Fiscal policy in a depressed economy.

Delong, J. Bradford ; Summers, Lawrence H.

IV. Conclusion

Real interest rates on Treasury securities have fluctuated within a relatively narrow range throughout their history, except for the few years of the Volcker disinflation of the early 1980s. Rates in this historical range, in a depressed economy at the zero lower bound, with even a modest short-run government purchases multiplier [mu] and a small hysteresis parameter [eta], generate as a matter of arithmetic the conclusion that expansionary fiscal policy does not impose a future fiscal burden. Moreover, as the appendix shows, even when expansionary fiscal policy fails to be self-financing in these circumstances, it is still likely to pass a sensible extra-output benefit-cost test, at least as long as there is no substantial wedge between the government's real borrowing cost and the real social rate of time discount.

Sections II and III made the case that the short-run reduced-form policy-relevant fiscal multiplier [mu] is likely to be substantial enough in a depressed-economy, and that hysteresis effects [eta] are likely to be present. And there is today no sign of a large wedge between the government's real borrowing cost and the real social rate of time discount.

It is important to stress that our argument does not justify unsustainable fiscal policies, nor does it justify delaying the passage of legislation to make unsustainable fiscal policies sustainable. If committed spending and committed revenue plans are inconsistent, adjustments will be necessary. Nothing in our analysis calls into question the widely held proposition that it is desirable for those adjustments to be committed to sooner rather than later. Indeed, the sooner that is done, the less likely is the emergence of the wedge between government borrowing costs and the social discount rate that would make expansionary fiscal policy unwise even in a depressed economy. Expansionary fiscal policy is more likely to be self-financing when there is confidence in long-run fiscal balance than otherwise.

Three crucial questions confront any attempt to draw policy implications:

--Doesn't the argument prove too much? Can it be the case that most governments at most times can take on increased debt, relying on the benefits of induced growth to pay it back?

--Is the kind of temporary fiscal stimulus envisioned in our model feasible in the world, or does it inevitably, in reality or perception, become at least quasi-permanent, thus amplifying debt-servicing costs without amplifying the output benefits?

--Third, whatever the merits of fiscal stimulus, should not monetary policy be relied on as an alternative and superior instrument? We briefly consider each of these questions in turn.

On the first question, it surely cannot be the case that more expansion is desirable most of the time. We have stressed our belief that, outside of extraordinary downturns where the zero lower bound constrains interest rates, the right assumption is that the fiscal multiplier is likely to be small. Increases in demand run up against supply constraints, (21) even when they are not offset by monetary policy. And in the normal-times case of a small policy-relevant multiplier, judgments about fiscal policies should be made on allocative rather than stabilization policy grounds. As a corollary, even in depressed economies, expansionary fiscal policy surely should not be pursued without limit.

With regard to the second question, the premise of our analysis is that expansionary fiscal policy can be both timely and temporary. Thus, it makes a case only for as much fiscal stimulus as can be delivered in a timely and temporary way. If, because of political frictions, stimulus will not in fact be temporary, or if there are substantial lags in its implementation, the calculus of costs and benefits is altered. Is temporary stimulus inconsistent with belief in long-run consolidation? It is possible that short-run fiscal expansion undercuts the credibility of long-run fiscal consolidation. It is also possible that, in a world with limited political energy and substantial procedural blockages, any effort toward one objective compromises the other.

Our reading of the recent U.S. experience is encouraging as to the feasibility of significant timely and temporary stimulus--contrary to Taylor (2011), Juan Carlos Suarez Serrato and Philippe Wingender (2010), and others who suggest that a substantial fraction of the fiscal stimulus enacted in the 2009 recovery act translated rapidly into increased spending and was not offset by triggered changes in state and local fiscal policy. There is also experience with phased-in long-run deficit reductions (for example, the 1983 bipartisan agreement on the Social Security recommendations of the Greenspan Commission). The recent U.S. experience also suggests that fiscal stimulus can be reversed: certainly whatever stimulus was provided by the 2009 act already has been.

But even if it is granted that stimulus can be timely and temporary, the question of how large it can be while preserving these attributes remains for future research. (22) And as Carlo Cottarelli (2012) warns, countries that commit to short-term deficit reduction as a down payment on a move to long-term sustainability may find that

 growth slows more than expected ... [they are] inclined to preserve
 their short-term plans through additional tightening, even if it
 hurts growth more ... my bottom line: unless you have to, you
 shouldn't ... interest rates could actually rise [even] as the
 deficit falls ... [if] growth falls enough as a result of a fiscal
 tightening.

On the third question, our analysis has taken it as given that at the zero bound, monetary policy does not change when fiscal policy is altered. Central banks, however, do have room for maneuver, both in their ability to operate directly on a wider range of financial instruments than they use in normal times, and in their ability to precommit policy. As a matter of logic, it is possible that increased fiscal actions will call forth a contractionary monetary policy response by causing central banks to use these tools less expansively. Perhaps, then, as Gregory Mankiw and Matthew Weinzierl (2011) assert, arguments for fiscal expansion in a depressed economy are even better arguments for monetary expansion.

On the other hand, in the United States the Federal Reserve has sought to encourage short-run fiscal expansion. There appear to be limits to the efficacy of nonstandard monetary measures and to the willingness of central banks to expand their balance sheets in order to engage in them. And expansionary fiscal policies may well both support and call forth a more expansionary monetary policy response by, for example, raising the credibility of commitments to monetary expansion after the economy has recovered, or increasing the extent of debt monetization.

