Paul Krugman: Deleveraging Shocks and the Multiplier (Sort of Wonkish)


Deleveraging Shocks and the Multiplier (Sort of Wonkish), by Paul Krugman, in NY Times: Jonathan Portes — who will be my teammate in a debate on fiscal policy in London next week — weighs in on the IMF’s multiplier mea culpa. He confirms that policy makers in many places were working with the assumption of a multiplier on fiscal contraction much less than 1, whereas experience now suggests that it’s actually more than 1.

What I thought might be worth pointing out is that the logic for a biggish multiplier and the logic of the crisis itself are very closely linked: times like these, the aftermath of a credit bubble, are precisely when you expect fiscal multipliers to be large. And that in turn says, once again, that fatalism — or worse yet, demands for fiscal retrenchment — in the aftermath of such a bubble are deeply destructive.

So, the simple but surely broadly correct story of the mess we’re in is that we had a period of excessive complacency about leverage, which came to a sudden end. Household debt in particular surged, then was suddenly perceived as excessive:

The crucial thing from a macroeconomic point of view is that leveraging and deleveraging are not symmetric in their effects. Leveraging up, other things equal, leads to high aggregate demand — but this can be and is in practice offset by the central bank, which can always raise rates. Deleveraging, on the other hand, can’t be offset equally easily; the central bank can cut rates, but only to zero, and unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried).

So a large leveraging/deleveraging cycle is likely to be followed by a persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy; what I consider depression economics.

Now, the same thing that makes deleveraging so hard to handle also makes the fiscal multiplier larger than it is in normal times. Normally, expansionary fiscal policy is offset by monetary tightening, contractionary policy by monetary loosening. Hence the lowish multiplier estimates based on recent history. But if deleveraging has pushed you into a liquidity trap, there are no offsets.

So how big would you expect the multiplier to be under these conditions? Bigger than one.

Start by provisionally assuming a frictionless world in which consumers have perfect foresight and perfect access to capital markets. In that case the multiplier should be exactly 1, with consumer demand neither rising nor falling in the face of a change in government purchases (so that the change in purchases translates one-for-one into a change in GDP). Why? Well, a rise in government spending does mean higher expected future taxes — but it also means higher incomes right now, and those two effects should exactly cancel each other.

Now add in realistic frictions, notably households that are liquidity-constrained and/or use rules of thumb based on current income to make spending decisions. (By the way, as Gauti Eggertsson and I have pointed out, once you’re using a debt/deleveraging model you are already in effect assuming that many households face liquidity constraints). These frictions will mean that a rise or fall in current income due to fiscal policy will lead to at least some movement of consumption in the same direction. So we get a multiplier bigger than 1.

But, you say, confidence! OK, if people believe that a movement in government spending now presages even bigger moves in the future, you could reverse this conclusion. But there is no reason at all to believe this when it comes to fiscal stimulus, which has proved completely temporary; and it’s a highly dubious proposition for austerity imposed in response to a fiscal panic, too.

So there really was no good reason to be surprised by large fiscal multipliers. They were a predictable consequence of the kind of crisis we’re in; and the unjustified assumption of small multipliers has helped make the crisis worse.

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