Does the effectiveness of fiscal stimulus depend on economic context?
Does the effectiveness of ﬁscal policy in stabilizing an economy depend on the underlying economic context in which the policy is implemented? The answer to such a broad question must certainly be yes, but I argue in this chapter that the answer differs across various dimensions of “context,” three of which are considered here. First, I consider in some detail the most obvious context: the state of economic activity relative to some measure of the economy’s potential. I discuss logic and evidence that implies that the presence or absence of idle resources is the key context for ﬁscal policy. Second, I explore whether the openness of the economy matters, especially the extent to which ﬁscal stimulus ﬂows abroad by boosting imports or is ﬁnanced by borrowing from abroad. While this dimension will likely affect the quantitative stimulus that a country gets from ﬁscal expansion, I conclude that the open-economy context is unlikely to affect the decision of a country that borrows in its own currency to undertake ﬁscal stimulus. Third, I look at how the level of government debt, what is sometimes called the “debt overhang,” matters for the decision to undertake ﬁscal stimulus. While I accept that government debt can, in principle, be excessive, I discuss why concerns about the current level of debt in developed, sovereigncurrency countries are likely exaggerated. At the outset, I note that the discussion that follows is largely based on the US economy. In the absence of political incompetence of the kind demonstrated by the US Congress in debate over raising the legal debt limit in the summer of 2011, default on a sovereign debt obligation is not a concern. Why would a government default on a debt when it has the means to discharge that debt by simply creating the means of payment?2 Creation of money to pay debt may have other consequences, but default should not ever occur for a government that borrows in its own sovereign currency. This US-based analysis extends to other countries with similar ﬁscal and monetary circumstances. It does not apply, however, to countries that borrow in foreign currency or to countries that must maintain a ﬁxed exchange rate, which takes its most extreme form for countries that are part of a currency union. Thus, the substantial recent difﬁculties of Greece, Spain, Portugal, Ireland, and Italy are outside the context of what follows. While this limits the relevance of the discussion to some extent, the issues addressed here are of fundamental importance, and seem badly understood in much of the
current discussion by journalists and policy analysts. Furthermore, I argue that to develop an effective institutional framework for a currency union like the one based on the euro, the designers must begin from the principles analyzed here.