It seems to us that, especially if fiscal policy is self-financing, it will be appropriate to include it in the instrument mix, for several reasons. First, given model and parameter uncertainty, diversification among policy instruments is appropriate, as William Brainard (1967) suggested long ago. Second, nonstandard monetary policies at the zero bound are perceived by central banks as carrying substantial costs or risks if engaged in on a large scale--hence central banks' hesitancy at undertaking them. Third, expansionary monetary policies carry costs not represented in standard models, including distortions in the composition of investment, impacts on the health of the financial sector, and impacts on the distribution of income. And fourth, history suggests a tendency for low-interest-rate environments to give rise to asset market bubbles, which economists and policymakers today fear more than they did even half a decade ago. Together these considerations indicate that monetary policy cannot bear all the burden. There is thus a strong case for expansionary fiscal policy in a depressed economy.

APPENDIX

An Extra-Output Benefit-Cost Test

If expression 7 in the text does not hold and the government borrowing rate exceeds or will exceed the critical value, then determining the desirability of expansionary fiscal policy calls for a benefit-cost calculation. It is appropriate to weigh present benefits from expansionary fiscal policy against future costs. A natural quantity to examine for such a benefit-cost calculation is the present value of the change in future output: the summed, discounted effects on present and future GDP of contemporary transitory fiscal expansion. (23)

Call these effects [DELTA]V. Then, in terms of the framework of section I, where [DELTA][Y.sub.n] is the impact of the transitory fiscal expansion [DELTA]G on present-period output and [DELTA][Y.sub.f] is the impact on potential output in a representative future period,

(A.1) [DELTA]V = [DELTA][Y.sub.n] + [[DELTA][Y.sub.f]/[r - g]], (24)

where r is in this case the real social rate of time discount, which we identify here with the real government borrowing rate.

Assume that the appropriate long-run measure of r is or will rapidly normalize to a value larger than the growth rate of the tax base g. The economy is thus dynamically efficient. If the economy is not dynamically efficient, then there is no benefit-cost calculation to perform: expansionary fiscal policy is worthwhile.

Fiscal expansion has benefits in terms of higher GDP in the short run through the multiplier. It has benefits in terms of higher future potential output in the long run through the avoidance of hysteresis. These benefits are counterbalanced by the supply-side drag on future potential output from higher tax rates needed to raise the revenue to amortize the higher debt burden.

Equation A.1 assumes that the long-term effects of fiscal expansion, both through avoiding hysteresis and through debt amortization, are truly permanent and scale with economic growth. Thus, [DELTA]V is calculated by discounting [DELTA][Y.sub.f] at the rate r - g. If the effects are long-lasting but not truly permanent, the appropriate discount factor in the analogue of equation A.1 would be higher, but the basic logic of the argument would remain the same: there are short-term benefits and both short- and long-term costs, with the long-term costs attenuated to the extent that the wedge between the borrowing costs and the growth rate of the tax base is relatively low.

The impact [DELTA][Y.sub.n] of the transitory contemporary fiscal expansion [DELTA]G on current-period output is as given by equation 1 in the text. The full impact [DELTA][Y.sub.f] on potential output in a representative future period is more complex. It has two components. The first is the positive impact [eta][DELTA][Y.sub.p] = [eta][mu][DELTA] G from the lessened shadow cast by the downturn on future potential output. The second is the burden imposed on future GDP by the cost of amortizing the debt incurred to finance the fiscal expansion. This second supply-side cost component depends on two factors: (i) the additional debt [DELTA]D that must be amortized, multiplied by (ii) the disincentive effect on potential output from the higher future taxes needed to fund each dollar of amortization; we model this second factor with the parameter [xi], which represents the reduction in future potential output from raising an additional dollar of revenue. However, these costs are themselves partially offset by another supply-side effect: by avoiding or reducing hysteresis, higher current-period GDP allows the burden of amortizing the preexisting costs of government to be spread over a larger tax base, and so allows for lower tax rates and thus further raises future potential output.

If raising an additional dollar of net tax revenue in the representative future period has disincentive effects that reduce future-period GDP by [xi], then the effect on future-period real GDP is

(A.2) [DELTA][Y.sub.f] = {[eta][mu] - [xi][(r - g)(1 - [mu][tau]) - [tau][eta][mu]]}[DELTA]G.

We assume the normal-case value of [xi] to be 0.25 and the extreme-case value to be 0.5.

Discounting equation A.2 back to the present and adding it to equation 1 then produces the net effect of contemporary transitory expansionary fiscal policy on the present value of real GDP:

(A.3) [DELTA]V = {[mu] + [[eta][mu]/[r - g]] + [[xi]/[r - g]][[eta][mu][tau] - (r - g)(1 - [mu][tau])]} [DELTA]G

The first term within the braces on the right-hand side of equation A.3, [mu], is the multiplier term. The second, [eta][mu]/(r - g), is the hysteresis term: the smaller long-term shadow cast by a smaller downturn. The third term is the impact on future potential output of the net burden of additional debt. It is equal to the net impact on government cash flow, from the left-hand side of equation 6, multiplied by [xi], which captures the supply-side benefits to output from lower tax rates, expressed as a present value through division by r - g. This third term is composed of two subterms: [xi][tau][eta][mu]/(r - g) and -[xi](1 - [mu][tau]). The first subterm is the Blanchard and Summers (1987) term: the effect on potential output from lower tax rates made possible by the counterhysteresis effects of the fiscal expansion [DELTA]G on potential output. The second subterm is the burden of amortizing the extra debt needed to finance the fiscal expansion [DELTA]G. Even if this third term is negative and fiscal policy is not self-financing, expansion still passes the extra-output benefit-cost test if the first two terms are large enough to more than counterbalance it.

