Shall We Target Inflation with Fiscal Policy?

Most Keynesians seem to think that fiscal policy influences AD and inflation, even when rates aren’t stuck at the zero bound.  This recent article from The Economist illustrates the conventional Keynesian view:

Even the lower estimates could easily be enough to tip the economy back into recession. Mr Greenlaw says the closest precedent was in 1968, when individual, corporate, excise and payroll taxes collectively rose by the equivalent of 3.1% of GDP, mostly to pay for the Vietnam war and to damp down inflation. The next year, the economy fell into recession.

Paul Krugman is certainly not a conventional Keynesian; he’s quite dismissive of this sort of old Keynesian reasoning:

People in my camp have repeated until we’re blue in the face that the case for fiscal expansion is very specific to circumstance — it’s desirable when you’re in a liquidity trap, and only when you’re in a liquidity trap.

In the case of the 1968 tax increases it looks like Krugman is right and Greenlaw is wrong.  America experienced 3.1% inflation in 1967.  After taxes were raised, inflation rose to 4.2% in 1968, 5.5% in 1969, and 5.7% in 1970.  So much for “damping down inflation.”  Indeed this was one of the key stylized facts that led to the resurgence of monetarism in the 1970s, often cited by Milton Friedman.  You can’t stop inflation by balancing the budget, only monetary restraint is effective.  And we had to wait until mid-1981 for a serious effort on that front. Krugman knows this history, and understands that monetary policy drives the economy when we aren’t at the zero bound.

Krugman has a nuanced approach to the question of fiscal vs. monetary policy, which can occasionally go right over the heads of his readers.  I bet lots of his fans nodded their heads when reading the quotation I just provided, not realizing that “my camp” might consist of not much more than one member.  If  I’m not mistaken Joe Stiglitz is much more typical of the Keynesian camp, and he certainly thinks there’s a case for fiscal stimulus when not at the zero bound.

Here Krugman criticizes British austerity:

And given that public investment is, you know, productive, this is almost surely a case of self-defeating austerity: by shortchanging infrastructure now the Cameron government is saving only a trivial amount on interest payments while reducing long-run growth and hence revenues.

Previously I’ve argued that there isn’t much austerity in Britain—in 2011 their budget deficit was nearly the largest in the world.  But the bigger problem is monetary policy, which seems committed to targeting some combination of inflation and NGDP growth.  Either way, fiscal stimulus is ineffective in the UK, as it’s offset by the BOE doing less unconventional monetary stimulus.

There are times where Krugman seems to acknowledge that monetary stimulus is needed to boost inflation.  At least I think he does—see what you think:

At this point an argument that was once considered way out there — that euro area adjustment won’t be possible unless the inflation target is raised — now has widespread support, albeit not from the crucial players. Inflation significantly above 2 percent is almost surely a necessary (though not sufficient) condition for the euro to survive.

So what’s happening to euro inflation expectations? We can look at the German breakeven — the difference in yields between German bonds, presumably viewed as safe, and yields on German bonds indexed to euro area inflation. This currently points to an expected inflation rate over the next 5 years of 1.3 percent — way too low to make euro survival feasible.

So how has that breakeven evolved over time?

.   .   .

And what happened in April 2011? The ECB hiked rates, even though it was obvious that the rise in inflation was a temporary blip driven by commodity prices. This was a clear signal that the price stability obsession was as strong as ever. And it has meant, in the end, a loss of hope.

This is exactly right.  But what exactly is Krugman saying here?  How should Europe raise inflation?  Should they use fiscal stimulus, or monetary stimulus?  Krugman would support either approach.  But unless I’m mistaken he’s referring to the ECB in this post—they are supposed to set a higher inflation target.   Now look at what he said just a day earlier:

Simon Wren-Lewis argues that if we’re up against the zero lower bound but are uncertain about the size of the output gap — how far the economy is operating below potential — we should deliberately overreach on fiscal policy. Why? Because monetary policy can correct any excess stimulus, but not an inadequate stimulus.

Krugman’s fans will suggest I don’t understand, he thinks monetary stimulus is worth a try, but supports fiscal stimulus because he doubts both the willingness of the monetary authority to stimulate, and the effectiveness of monetary stimulus at the zero bound if they did.

I don’t believe fiscal stimulus can do very much, even at the zero rate bound.  But if I thought it could, and if I thought higher demand was needed, I’d recommend that the fiscal authorities raise their inflation target from 2% to 4%.  Oddly, I’ve never seen a fiscal proponent make that recommendation.  Why not?  My hunch is that deep down they know that fiscal authorities can’t really control inflation.  But in that case, how can they control aggregate demand?

BTW, Marcus Nunes has constructed an excellent graph that shows why I’m skeptical of fiscal stimulus:

It sure looks like the Fed is trying to steer the economy.