Fiscal policy and growth in light of the crisis

Robert Solow interviewed by Viv Davies, 01 April 2011

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<p><em>Viv Davies interviews Robert Solow for Vox</em></p>
<p><em>March 2011</em></p>
<p><em>Transcription of a VoxEU audio interview []</em></p>
<p><strong>Viv Davies</strong>: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 8th of March, 2011, and I'm in Washington, DC, attending a conference hosted by the IMF on &lsquo;macro and growth policies in the wake of the crisis&rsquo;. I'm speaking to Professor Robert Solow, Nobel laureate and Professor Emeritus at MIT. Professor Solow discusses his views on fiscal policy in light of the crisis, the role of automatic stabilisers, and the importance of international coordination of fiscal policy. He also discusses industrial policy and global imbalances. I began the interview by asking Professor Solow to outline the main points from his earlier presentation to the conference on fiscal policy in the wake of the crisis.</p>
<p><strong>Professor Robert Solow</strong>: Well, why don't I start with a little background, what came before the conference. It's been an intellectual and other kind of problem, for me, that over the last decade or two, the tendency in macroeconomics has been to proceed as if market failures, in the form of a little excess demand or a little excess supply, are always short and temporary and can be dealt with easily by monetary policy. I come from a somewhat older generation that remembers the depression of the 1930s, and it has seemed to me that the potential for substantial periods of excess supply - that is, inadequate demand and unemployment in excess capacity, for that to persist for a long enough time to be damaging to the economy and damaging to the future of the economy, that that's a real danger. And one of the lessons that we're talking about, lessons from the financial crisis and its aftermath, has been &lsquo;here we are in the middle of an example of that&rsquo;. We are in a recession. The recession began - I don't know when the National Bureau has decided- in 2007 or 2008. And while an upturn has started, there is still a lot of unemployment and a lot of excess capacity in this country and also elsewhere. And the monetary authorities the Federal Reserve, the ECB, other central banks have been doing all that they can to temper that and turn it around and repair it.</p>
<p>But, what experience has shown us, again, this time, as was true in the 1930s, is that a serious recession can simply outrun the capacity of monetary policy to repair the situation, so that the federal funds&rsquo; rate, the policy rate of the Federal Reserve, has been at zero for some time. The ECB's policy rate is at about one percent, and can hardly go very much lower. And faced with an instance of prolonged excess supply, prolonged inadequate demand, in the economy at large, almost every country in the world that I know of has, without argument, gone over to discretionary, expansionary fiscal policy, and chosen the fiscal policy route as all that it has left to do to repair that kind of situation. And the dominant macroeconomics of the past couple of decades has simply ignored that possibility.</p>
<p>So I began by insisting that the first lesson one wants to learn from the current experience is that our economies are vulnerable to this sort of thing, not every other year or every decade, but once in a while. And when it happens, it's bad enough to be a problem.</p>
<p>So there is a need to be able to do intelligent, discretionary fiscal policy. And then I continued by reminding everyone that, in order to do fiscal policy rationally, one needs to have some idea of its effectiveness. What does a billion dollars of additional spending of this kind do to the whole economy, to the real economy as well as to the price level? A tax reduction in this kind of tax, of that size, what consequences does it have? The way we do that normally are what are called fiscal policy multipliers. They are the numbers that you apply to those measures to forecast or estimate the macroeconomic effect.</p>
<p>And so I took it as one useful thing I might do, in 10 or 15 minutes, is to remind everyone that the problem with the fiscal multipliers that we estimate is that they seem to be very unreliable. For one thing, different methods give results that are different enough to matter in practical terms. If the fiscal multiplier is one, as some estimates have it, or even smaller, then you either have to give up on fiscal policy or have such very large impulses that other difficulties arise. If the multiplier is two, then it becomes a much more practical way to proceed.</p>
<p>And if one thinks about it, it seemed to me and not only to me; I'm not breaking new ground here that one has to take account of the fact that the notion of &quot;the&quot; fiscal multiplier, applying it to almost any expansionary fiscal policy move, can't be right; that the multiplier varies depending on the state of the economy. And I gave a number of examples in which that would be so, and suggested more than suggested, I &lsquo;claimed&rsquo; that if one took account of this dependence of the fiscal multiplier on the state of the economy, one would get better estimates of the fiscal multipliers, and estimates which were much less variable among themselves, and we'd have a better way of going at this sort of thing.</p>