We draw five significant lessons from equation A.3:

--A fiscal expansion's effects are as much long-run as short-run.

--In a nondepressed economy, fiscal policy is highly likely to fail its benefit-cost test (equation A.3) because the multiplier [mu] is likely to be near zero.

--Even in the absence of hysteresis, fiscal policy may pass its benefit-cost test.

--Failure of the benefit-cost test in a depressed economy seems to require a high disincentive coefficient [xi].

--If interest rates substantially exceed the social rate of time discount, fiscal policy will fail its benefit-cost test.

The first lesson follows from observing that in equation A.3 only the initial term [mu] is a short-run term. Even outside of the consequences for cash flows, long-run benefits are a factor [eta]/(r - g) greater than short-term benefits. For the central case of table 2, with [eta] = 0.05 and [mu] = 1.0, this ratio of short- to long-term benefits is 1.7 at the critical real interest rate of r = 5.77 percent per year. Expansionary fiscal policy thus should not be analyzed as if pursuing it removes political-economic focus from the long run.

As with all present-value calculations at interest rates not too much larger than growth rates, a large proportion of the value comes from the distant future. If we impose the condition that our forecasting horizon ends 25 years into the future, on the grounds that the world more than a generation hence is likely to be different from the world of today in an "unknown unknowns" fashion, the ratio of long-run to short-run benefits falls to 1.14. But it is not just the long-run benefits of current expansionary policy from the counterhysteresis effect that are subject to exhaustion when a truly new deal is dealt; a truly new deal might well alter government financing burdens as well.

Our second lesson is that in a nondepressed economy, the policy-relevant reduced-form multiplier is likely to be small, and thus fiscal policy is highly likely to fail the benefit-cost test. The positive terms in equation A.3 are all linear in [mu] and thus shrink with [mu]. But the negative term [xi](1 - [mu][tau]) is not linear in [mu] and does not become small. The multiplier [mu] relevant for equation A.3 is a reduced-form multiplier inclusive of monetary offset. It is not the multiplier holding real or nominal interest rates constant. It is not even the multiplier holding the monetary base or the money stock constant. It is the multiplier taking into account whatever the typical monetary policy reaction function to macroeconomic news is.

In normal times that inclusive-of-monetary-offset multiplier is small. The central bank will almost invariably have strong views about what course of real aggregate demand is appropriate given its long-run price stability objectives. The central bank will be uninterested in having real demand pushed off what it regards as the appropriate path by the actions of any other agencies of government. It will thus attempt to offset whatever effects expansionary fiscal policy has on aggregate demand. And because central banks can work inside the discretionary fiscal policy decision loop of legislatures and executives, they will do so.

In a depressed economy, things are different. With interest rates at the zero bound, the central bank may lack the power to manage aggregate demand by itself without pushing nonstandard monetary policy beyond the limits it regards as plausible. And even if the central bank believes that it has the power, it may lack the will--and may well lack the formal legal authority--to undertake nonstandard policy measures that might be better classified as quasi-fiscal policies.

If, in a depressed economy, a central bank possesses both the power and the will to target real aggregate demand and offset any effects of fiscal expansion, then the policy-relevant multiplier [mu] in equation A.3 will be sufficiently small that expansionary fiscal policy fails to pass its benefit-cost test. But if the central bank lacks either the power or the will to do so, our argument applies. The fact that expansionary discretionary fiscal policy fails the benefit-cost test of equation A.3 in normal times carries no implications for the test in a depressed economy.

Our third lesson is that even in the absence of hysteresis effects, discretionary expansionary fiscal policy may well pass its benefit-cost test. In the absence of hysteresis effects, when [eta] = 0, equation A.3 becomes

(A.4) [DELTA]V = [[mu] - [xi](1 - [mu][tau])][DELTA]G.

This expression is positive when

(A.5) [mu] > [xi]/[1 + [xi][tau]].

For a tax-and-transfer share [tau] of 1/3, a multiplier p of 0.5 produces a positive extra-output benefit-cost test for any [xi] less than 0.6:

--A [mu] of 1.5 produces a positive benefit-cost test for any [xi] less than 3: a [xi] of 3 would mean that the economy is so far to the right on the Laffer curve that the marginal dollar raised from taxes reduces potential output by $3.

--A [mu] of 1 produces a positive benefit-cost test for any [xi] less than 1.5.

--Even a [mu] of 0.5 would require a [xi] of 0.6, which seems unlikely: other North Atlantic countries have significantly higher values of [tau] with no clearly visible signs of such severe effects of taxes on potential output.

Our fourth lesson is that adding in hysteresis effects through a positive value of [eta] makes the arithmetic of the benefit-cost test of equation A.3 even more compelling. The analogue of expression A.5 then becomes:

(A.6) [mu] > [xi]/[1 + [xi][tau] + [eta](1 + [xi][tau])/(r - g)].

