 2006 1. Euro Area: 4.5 × 2. Sweden: 5.1 × 3. Switzerland: 8.3 ×

I Basic theory: MP can raise inﬂation only if... I backed by appropriately expansionary FP I this is what “passive” FP delivers I Europe has been all about ﬁscal consolidation European Fiscal Policy: Primary Surpluses

Germany 2

Switzerland

Euro Area Sweden

-2

France

-4 Spain

-6

-8 2011 2012 2013 2014 2015 2016 2017 2018 2019 European Inﬂation

2.5 Euro Area

Target (upper bound) 2

Germany 1.5 Sweden 1

0.5

0 Switzerland

-0.5

-1

-1.5 1/11 7/11 1/12 7/12 1/13 7/13 1/14 7/14 1/15 7/15 1/16 7/16 1/17 7/17 1/18 7/18 1/19 7/19 1/20 7/20 Policies Working Together

I Thesis: unbacked fiscal expansion triggered America’s recovery from the Great Depression I Two steps 1. Monetary: reduced gold value of $, abandoned convertibility of gold, abrogated gold clauses 2. Fiscal: expanded government spending financed with nominal bonds and convinced people bonds would not be backed by taxes until economy recovered I Monetary component necessary for fiscal step I under convertibility: bonds are claims to gold I credibility requires bonds be backed fully by taxes I revoking convertibility made bonds genuinely nominal I Policy explicitly state-dependent, lasting until economy & prices recovered I fiscal communication essential to implementation The Policy Problem

I Gold standard ⇒ price level mean reverting, but reversion can take decades

180

160 Mean 1921-1929 = 159.9

140

120

Mean 1834-1933 = 100.0 100

1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 CPI since 1834 Coinage Act setting 1 oz. gold = $20.67, rescaled to make mean = 100 The Policy Problem

I FDR & Congress concerned about debtors who incurred their debts at 1920s prices I deﬂation raised real costs of debt obligations I household debt-income ratio peaked at 80% in 1933 I farm foreclosures tripled in 1933

I Policy objective called for permanent increase of the price level to level 60% above long-run average I requires substantial permanent revaluation of dollar price of gold I without revaluation, gold cover ratio would fall below legal standard

I Cannot permanently raise price level under classical gold standard VAR Evidence from 1930s

I Primary surpluses quantitatively important I S most important source of P & Y (17%), aside from own innovations I S most important source of M (39%) I S most important source of G (27%), aside from own innovations I S close to exogenous, explaining 92% of itself

I Historical decompositions: S most important contributor to paths of P & Y, aside from own innovations

I Estimated output multipliers large—3 to 4—and signiﬁcant What Is Unbacked Fiscal Expansion?

I Definition: Unbacked fiscal expansion (UBFE) 1. increase spending—purchases or transfers, 2. issue nominal bonds to cover the deficit, and 3. convince people surpluses will not rise in future to pay off the bonds

I New nominal debt is not expected to be backed by higher primary surpluses I higher nominal debt raises aggregate demand ⇒ higher prices & output

I Unbacked ﬁscal expansion can permanently raise price level, as FDR desired Keynesian Hydraulics + Debt Dynamics

I UBFE challenges conventional wisdom: recovery unrelated to fiscal policy I Brown (1956), Romer (1992), Hausman (2016). . . I fiscal deficits too small to close gap in output I Conventional view: “Keynesian hydraulics” I narrowly construed transmission mechanism I real spending ↑⇒ real demand ↑⇒ multiple output ↑ I expansion in nominal demand from higher nominal debt provides no additional stimulus I implicitly, taxes extinguish wealth effects from debt I Broader view: hydraulics + impacts of debt dynamics I unbacked fiscal expansion raises wealth & demand I Multipliers substantially larger when fiscal expansion unbacked FDR’s Triple-Barreled Approach 1. Executive branch—with Congressional blessing—took control of monetary policy I Fed universally regarded as “inept” I Executive reduced gold content of dollar I abandoned convertibility 2. Ran “emergency” deficits financed by nominal bonds I relief through works programs & infrastructure I “emergency” communicated temporary & state-contingent nature of the fiscal policy 3. Political strategy made unprecedented fiscal policy credible I recovery the priority: “more grave” than WWI I feared “agrarian revolution” & “amorphous resentment” of economic institutions I faced “a choice between rise in prices or rise in dictators”; recovery a “war for survival of democracy” Recovery Was Stunning

I Recovery coincides with departure from gold I April 1933 the economy turned around I over course of 1933, Treasury & FDR steadily raised dollar price of gold from $20.67 an ounce I FDR was clear there would be no return to gold I Abrogated gold clauses in debts & set price of gold at $35.00 an ounce I a 59% devaluation of the dollar value of gold I Jalil-Rua: inﬂation expectations rose sharply 1933Q2 I contemporary news accounts & business forecasts I attribute much to FDR’s speeches, ﬁreside chats, press conferences Real Economic Activity Output

130

120

110

100

80 Real GNP IP 70

60 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 Nominal Economic Activity Price Levels

160 GNP Deflator CPI 150 WPI

140

130

120

110

100

1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 Corroborating Evidence

I Revaluation of government bond portfolio at heart of UBFE

I surprise changes in price level I surprise changes in bond prices (expected inﬂation) I changes in real discount rates

I How do facts about government debt line up with UBFE? Government Debt Facts

I Construct detailed government bond portfolio data I Data consistent with UBFE story I nominal debt grew 20% faster than real debt I debt-GNP ratio stabilized at 40% I post-gold standard: real returns more negative I post-GS: surprise devaluations large & negative I post-GS: surprise inﬂation & lower bond prices important I post-GS: relative price of bonds fell—bonds lost value Government Bond Valuation Indexes of Gross Debt (100 = 32Q2-33Q1)

200 1.3 Nominal 180 Real Real/Nominal (right) Leave Gold 1.2 160

1.1 140

120 1

100 0.9

80 0.8

1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 Debt Stabilized Under UBFE Gross Debt as Percent of GNP 50

Par Value 15 Market Value

10 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 Lessons for Today

1. Initially FDR was single-minded in pursuit of higher prices & employment; willing to experiment I fiscal policy state contingent I clear deficits would not be offset by surpluses 2. Joint monetary-fiscal behavior triggered recovery I doubling of nominal debt critical I communication about policy goals 3. Policy makers do not understand fiscal inflation I perceive it is a slippery slope: easily leads to runaway inflation Lessons for Today

4. Governments today lack single-mindedness I objectives bounce between stimulus and austerity I fears of sustainability taint policy actions I renders ﬁscal policy impotent for stimulus

5. Fiscal backstop against deflation (Sims) I no purely monetary cures to serious deflation I commitment to trigger UBFE in face of falling prices 6. Anchoring fiscal expectations I at least as important as monetary expectations