Research: Fiscal Spending in Crisis Does Not Hike Borrow Costs

--NY Fed's Dudley: Fiscal Pol Could Prevent Need For ZLB Mon Policy

By Karen Mracek

     JACKSON HOLE, Wyoming (MNI) - With the U.S. economic recovery entering its

eighth year, policymakers are beginning to think about dealing with the next

shock to growth and how both monetary and fiscal policy should respond.

     To this end, new research presented Saturday show fiscal stimulus during a

crisis could be the best response by providing evidence that government spending

does not lead to persistent increases in debt-to-GDP ratios or higher borrowing

costs, especially during periods of economic weakness.

     "Although economists do not believe that expansions die from old age, the

prolonged U.S. expansion will end sooner or late, and there is serious concern

about the ability of policymakers in the United States and other developed

countries to fight the next economic downturn," write University of

California-Berkeley professors Alan Auerbach and Yuriy Gorodnichenko, 

     Auerbach, while presenting the paper at the Kansas City Fed's annual

economic symposium in Jackson Hole, said "the next time we face a very serious

recession we should be resistant to calls for fiscal consolidation."

     The paper presented to policymakers from around the world did not address

whether another recession is on the horizon for the U.S. or other countries, but

instead focused on the longer run fiscal sustainability of fiscal responses to

crises.

     "In the current low-interest-rate, low-inflation environment, an even

greater reliance on fiscal policy may be needed to address the next recession,

whenever it begins," Auerbach and Gorodnichenko write.

     In response to the Great Recession, monetary policymakers quickly drove

rates to zero and then ventured into unconventional policies of quantitative

easing and forward guidance. And while the Federal Reserve kept rates positive,

some central banks moved into negative interest rates.

     New York Federal Reserve Bank President William Dudley, in the discussion

of the paper, said one benefit of better utilizing the fiscal space to respond

to a crisis is that it "would reduce the likelihood monetary policy is pushed to

the zero lower bound" in the future.

     This would be good, because central banks are "much more limited now than

before the Great Recession and it is unlikely that expansionary monetary policy

can be as aggressive and effective as it was during the crisis," Auerbach and

Gorodnichenko said in their paper.

     Additional rounds of quantitative easing "may run into diminishing

returns," they write. "Likewise, it is hard to expect that moderate decreases of

interest rates can turn the tide."

     Therefore, "with tight constraints on central banks, one may expect -- or

maybe hope for -- a more active response of fiscal policy when the next

recession arrives," the authors say. Fiscal policy did have a countercyclical

component during the Great Recession, they acknowledge, but "it was not used to

full potential, given the depth of the recession."

     The question going forward is: Will new fiscal stimulus programs be

jeopardized by already heavy public debt burdens?

     "It is certainly conceivable that a significant fiscal stimulus can raise

doubts about the ability of a government to repay its debts and, as a result,

increase borrowing costs so much that the government may find its debt

unsustainable and default," the authors agree.

     Still, it is "critical to establish how government spending shocks

influence not only output and prices but also indicators of fiscal

sustainability such as the debt-to-GDP ratio and interest rates on public debt,"

they said.

     Their research shows "expansionary government spending shocks have not been

followed by persistent increases in debt-to-GDP ratios or borrowing costs."

     This is particularly true when the spending comes when the economy is weak.

"In fact, a fiscal stimulus in a weak economy may help improve fiscal

sustainability," Auerbach and Gorodnichenko said.

     There is evidence that this effect "is undercut when the debt-to-GDP ratio

is elevated," they continue, "although the penalty for a high debt-to-GDP ratio

does not appear to be high at the debt levels experienced historically for

developed countries."

     Even in countries with high public debt, "the penalty for activist

discretionary fiscal policy appears to be small," they find.

     In fact, expansionary fiscal policies adopted when the economy is weak "may

not only stimulate output but also reduce debt-to-GDP ratios as well as interest

rates and CDS spreads on government debt, while the outcomes when the economy is

strong are more likely to have the conventional effects," they write.

     Jason Furman, head of the Council of Economic Advisors under President

Barack Obama, said the scale of fiscal policy "matters."

     He noted in his discussion of the paper that there is more fiscal space for

providing stimulus in part because of reforms in advanced countries to address

health care and pension costs. While these costs are still going up, he noted,

they are going up by "considerably less" than had been expected five years ago.

--MNI Washington Bureau;tel: +1 202 371-2121; email: karen.mracek@marketnews.com

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