For temporary expansionary fiscal policy to fail its benefit-cost test with even very moderate multiplier and hysteresis effects, the requirements are stringent. For [tau] of 1/3, g of 2.5 percent per year, [mu] of 0.5, [eta] of 0.05, and r of 6 percent per year, temporary fiscal expansion fails its benefit-cost test only if [xi] is greater than 10.

This leads to the fifth and last lesson: Only a small value of [mu] is typically needed in expression A.6 for expansionary fiscal policy to pass the benefit-cost test, because the critical value of [mu] is reduced by the hysteresis term in the denominator, and because the presence of r - g can make this term large. Any set of parameter values in which [eta]/(r - g) is nonnegligible makes the critical value of [mu] small. Thus, the benefit-cost test is likely to be passed unless r - g is relatively large--and in this case r is not the real social rate of time discount but instead the real Treasury borrowing rate. It follows that discretionary fiscal policy in a depressed economy is most likely to fail its benefit-cost test if there is a wedge between the real Treasury borrowing rate (which determines the burden of the debt) and the social rate of time discount (which determines the multiple at which future benefits and costs are capitalized). For a wedge p between the real social rate of time discount r and the government's real borrowing cost r + [rho], the benefit-cost calculation in equation A.3 becomes

(A.7) [DELTA]V = [[mu] + [[eta][mu]/[r - g]] + [[xi][eta][mu][tau]/[r - g]] - [(r + [rho] - g)(1 - [mu][tau])/[r - g]]][DELTA]G.

The costs in the final term on the right-hand side are then amplified by the factor (r + [rho] - g)/(r - g), while the benefits in the first three terms stay the same as they were in equation A.3. A government that must borrow at the terms of a present-day Greece or Spain--or that fears that even marginal additional borrowing will produce a market reaction that will force it to borrow on such terms--will find the arithmetic of expansionary fiscal policy unpleasant indeed. But there is no such wedge for the United States today. Nor are there any visible signs in asset values that the future emergence of such a wedge is priced into today's markets, at any detectable probability.

ACKNOWLEDGMENT'S We would like to thank the Coleman Fung Center for Risk Management at the University of California, Berkeley, and the Berkeley Freshman Seminar Program for financial support. We would like to thank Simon Galle and Charles Smith for excellent research assistance. And we would like to thank Alan Auerbach, Robert Barsky, Gregory Clark, Raj Chetty, Gabriel Chodorow-Reich, Giancarlo Corsetti, Jan Eberly, Barry Eichengreen, Martin Feldstein, Justin Fox, Paul Krugman, James K. Galbraith, Yurii Gorodnichenko, Bob Hall, Jan Hatzius, Bart Hobijn, Greg Ip, Daniel Lee, Miles Kimball, Brock Mendel, John Mondragon, Peter Orszag, Adam Posen, Jonathan Portes, Valerie Ramey, Jesse Rothstein, Matthew Shapiro, Mark Thoma, Robert Waldmann, Johannes Wieland, Jim Wilcox, Michael Woodford, and others, especially Laurence Ball and Christina Romer, and the editors, for helpful comments and discussions.

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Comments and Discussion

COMMENT BY MARTIN FELDSTEIN Bradford DeLong and Lawrence Summers have written a paper that usefully advances the analysis of fiscal deficits, especially in the unusual conditions of the type that have recently prevailed. Their paper takes the analysis of fiscal stimulus programs beyond the commonly asked question, "Does it work in raising GDP?" to the more appropriate analysis of whether the benefits of a fiscal stimulus outweigh the economic costs.

The authors identify three components of that cost-benefit analysis: the basic multiplier measuring the change in short-run GDP due to the increased fiscal deficit, the deadweight cost of raising funds to finance the resulting future debt, and the potential counterhysteresis effect of the increased GDP on human capital and business investment. They are careful to emphasize that their results apply only to the very unusual condition of a deep recession with the Federal Reserve's policy interest rate constrained by the zero lower bound. I will begin by commenting on the cost of raising funds to finance the increased debt and will then turn to the measurement of the multiplier and the hysteresis effect.

THE COST OF INCREASED NATIONAL DEBT The paper lays out the possibility of what others have called a "fiscal free lunch," in which the economic cost of raising funds is zero or negative, appearing to make any kind of government deficit creation worthwhile no matter how small the multiplier may be. If only that were true! There are so many good things that could be done if the economic cost of increasing the national debt were actually zero or negative. Extending the tax cuts that are due to expire at the end of 2012 would have favorable incentive effects in addition to any Keynesian demand effects. Reducing the mortgage debt of homeowners who owe more than their homes are worth not only would help those individuals but also would remove the housing debt overhang as a barrier to a robust recovery. There are so many appealing things to do when government money is essentially free.

It is important to understand what causes the fiscal free lunch in the authors' analysis and to recognize several other considerations that they have omitted that increase that cost of funds. DeLong and Summers conclude that government financing today, with the real interest rate on long-term Treasury bonds below the real growth rate of the economy, is costless because, under that condition, the denominator of the debt-to-GDP ratio rises more rapidly than the numerator. Specifically, the real annual interest rate on 30-year Treasury inflation-protected securities as of early 2012 was just 0.80 percent, below the 2.5 percent long-term real GDP growth rate projected by the Congressional Budget Office. The debt ratio therefore declines without the need to raise future taxes.

