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“Economy in deflation: debt, competitiveness and growth”
Zdravka Nikolova
University Bocconi, Milan, Italy
Master of Science in Economics and Social Sciences
Introduction
Over the last six years the global economy has been suffering from a large negative demand
shocks that were driven initially by a sharp decline in house and stock prices and a tightening of
the financial conditions. As a consequence, output substantially declined and unemployment rose.
Governments and central banks across the globe responded by introducing measures to cope with
solvency and liquidity problems in financial institutions. For instance, central banks reduced the
target interest rate to unprecedented levels to support the aggregate demand. Unconventional
monetary policy, i.e. quantitative easing and credit easing was used in order to provide more
liquidity and to reduce the risk premia. However, with nominal interest rate close to zero, output
and employment below their potential levels monetary policy turned out to be unable to bust the
aggregate demand. Thus many countries turned to fiscal policy. The implementation of largescale fiscal spending programs in USA as well as in Europe gave rise to policy debate. There has
been a lot of controversy among economists and policy makers regarding the effectiveness of
fiscal policy in lessening the depth and the duration of the recession. Moreover, the use of
expansionary fiscal policy has been put into question because of the rapidly expanding public
debt.
Deflation, Liquidity trap and Economic growth. Austrian school versus Keynesians
Since the World War II and the rise of Keynesian economics, economists have understood
deflation as a decrease in CPI (Consumer Price Index). Before that, the term deflation was
defined as a decrease in the stock of money. Thus one problem with defining deflation as the
effect, i.e. price deflation, instead of the cause, i.e. monetary deflation, is that it can mislead
economist form the causes, the effects and consequently the right policy approach to deflation.
Samuelson (1998), Krugman (1998), and De Long (1999) are examples of economists working in
the Keynesian tradition who equate periods of deflation with economic contraction. Krugman
(1998) defines “liquidity trap” as a situation in which conventional monetary policy is impotent
because the nominal interest rate are close to zero. In that case private agents conceive bonds and
currency as perfect substitutes. The only instrument that can be used to escape the liquidity trap is
government spending. An increase in government spending, according to Keynesians, could boost
aggregate demand and bring the output and employment back to their potential levels. Supporters
of Austrian school argue that deflation per se should be viewed as an integral part of the
economic process that helps the capitalist economy with destabilized money and credit systems
recover. The price deflation is an effect; it is a part of the efficient working of the market
economy and the process of economic growth. The process of deflation, where the prices of
goods, commodities, labor and asset prices fall, is the process of economic recovery, where labor
and capital are reallocated. According to Austrians the fear of deflation is confusion between
“cause” and “effect”. This group believes that real shocks to the economy, as well as real shocks
in the demand and supply of money, should be allowed to work themselves in the market, without
any government intervention and that these changes should be reflected in price, value or the
purchasing power of money.
Monetary versus fiscal policy as an instrument for recovery. Literature review
Main objective of many central banks is to keep inflation low. Since 1997, central banks around
the world have enacted monetary policy in terms of inflation targeting. This type of monetary
policy is implemented through Taylor rule1. According to this rule a central bank raises shortterm interest rate if inflation is above the target and if output is above economically sustainable
level. There are two circumstances in which inflation targeting, using Taylor rule may run into
difficulties. First, when there is a combination of high inflation together with low output. In that
case the Taylor rule will require high and low interest rate simultaneously and policy-makers face
the following trade-off: they should choose either that the actual inflation is higher than the target
or that output is below its potential levels. Second, when monetary policy is constraint at the zero
lower bound on nominal interest rate, the Taylor rule will require negative interest rate. In recent
years, interest rates were very low, which brought the potential threat of deflation and a binding
zero bound on the nominal interest rate into focus. In this context monetary policy is no longer in
a position to further reduce the nominal interest rate or to pursue a policy of quantitative easing.
