Crisis section

Crisis section
Gödel's Money : The future of freedom and civilization
- Money and Fiscal Policy - A hidden point -

Senior Fellow, RIETI

Fiscal policy increases liquidity on hand but not income

When considering what action to take against a financial crisis, many would feel that Ricardian equivalence, which holds that fiscal policy is ineffective, would seem logical and yet it does not match how they see the real world. Ricardian equivalence argues that if the government gives money to the public by increasing fiscal spending, people will anticipate future tax hikes and put the money into savings and as a result neither consumption nor investment increase.

Many people, including politicians (but excluding economists), believe that if people are given cash they will want to spend the money. The reason ought not to be that people are irrational, but rather should be explained by economics. However the old explanation based on Keynesian economics (fiscal policy will raise personal incomes, which in turn will increase spending) has been refuted by Ricardian equivalence. If human beings could effectively anticipate the future, the expansion of public spending would not be effective, in principle. New Keynesian economics has basically accepted this argument.

However, there is a point that Keynes himself would have considered, but which has been forgotten in the IS/LM model of simplified Keynesian economics. That is the liquidity constraint, which I discuss below. Fiscal policy stimulates consumption and investment in the real world because the expansion of public spending eases liquidity constraints.

Liquidity constraints are limits on spending by a large number of households or companies imposed by their holdings of means of payment (such as cash or negotiable financial assets). If households or companies find it difficult to borrow money for some reason, they cannot buy goods and services unless they have cash (or means of payment similar to cash) on hand. Without those means, they cannot spend or invest. If the government distributes cash to households in the form of grants in this situation, or if it pays cash to businesses by ordering public works projects, cash on hand will increase in households and businesses, enabling them to increase spending. In this way, the expansion of public spending can stimulate demand (by increasing cash on hand in households and companies) and raise the level of economic activity. Fiscal policy expands demand by easing the liquidity constraints that households and businesses face. The mechanism of fiscal policy easing liquidity constraints is consistent with Ricardian equivalence. Ricardian equivalence holds when households and businesses do not have liquidity constraints. It is useful and fiscal policy becomes ineffective only if households and businesses can freely borrow at the level they desire without having to put up security within the limits of their future income. (We are considering the closed economy model of large countries such as Japan and the United States. For a small open economy, it is known that fiscal policy becomes ineffective due to the Mundell-Fleming effect, even if Ricardian equivalence is not assumed.) However, if households and businesses have liquidity constraints, they cannot borrow even if the borrowings are within their lifetime earnings. Consequently, they cannot increase spending or investment even if that is what they want to do. If the liquidity constraints are eased through fiscal policy in that situation, however, spending and investment, which have been held down to unreasonable levels, will increase, and economic activity will rise.

I could summarize this argument as follows: If the government distributes grants to the public or purchases goods from businesses through the expansion of public spending, people's lifetime earnings will not increase, since they anticipate that if the government distributes money to people and increases their income now, it will take the same amount from their earnings by raising taxes by an equivalent amount (the Ricardian equivalence proposition). Thus, the old explanation based on Keynes economics is basically incorrect, in that it argues that when the government expands public spending, people will have the illusion that their lifetime earnings have risen and will increase spending. However, although the expansion of public spending does not increase people's lifetime earnings, it does increase their cash on hand. If cash on hand rises, people will increase spending even if their lifetime earnings remain unchanged (provided that people have liquidity constraints that make them short of cash and prevent them from spending and investing).

Financial crisis revealed flaws in macroeconomics

Fiscal policy does not increase income but it does increase cash on hand and this difference is important. The argument that the expansion of public spending will ease liquidity constraints has been pointed out by a number of economists, but for some reason has never been accepted as a pillar that supports the framework of macroeconomics in the history of economics.

Rather, in the IS/LM analysis based on Keynesian economics, there is an established recognition that boosting public spending has the effect of increasing income and that only the monetary policy of the central bank has monetary functions (including the easing of liquidity constraints through the distribution of means of payment to the entire economy). I believe that this fixed idea has kept economists away from the thinking that the true effect of fiscal policy is providing a means of payment (money). If this is indeed the case, then it is natural that current macroeconomics theory should largely shun fiscal policy as a subject of research.

The current financial crisis may have revealed the weakness of mainstream macroeconomics. The experience of the financial crisis has shown us that expanding public spending is a clear policy imperative, at least in an emergency. Macroeconomics as it presently stands cannot explain the need for public spending in a consistent theoretical system, suggesting theoretical flaws. I suspect the cause of the theoretical flaws might be that macroeconomics has not studied money as a means of payment (or as a medium of exchange) as a central focus. The financial crisis suggests that it might be time to do this.

* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the August 17, 2009 issue of Kinzai Financial Weekly

October 22, 2009

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