But DeLong and Summers's focus on interest payments ignores four important costs of increasing the national debt even under the special economic circumstances that their paper assumes. When these are taken into account, the cost of increasing the national debt is potentially much greater than just the real net interest payments.

The first cost is that due to foreign ownership of the debt. In the early Keynesian debates about the cost of fiscal deficits, a commonly heard statement was that the debt had no cost because "we owe it to ourselves." Economists eventually recognized that that argument was wrong because servicing the debt requires distortionary taxes and because government borrowing can crowd out productive private investment. DeLong and Summers take the tax cost into account but assume away the possibility of crowding out.

Unlike in those early days, however, the majority of the U.S. government debt is now held by foreign investors, who are likely to buy an even larger share of any prospective increases in the debt. Servicing that increased debt in the future will require an increase in net exports, requiring in turn a lower real value of the dollar relative to the currencies of the United States' trading partners. Such a decline in the U.S. terms of trade reduces real incomes in the United States by raising the cost of imports in terms of forgone consumption of goods and services produced in the United States.

The second unaccounted-for cost is reduced real investment. DeLong and Summers acknowledge that under normal economic conditions an increase in the government debt crowds out productive investment in plant and equipment. They argue, however, that such crowding out is not relevant now because real interest rates are low and are not increased by additional government borrowing.

But investment in plant and equipment depends on more than the rate of interest. American companies now have enormous amounts of liquid assets but are not investing those funds in new plant and equipment. Although there are many reasons for this reluctance to invest, a significant one is the concern about the future tax implications of the large and growing fiscal deficit. DeLong and Summers can argue that current deficits do not imply higher future taxes, but any business executive who reads the newspaper can anticipate that those deficits will raise future taxes on corporate profits and personal incomes.

To the extent that each dollar of government deficit reduces investment in plant and equipment, it lowers future incomes by the product of that change in capital and the real marginal product of capital. The long-run value of the real marginal product of capital is about 10 percent. Although the magnitude of the deficit-induced reduction in the capital stock is difficult to estimate, I have no doubt that it exists at the current time.

A third cost is increased economic vulnerability. A larger national debt makes the United States more vulnerable to external upward shocks to interest rates. It also makes such shocks more likely, as the recent experience in Europe demonstrates. Such interest rate increases could be caused by a lack of confidence in U.S. budget controls or by expectations of increased inflation in the United States. Here the fact noted above, that more than half of all U.S. government debt is held by foreign investors, takes on further significance.

A rise in interest rates globally because of a changing balance of supply and demand for fixed-income securities would have a greater impact on the cost of future debt service in direct proportion to the size of the national debt. Thus, any increase in the debt now could raise debt-service costs in the future in response to the higher interest rates.

More generally, the increased likelihood of higher future interest rates that results from an increased debt applies to the entire stock of the government debt as it is rolled over. It also applies to private debt and equity markets.

A final cost of increased government debt takes the form of a reduction in the government's room to maneuver. The United States may want to increase the deficit in the future for any of a variety of reasons, including countercyclical policy and national security spending. The ability to do so depends on the level of the national debt at the time. An increase in the national debt now may reduce the government's discretion to deal with future problems.

It is well beyond the scope of this comment to evaluate the implied cost of these four adverse effects of a greater national debt, but I have no doubt that they are real and significant. Even if the comparison of the real net interest rate and the growth rate implies a low or negative cost of deficit finance at the present time, these four adverse effects imply that the benefits of fiscal policy even under the current circumstances must be substantial if they are to outweigh the total costs.

THE MULTIPLIER DeLong and Summers, relying on work by Valerie Ramey and others, estimate a multiplier on government spending of about 1.5. They note in passing that these econometric estimates of the multiplier refer to government spending and, specifically, to the national income and product accounts (NIPA) measure of government spending. They are not based on the budget measure of the fiscal policy that adds to the national debt. One reason that researchers have had a hard time estimating the fiscal multiplier is that there have been very few changes in NIPA government spending other than military spending.

DeLong and Summers's analysis is presumably intended to apply to fiscal policies like the major stimulus package enacted in 2009, the $850 billion American Recovery and Reinvestment Act (ARRA). It is important that very little of this $850 billion in increased government spending was counted as such in the NIPA. The major parts of the ARRA took the form of transfers to state governments and individuals as well as temporary tax cuts. The multiplier evidence that DeLong and Summers cite is therefore not relevant to this type of budget spending. Although it might be assumed that the transfers to states would lead to spending by state and local governments that could be then evaluated using spending multipliers based on NIPA data, that assumption is not warranted. It is not known to what extent the ARRA funds substituted for state governments' rainy-day funds or for the temporary tax increases (with low multiplier effects associated with temporary tax changes) that states might otherwise have enacted.

HYSTERESIS EFFECTS DeLong and Summers note that in a deep and long downturn like the one that began in 2007, workers who experience long spells of unemployment suffer a loss of human capital, and underinvestment in plant and equipment results in lost productivity. They argue that to the extent that fiscal stimulus raises GDP, it will reduce these losses of human and physical capital.