By the second quarter of 2009, policy interest rate had fallen below 1% in USA, Canada, UK,
Sweden, Switzerland and euro area. These developments triggered a debate on whether monetary
policy can be used as an instrument to boost aggregate demand. Many economists argue that the
existence of zero lower bound constraints suggests that in a financial crisis or a severe recession
there may be a role for fiscal stimulus to boost aggregate demand. The first paper to study the
effects of government spending at zero lower bound (ZLB) in a New Keynesian DSGE model, is
Eggertsson (2001). This paper builds upon previous literature on monetary policy at ZLB, such as
Summers (1991), Krugman (1998), Svensson (2001) and others. Eggertsson (2001, 2003) argues
that government spending at ZLB on nominal interest rate could be expansionary. A natural
proposal for a stimulus plan could be a temporary increase in government spending, temporary
investment tax credit, and temporary elimination of sales taxes. Woodford (2011) also has
suggested that it will be plausible that a central bank does not tighten its monetary policy in
response to an increase in government spending when monetary policy is constraint at ZLB on
nominal interest rate. The reason for the effectiveness of a fiscal policy in that case lies on the
fact at the ZLB the nominal interest rate does not respond to an increase in government spending
and the real interest rate declines. As a consequence, the inflation expectations will increase.
Christiano, Eichenbaun and Rebelo (2011) argue that the government spending multiplier could
be greater than one when the ZLB on nominal interest rate binds. They develop a model, where
the nominal interest rate does not respond to an increase in government spending. In such
economy, it will be welfare improving to increase government spending, when the ZLB on the
nominal interest rate is binding. Recently Galì (2014) has suggested that in presence of nominal
rigidity, money financed fiscal stimulus could increase aggregate demand by boosting the output
and employment back to their potential levels without any inflationary consequences.
Furthermore, such intervention does not require a reduction in the nominal interest rate, an
increase in the government debt and/or an increase in taxes. According to Galì if output is
sufficiently below its efficient levels, an increase in government spending my increase output
even if such spending is wasteful. This paper is related to large literature on the effects of
government spending on output. Much of it has focused on the size of he government spending
multiplier under alternative assumptions. That multiplier is predicted to be below one in the
context of standard RBC (Real Business Cycle) or New Keynesian models, but it can
substantially increase in the presence of non-Ricardian households (Galì, Lopez), or when ZLB
on the nominal interest rate is binding. However, to have the ability to run a fiscal deficit perhaps
1
The Taylor rule can be written as 𝑖 = 𝛼 + 𝛽 𝜋 − 𝜋 ∗ + 𝛾 𝑦 − 𝑦 ∗ , where 𝜋 and 𝜋 ∗ are the actual and the target inflation rate and
(𝑦 − 𝑦 ∗ ) is the output gap, that is the difference between the actual and the potential output. for several years requires fiscal rules and institutions to ensure that government finances are in
robust shape in good times to allow fiscal flexibility in bad times (Wyplosz, 2005). The failure to
ensure that public finances were sufficiently strong prior to the financial crisis, combined with the
severity of the crisis itself means that periphery countries in euro area are now in a difficult
position. Not only is the nominal interest rate close to zero but also fiscal sustainability requires a
deficit reduction. In particular, governments have to deal with sizeable structural budget deficit in
the aftermath of the crisis and to head off the possibility that the interest rate at which government
can borrow are subject to rapidly increasing risk premia (IFS, 2010). Textbook Keynesian models
and New Keynesian models with less than perfectly flexible prices, predict that spending cuts are
always recessionary2 and that the government spending multiplier should be larger in theory than
that for taxes. In a seminal paper Alesiana, Favero and Giavazzi (2014) show that the spendingbased (SB) adjustment is much less costly (in terms of recession) than the tax-based (TB) one.
The difference between the SB and the TB adjustment is remarkable in size and cannot be
explained by different monetary policy or other accompanying policy, such as supply-side policy,
e.g., labor market and product market liberalization. Moreover, the difference in the output effects
of the two types of fiscal adjustment is due to the response of private investment, rather than that
of consumption growth.