<p>So that was the first half, roughly, of what I had to say.</p>
<p><strong>Viv</strong>: You spoke, also, a little about automatic stabilisers and what are the benefits of those and the disadvantages.</p>
<p><strong>Professor Solow</strong>: Yes. That was more or less the second large point I wanted to make. I led into it by pointing out that many central banks in recent years have operated, either consciously or implicitly, according to what has come to be called the Taylor rule, after John Taylor of Stanford University who proposed it, which is a sort of rule by which the central bank is meant to determine its policy rate in terms of the deviations of the current inflation rate from whatever the target is and the deviations of the current level of GDP from whatever the target GDP is. And I pointed out that when the central bank behaves that way, that amounts to an automatic stabiliser. It behaves exactly like an automatic stabiliser. There are many others that are known. And the importance of this is that automatic stabilisers, while they have good aspects in particular, they avoid the legislative hassle -- you don't have the delay that comes from having fresh legislation, and you have a sort of automatic adaptation of the size of the fiscal response to the size of the need. Those are all good things. They also have a bad side. The bad side is that the normal automatic stabiliser asks the central bank, in the case of the Taylor rule, or by itself arranges, so that any movement of real output is resisted, partially. When output starts to fall, in the onset of a recession, the point of an automatic stabiliser is to temper that fall. That sounds good, unless we're talking about excess demand.</p>
<p>But also, after the bottom of a recession, as the economy starts to recover, an automatic stabiliser &lsquo;automatically&rsquo;, from the very bottom up, partially resists, offsets, the upward movement. And that's not a good thing, since we would rather get back to normal quicker rather than more slowly. And thisfits in with what I was saying earlier, because the operation of automatic stabilisers affects the fiscal multipliers. So one has to take them into account, both in estimating multipliers and in planning fiscal policy.</p>
<p>But the more interesting point, I thought, was that with more effort, it is possible to design automatic stabilisers which are more complex and which can avoid that difficulty and can have the effect of resisting only movements away from the target and not movements toward the target. And while they're more complicated, they're harder to legislate and harder to operate, but I thought that it's important. There is an older literature which discusses that sort of thing, under the name of &lsquo;formula flexibility&rsquo;, and it offers a real possibility of advance in the making of a fiscal policy.</p>
<p>I mentioned one other problem with automatic stabilisers, which would also affect even sophisticated automatic stabilisers of the kind I've been describing, and that is that a change in any tax or a change in any line of expenditure by government has not only stabilising effects, but also has distributional effects. There will be some people who will gain, others who will lose or gain less, and so on. And allocational effects: there'll be some lines of output that are favoured and some kinds of production that will not be favoured. And those are unintended consequences. They're unavoidable, really, because it's very hard to find a neutral tax or a neutral expenditure programme, and that would be true even of more flexible and more sophisticated automatic stabilisers.</p>
<p>I went on about that. And the last serious point that I wanted to make, and I didn't have time to say very much, is the importance of international coordination. There I'm thinking primarily of Europe, actually, where this, again, comes back to the size of fiscal multipliers. If the Netherlands has an expansionary fiscal policy move, a good part of the effect is bound to leak abroad, because the Netherlands is engaged in international trade to a much greater extent than a larger country would be.</p>
<p>And because a large part of the effectiveness of any fiscal stimulus leaks abroad, there is a two sided tendency. Some countries which are closely linked with many others through trade and capital flows tend to free ride. &ldquo;I can benefit from my neighbour's fiscal policy without making any effort myself.&rdquo; That being so, the neighbour is likely to say, &quot;Well, why should I be the one to do this when I'm benefiting my unresponsive neighbour about as much as I'm benefiting myself?&quot; So there would be a tremendous payoff if it were possible to coordinate, in a closely linked area like Europe a national fiscal policy, so that everybody moved at more or less the same time, or arranged that their automatic stabilisers would move at about the same time, and avoid this leakage effect as best they can.</p>
<p><strong>Viv</strong>: I think a lot of people are bringing to light now this issue of a more coordinated fiscal policy. In the Eurozone area, for example, within the sovereign debt crisis, people are calling for a much more coordinated approach to fiscal policy.</p>