Although I accept that general point, it is unclear how substantial this effect is. To the extent that the basic multiplier on outlays like those under ARRA is small, the counterhysteresis effects will be correspondingly small. More important, I think the authors ignore the significant countervailing effect of increased productivity that occurred in this downturn, as firms responded to the slow recovery of demand by laying off workers and changing production methods.

CONCLUSION This paper is important because it develops a benefitcost framework for evaluating the desirability of fiscal stimulus policy by taking into account the size of the multipliel, the present value of the deadweight costs of future debt service, and the counterhysteresis effects of the improvements in human and physical capital that under certain circumstances accompany the multiplier-generated increase in GDE The authors are careful to note that their conclusion about the desirability of a fiscal stimulus applies only to the case of a deep recession with monetary policy constrained by the zero lower bound on interest rates. My analysis within their framework, however, does not lead to the same support for the kind of fiscal policy represented by the ARRA. The reason for my skepticism about the positive benefit-cost ratio reflects different evaluations of their three components of the benefit-cost calculation. To summarize:

--I believe the multiplier evidence based on NIPA military spending cannot be applied to budget outlays that do not raise NIPA government spending.

--I think the cost of adding to the deficit includes more than just the deadweight losses associated with the additional future interest costs.

--I view the gains from counterhysteresis effects as overstated both because the multiplier effect is small and because the downturn also induced productivity-enhancing changes in production.

COMMENT BY VALERIE A. RAMEY This paper proposes the very intriguing idea that government stimulus packages enacted during a severe downturn can be self-financing. Bradford DeLong and Lawrence Summers have actively participated in the public debate on this issue, both in and outside of government, in op-eds and on blogs, so a paper on this topic by them is of particular interest. When I was first asked to discuss the paper, I felt the same kind of anticipation that I did for the 1992 Olympics. Why? Because those were the first Olympics in which athletes who had gone professional were allowed to come back and compete with the amateurs. In the 1992 Summer Games, the U.S. basketball "Dream Team," which included such players as Michael Jordan, Magic Johnson, and Larry Bird, beat every other team by huge margins and won the gold. However, the returning pros in the subsequent Winter Games, which included such celebrated skaters as Katarina Witt and Brian Boitano, and Jayne Torvill and Christopher Dean, did not do as well. Although they all skated beautifully, the Olympic judges put more emphasis on precision than did the audiences they had performed for as pros. Thus, Torvill and Dean captured only the bronze and the rest did not win medals at all. The question then is, Are DeLong and Summers the "Dream Team," or are they Torvill and Dean?

I will first summarize DeLong and Summers's central idea and highlight some notable elements of their model. Since a key part of their hypothesis is the ability of government spending to reverse hysteresis effects, I will offer some evidence that can be viewed as a test of these effects. I will then assess the notion, which also appears elsewhere in the literature, that the fiscal multiplier may be higher when interest rates are at the zero lower bound and economic slack is high. Finally, I will offer a word of caution on extrapolating from past interest rates.

HYSTERESIS, THE ZERO LOWER BOUND, AND FISCAL STIMULUS DeLong and Summers very clearly present their main idea and their view of how the economy works. They argue that most of the time output is supply-determined and equal to potential output, as in a neoclassical model. Government spending at such times has no impact on output. During times such as the Great Recession and its aftermath, however, output is below potential and is demand-driven. In such a depressed economy, government spending can raise output.

In addition, the authors assume that current output levels can have an effect on future potential output, and thus on actual future output during supply-determined times--a hysteresis effect. Olivier Blanchard and Summers (1986) first introduced the idea of hysteresis effects in the context of lingering high unemployment in Europe, and they appealed to an insideroutsider theory of labor markets to motivate the idea. In the present context, DeLong and Summers appeal to various factors, such as the deterioration of the skills and labor force attachment of the unemployed and the long-term effect on capital of depressed investment rates. They present a very useful summary of the micro evidence on persistence of labor supply decisions as well as macro evidence on the link between financial crises and subsequent output growth.

On top of this structure, the authors also consider the unusually low interest rates prevailing in the U.S. economy today. These low rates potentially have two effects. First, as numerous papers have argued, when nominal interest rates hit their zero lower bound (ZLB), monetary policy becomes impotent and fiscal policy can become more powerful than usual. Second, the low interest rates make budget deficits very cheap to finance.

This view of how the economy works naturally leads to DeLong and Summers's main conclusion: for a variety of parameter values, short-run increases in government spending during a slump can pay for themselves in the long run. The obvious implication is that fear of large budget deficits should not prevent the federal government from enacting another stimulus package in order to boost aggregate demand. This conclusion is essentially the Keynesian version of so-called supply-side economics, which the Reagan administration used to argue that tax cuts could stimulate the economy enough so that tax revenue would actually rise. Another way to look at it is as the new version of Say's Law: "In a depressed economy, government spending creates its own financing."

IS A SIMPLE MODEL BETTER? DeLong and Summers's model has more in common with standard undergraduate textbook macroeconomic models than with the typical models used at the graduate level or in research papers. For example, there is no discussion of their assumptions about fundamentals such as preferences, technology, and resource constraints. Also, the model is missing the "GE" of DSGE models, for there is no general equilibrium. The paper is silent on why interest rates are so low and why they should be expected to remain so low. Overall, the model is quite stripped down relative to standard modern macroeconomic models.