What can we learn from history? UK versus USA
In 1930 UK economy entered a recession with unemployment rising very rapidly. The UK
budgetary position deteriorated as tax revenues fell and transfer payments rose. Fiscal
sustainability was threatened by falling prices and risk premia lead to an increase in interest rates
on government debt. By abandoning the fixed exchange rate, UK was able to regain control over
its monetary policy, eliminate the need for deflation of prices and wages, remain competitive and
improve its budget. Thanks to the fiscal consolidation plan (a mix of expenditure cuts, notably on
unemployment benefits and tax increase) that was implemented 1929/1930 and continued until
1933/34, the budget had returned to surplus. After 1934, as the recovery from the recession
progressed, fiscal policy was eased. From 1935 deficit-financed government expenditure
delivered a significant fiscal stimulus, around 3% of GDP.3 USA instead was marked by the era
of the New Deal. The main difference between the fiscal policy in the two continents lay in
Keynesian stimulus in USA compared with deficit-reduction in UK. It is well known that the
New Deal was a massive fiscal stimulus. However, one should take into account the fact that it
was largely financed by tax increase and that the discretionary increase in the budget deficit
between 1933/36 was actually less than 3% of GDP. Fiscal consolidation in UK was
accompanied by strong economic growth in 1933/34. The strong effect of this type of fiscal
policy should be put in the context of supportive policy measures initiated in 1932 that offset the
deflationary effect of the fiscal consolidation. Such accompanying policies include exchange rate
depreciation as well as tariffs on imports and interest rate reduction that changed the expected
rate of inflation. Given the adverse trends in the world economy one could conclude that the
recovery in UK was based on domestic demand. By contrast, USA in 1933 gave strong massage
to the public: both leaving the gold standard plus the New Deal was clearly understood as a
regime change very quickly and recovery started much faster.
Conclusion
The experience of 1930 gives us useful lessons for today. The key to promoting growth in 1930 in
UK was to combine fiscal consolidation with other policy that helped in boosting the aggregate
2
3
See De Long and Summers 2012, Galì et al 2007
See for a survey Thomas 1983 demand. As part of the so-called “managed-economy strategy”, UK abandoned free trade and
imposed tariffs on manufactures in 1932. The main policy stimulus that accounted for the UK
economic growth between 1933/35 was the use of “cheap money” policy that consisted in
reduction of the nominal and real interest rates. Cheap money was a policy package aimed at
keeping short term interest rates close to zero while rising inflationary expectation through
announcing policies intended to rise the price level. This strategy had a direct effect on private
investments that accounted for the 23% increase in GDP and it worked because it was clearly
communicated and committed to. Fiscal stimulus strategy between 1933/36 brought the USA
economy out of the recession. The reason for the success of the New Deal lies on the fact that it
was perceived as a credible regime change.
In the current context, the use of expansionary fiscal policy has been put into question because of
the rapidly expanding public debt. It is neither feasible nor desirable to impose tariffs in the
context of free and integrated market. The single currency in euro area excludes the use of
currency devaluation as an option to improve competitiveness and boost export and economic
growth. Given that interest rates are at the lower bound, a modern equivalent of “cheap money”
policy could be appropriate if there is a risk for the economy to enter a double-deep recession.
Textbook models teach us that at the zero lower bound, the real interest rate could be reduced
only with a policy that can convince people that the price level will be higher in the future.
Quantitative easing in its present guise is not able to do this. Thus many economists have started
to think on the usefulness of fiscal policy as a tool for macroeconomic management. Textbook
discussions of fiscal policy describe it as a stabilizing force of the economy. Fiscal policy can
stabilize aggregate demand by adding to demand during recession and subtracting from demand
during boom. However, actual fiscal policy in both USA and EU has deviated form this textbook
description during the last decade. In short run, fiscal policy has magnified business cycles by
subtracting from demand during recession and adding to demand during expansions (Frankel
2012). Long-run fiscal policy, in terms of the government debt relative to the size of the economy
and the debt ratio in periphery countries has been allowed to increase to unprecedented levels.
Predictability is an important aspect of fiscal policy and there is strong evidence that increased
uncertainty about future fiscal policy has had an adverse effect on private economy (Becker et al
2013).
Policy makers should bear in mind that the key to recovery both in UK and USA in 1930 was the
adoption of CREDIBLE policies to raise the price level and in so doing to reduce real interest rate
and to increase inflationary expectations. The 1930’s experience tells us that to be effective a
change in both monetary and fiscal policy would have to be clear and credible.
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