<p><strong>Professor Solow</strong>: Yeah. But you realize that the problem there is what I referred to earlier, that any fiscal policy is more than mere stabilisation. It is also an allocation device and a distribution device. And no country wants to think that it's having effects on the allocation of resources or on the distribution of income within the country for the benefit of a group of countries. But coordination might be able to avoid that.</p>
<p><strong>Viv</strong>: One of the lessons from the crisis has been that unfettered markets don't always work best. In many countries, there's an increasing talk of the importance of industrial policy. Should we be revising our views about the pros and cons of industrial policy?</p>
<p><strong>Professor Solow</strong>: I'm not sure that revising the views is exactly the right word. I think one should be thinking about more sophisticated industrial policy. I'm not one of those who thinks that industrial policy is, per se, a bad thing, it's a bad word, one shouldn't use it. The usual argument is that governments are unable to pick winners, to decide where to push and where not to push. And I think that there's validity to that. But what one can do is let industrial policy take the form of promoting research and innovation in a broad sector of industry, or doing something like that, something that depends less on the government knowing where the likely prospects for successful industrial development are likely to be. Another way to do that, of course, is for the government to insist on the participation of private industry in any attempt to develop a particular part of the economy. But I do think that industrial policy can be designed in a cleverer way, in a more subtle way, than we talked about when the conversation about industrial policy first began.</p>
<p><strong>Viv</strong>: I'd quite like to get your view on the issue of global imbalances, currency manipulation, and whether you think targets for current account surpluses and deficits are a good thing.</p>
<p><strong>Professor Solow</strong>: That's a terribly complicated issue. I think that a country is entitled to have a view about its current account deficit or surplus, thinking about it as part of its inter generational, its longer term, policies for itself. We have a clear set - or a not so clear set, maybe, but we have a set anyhow of notions about what are the acceptable ways of effecting current account deficits and surpluses, and what are not ways of doing that. We had a discussion this afternoon as to whether defending... everyone agrees that defending an overvalued exchange rate is likely to come to no good, will eventually collapse. There was difference of opinion about what happens if a country tries to maintain for a long time an undervalued exchange rate. There is an asymmetry. There's no doubt an element of asymmetry, and a country has to be careful, but can, for a longer time, defend an undervalued exchange rate. And if the international community thinks that's bad for the group, that it's bad policy for the world as a whole, then it has to find some way of gaining commitments for that elsewhere. What I don't think is that we want now to revert to a free for all interferences in trade and capital movements.</p>
<p>I will say something more. In the course of the discussion this afternoon about managing international capital flows, I was amazed, really, that nobody bothered to distinguish between flows that arise from direct investment and flows that arise from portfolio investment. And I do think that the points made, in yet another session, by Adair Turner, the question raised about one having to come to some view about the social value of the last bit of financial intensity, the last bit of refinement in capital markets, plays a role here. And I have no doubt that there are speculative international capital flows that are benefiting the real economy of neither the exporter nor the importer, particularly, and I have very little compunction about limiting those.</p>
<p><strong>Viv</strong>: I'd like to talk a little, before we wrap up, about developing countries, or the emerging economies. How have developing countries and emerging economies been affected by the crisis? Before the crisis, growth rates were much higher in emerging market countries than they were in advanced economies. And part of the reason for that was that many emerging economies followed an export led growth strategy. But now, given that world demand has changed and that the major economies, like the US and Europe, et cetera, are experiencing sluggish growth at best, what do you think are the implications for the growth model of these emerging economies?</p>
<p><strong>Professor Solow</strong>: Well, one lesson that's been learned. I think that the emerging economies - I'm not sure this is true of all of them, but true of most of them - suffered less from the financial crisis because they were less involved in the interconnected banking affairs. It matters a lot to the emerging economies that the rich countries will, at least for a substantial interval of time, be a less good and a less rapidly-growing market for their exports. That's a very important fact for them, and it will certainly cause any policymaker in one of those countries to reason that it will be difficult to have exports play such a large role in growth as they did before. And I would expect there to be some shift of focus to internal demand in emerging markets. That's not a bad thing at all. First of all, the standards of living in some countries, in these middle income countries, are not so high that there's not a lot of value to increased domestic consumption, and domestic investment can be cultivated as well.</p>