There are advantages and disadvantages of presenting this idea in such a simplified model. The advantages are several. First, because the model is so stark, the idea is very clearly presented and not obfuscated by inessential technical details. Second, because the idea is not embedded in one of the standard macroeconomic models, it avoids invoking those models' sometimes questionable assumptions.

However, the reason that modern macroeconomics has moved to models with carefully specified assumptions and microfoundations is that without them, one can often end up implicitly making contradictory or dubious assumptions. The reason that one can find many faults with modern macroeconomic models is precisely that they are explicit about their assumptions. Although these models have a long way to go to find better ways to model the economy, I do not think that replacing them with a model based on imprecisely specified intuitive ideas is an improvement. Indeed, I see that as a disadvantage of the approach.

THE KEY RELATIONSHIP IN THE MODEL DeLong and Summers's idea boils down to one key mathematical expression that they derive from their assumptions about government spending multipliers and hysteresis. According to their model, an increase in government spending to stimulate the economy during a recession can be self-financing (in the sense of generating an increase in annual tax revenue sufficient to pay for the increase in annual debt service) if the following condition holds:

r < g + [eta][mu][tau] / 1 - [mu][tau],

where r is the interest rate on government bonds, g is the growth rate of potential output, [eta] is the hysteresis effect of current output on future potential output, [tau] is the tax rate, and p is the government spending multiplier. The intuition behind this equation is as follows. If output is below potential, it can be spurred by an increase in government spending. The multiplier p is the measure of how much output rises for a given dollar increase in government spending. This increase in current output is then translated into higher future potential output through the hysteresis effect [eta]. These two effects imply that for plausible values of [mu] and [eta] and a given tax rate [tau], future annual tax revenue will increase more than the required increase in annual debt service. I will devote the rest of my discussion to exploring some evidence on three of the five parameters of this equation: the hysteresis parameter [eta], the government spending multiplier [mu], and the long-term interest rate r.

THE HYSTERESIS PARAMETER DeLong and Summers include a very nice summary of the literature on various features of the economy that could lead to hysteresis. As they acknowledge, however, estimating the extent of hysteresis is very difficult, since it is difficult to distinguish the lingering effects of the recession itself (that is, state dependence) from the continuing effects of the unobserved forces that caused the recession. Nevertheless, the evidence the authors compile is quite interesting. One of the mechanisms they discuss is the potential loss of worker skills or labor force attachment that might result from extended periods of unemployment. The recent evidence presented by Steven Davis and Till yon Wachter (2011) of significant and persistent losses in income to workers displaced during a recession is certainly suggestive. As Robert Hall points out in his discussion of that paper, however, whether losses to individual workers represent social losses or just redistributions of rents remains to be seen. If they are the latter, then these losses do not represent actual losses in worker skills.

DeLong and Summers discuss a second mechanism for hysteresis that works through private investment: shortfalls in private investment during a recession, they argue, can lead to persistent effects through reductions in the capital stock. It is certainly the case that a prolonged slump in investment can lead to a significantly lower capital stock and hence lower potential GDE As I will argue below, however, it is not clear that government spending can reverse this effect.

As DeLong and Summers themselves recognize, most of their arguments suggest persistent, but not permanent, effects. A positive depreciation rate on the hysteresis effect can have a sizable effect on their calculations. For example, consider the simulation results in their table 2, which indicate that for [eta] of 0.025 and [mu] of 1.5, a stimulus package is self-financing as long as the real government interest rate is below 4.95 percent. But suppose, using the same parameters, that the hysteresis effect has a depreciation rate of 10 percent per year. Then only half of the necessary tax revenue is being collected 6 years in the future. Thus, their calculations hinge importantly on their assumption of permanent hysteresis effects.

For the sake of argument, suppose that hysteresis effects are indeed permanent. DeLong and Summers's argument still requires another assumption to support their policy prescription of more stimulus spending: they must assume that raising output with government spending can reverse the hysteresis effect. It is not obvious to me that an increase in government spending would create the private investment and skill-building jobs required to do that.

Even without specifying the individual mechanisms, one can test this hypothesis on U.S. data. In particular, if DeLong and Summers are correct that a change in real government spending G raises real GDP Y in the short run, it should have a persistent effect on output. That is, if one can identify exogenous movements in government spending that have led to temporary increases in real output, those increases should have a much more persistent effect on output if there are hysteresis effects. To study this, I use my analysis from Ramey (2011, 2012), which identifies exogenous shocks from military events that generated changes in the expected present discounted value of government spending. I also use a method of identification like that in Blanchard and Roberto Perotti (2002) to show that the results are not limited to just my identification method. The models are estimated from 1939Q1 to 2008Q4. Estimation is by vector autoregressions (VARs) containing log real government spending per capita, log real GDP per capita, the average marginal tax rate from Robert Barro and Charles Redlick (2011), the 3-month Treasury bill rate, log total hours worked per capita, and log real nonresidential investment per capita (all in levels). The Blanchard and Perotti structural VAR (SVAR) identifies the shock to be the shock to government spending, ordered first in the VAR. My EVAR ("expectational VAR") includes my military news variable ordered first and uses shocks to it as the government spending shock. Four lags are used and a quadratic trend is included.