<p>So I think that, while export led growth is a reasonable and fairly easy strategy when the importing world, the rich world, is growing rapidly, one has to take account of the fact that it's unlikely to be such fertile territory for the next decade, perhaps. And not to adjust to that would be a bad mistake.</p>
<p><strong>Viv</strong>: And what are your views on the current growth prospects for the US?</p>
<p><strong>Professor Solow</strong>: I've had another difficulty with the discussion at the conference today, which relates to this, and I'll mention it first. Some of the speakers, it seemed to me, talked about economic growth, when what they were talking about really was short term increases in output. Since I've spent my life doing growth theory - my adult life, anyhow, doing growth theory - this kind of distinction matters a lot to me. I think of economic growth as being a fundamentally long term proposition that relates primarily to the growth of potential output, of the supply of output. Of course, it's an economic responsibility to have demand grow to match the supply, but the growth problem for an economy is to make its capacity to produce grow.</p>
<p>The US, I don't think, in the course of the crisis or the recession, has suffered any dramatic loss in those factors that lead to long term growth, which are primarily productivity increases and innovation, whether organisational or technological, and to a lesser extent, investment in human capital and tangible capital.</p>
<p>The problem that's been created by the recession is, because of the loss of wealth and the buildup of debt, private and public, the problem has been a difficulty in using the capacity that we have. But I think that, if and when we can solve the problem of a return to reasonable full utilisation of the productive capacity that's already in existence, and to a much lower unemployment rate, the underlying growth factors in the economy are still there, so that over the next 50 years, 30 or 40 years, I would not think that the likely long term growth rate of the US will be very different from what it was before.</p>
<p><strong>Viv</strong>: So you don't buy into this idea that's been expressed recently of a great stagnation, which suggests that rich countries like the US have already captured the easy gains that can be made from education, land use, innovation, and so on.</p>
<p><strong>Professor Solow</strong>: No. I find that difficult to believe, and I wonder where it comes from. Since, if you look at what has happened to productivity in this country, either labour productivity or total factor productivity, as best we can measure it, during the recession and in the course of the recovery, it has not looked drab at all. There's been remarkably fast productivity increase for a depressed economy. And indeed, that productivity increase creates a handicap in restoring employment. Part of this increase in productivity seems to have come in what you could think of as unfortunate or bad ways, that businesses have been going in for cost reduction in a very big way, instead of sort of allowing a little slack to exist. That kind of cost reduction can't be repeated. Once it's done, it's done. When you've got rid of the slack in an industry or a company or a plant, you've got rid of it, and you can't get rid of it again tomorrow.</p>
<p>But I think that that's given rise, perhaps, to what looks like a short term acceleration in productivity growth. But the underlying rate, which, in labour productivity terms, is something like two percent a year, or maybe even a little larger than that, that seems undamaged by the recession.</p>
<p>And so, while I don't think we can maintain the productivity growth at over two and a half percent a year that we have in the last year or two, I don't see that it's disappearing.</p>
<p>And I certainly expect the long term rate of growth to be better than it was during the period, say, from the 1960s to the 1990s.</p>
<p><strong>Viv</strong>: So, overall, you're optimistic about the global recovery and the prospects for growth.</p>
<p><strong>Professor Solow</strong>: I didn't say that. I said I'm optimistic about the long term growth prospects, provided we can manage the recovery. But I am not so optimistic about the recovery prospects at all.</p>
<p><strong>Viv</strong>: Robert Solow, thanks very much for talking to us today.</p>
<p><strong>Professor Solow</strong>: It's a pleasure.<br />
<br />

Topics:  Global crisis Global economy

Tags:  global imbalances, automatic stabilisers, discretionary fiscal policy

See also:

IMF Conference Website ‘Macro and Growth Policies in the Wake of the Crisis’ for coverage and background material.

New Ideas for a New World: Robert Solow — an IMF video interview with Robert Solow at the conference

Activist Fiscal Policy

Rethinking Fiscal Policy


Nobel laureate and Professor Emeritus, Massachusetts Institute of Technology


CEPR Policy Research