[FIGURE 1 OMITTED]

My figures 1 and 2 show the impulse responses (with 95 percent confidence intervals based on bootstrap standard errors) of four of the variables of interest: government spending, real GDP, total hours, and nonresidential investment. In both specifications, a shock raises both government spending and real GDE They both peak around 6 quarters after the shock and are back to normal by 16 quarters. Total hours also rise, but nonresidential investment falls. Thus, in the historical data, investment is moving in the opposite direction from that which would produce the counterhysteresis effects that the authors argue for. Nor is there evidence of a persistent effect of government spending on real GDE

[FIGURE 2 OMITTED]

Since my news variable captures only movements in government spending based on military events, one might wonder whether other types of government spending would have more long-lasting effects. The results using Blanchard and Perotti's framework use a shock to all types of government spending, and yet there is no more evidence of persistent effects on output. In sum, this evidence does not support the notion that an increase in government spending that raises output in the short run has lingering effects on output.

THE GOVERNMENT SPENDING MULTIPLIER A recent paper of mine (Ramey 2012) uses a more precise way to estimate the multiplier in both a VAR and an instrumental variables regression. In particular, it looks at the effect of government spending on private spending (Y-G). This method indicates that the multiplier is significantly below unity--about 0.5 when tax effects are accounted for. DeLong and Summers and numerous others have argued, however, that the multiplier may be higher when there is slack in the economy (Auerbach and Gorodnichenko forthcoming) or when interest rates are at the zero lower bound (Eggertsson 2001).

In principle, it is possible to test this hypothesis on historical data. In work in progress, I have been studying the period from 1933 to 1951. As my figure 3 shows, this period was characterized by very low interest rates, similar to today's, as well as very high unemployment rates for much of the period. Of course, the presence of World War II, with patriotism raising labor force participation rates and controls on the economy dampening consumer spending, make interpretation of the period very complex. It is nonetheless interesting to at least search for differential multipliers during this period.

For this period, I thus estimate the following equation:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where I is a dummy variable that takes the value of 1 when the unemployment rate is above 7 percent and zero otherwise, and [epsilon] is the error term. I allow all of the coefficients, including the multipliers, to vary according to whether the unemployment rate is above or below 7 percent. The coefficient [[beta].sub.1] gives the multiplier when the unemployment rate is below 7 percent, and [[beta].sub.1] + [[beta].'sub.1]'gives the multiplier when the unemployment rate is above 7 percent.

The data used are monthly from January 1933 to March 1951 (the month when the Treasury Accord restoring Federal Reserve independence was signed). The GDP and government spending data are from Robert Gordon and Robert Krenn (2010). The unemployment series are based on my data collection and include emergency workers. To address both the possible endogeneity of government spending and the impact of measurement error from the way that Gordon and Krenn construct their interpolated series, I instrument for government spending growth with lags 2 through 4 of government spending growth (relative to GDP).

My estimate of the multiplier [3, when the unemployment rate is below 7 percent is 0.581, with a standard error of 0.119. The increment to the multiplier during slack times is estimated to be -0.012, with a standard error of 0.535. Thus, the regression provides no evidence of a higher multiplier during slack times, although the high standard error indicates substantial uncertainty.

[FIGURE 3 OMITTED]

This simple analysis finds no support for multipliers that are higher during times of slack and accommodative monetary policies. The analysis presented above is quite simple, and there is some evidence to the contrary in later periods, so more research should be done on this issue.

THE GOVERNMENT INTEREST RATE DeLong and Summers look at historical data on long-term government interest rates to argue that it is unlikely that interest rates will rise significantly. Here it is wise to bear in mind the Lucas critique (Lucas 1976). In particular, the historical data the authors examine were not generated in a regime in which entitlements were projected to lead to ever-rising deficits as in the current situation.

[FIGURE 4 OMITTED]

To illustrate the perils of extrapolating from the past, consider the "tale of two countries" told in my figure 4. The top panel shows interest rates on long-term government bonds for two countries from 2000 through 2007. Both countries displayed similar patterns in interest rates over this period.

Now consider the paths of interest rates in the two countries when the sample is extended through 2011 (bottom panel). The interest rate for country A remains low while that for country B suddenly explodes and reaches 25 percent. Country A is the United States, and country B is Greece. Simply extrapolating from the past behavior of interest rates would never have led one to predict that interest rates would rise so far in Greece. Thus, current low interest rates should not be taken as a sign of future low interest rates.

CONCLUSIONS DeLong and Summers present the very intriguing idea that government spending can be self-financing when used to stimulate an economy in which output is below potential. Although I have concerns about the lack of rigor of their theoretical model, the idea is still quite interesting. My simple empirical investigations of the hysteresis effect and the government spending multiplier, however, indicate that those two parameters might not be as high as they need to be for this idea to work. Moreover, I have suggested caution in using current low interest rates to forecast the future path of interest rates. Nevertheless, DeLong and Summers have introduced an important new idea that clearly merits future research. This is what we expect from Olympic gold medal winners.

REFERENCES FOR THE RAMEY COMMENT

Auerbach, Alan, and Yurii Gorodnichenko. Forthcoming. "Fiscal Multipliers in Recession and Expansion." In Fiscal Policy after the Financial Crisis, edited by Alberto Alesina and Francesco Giavazzi. University of Chicago Press.

Barro, Robert J., and Charles J. Redlick. 2011. "Macroeconomic Effects from Government Purchases and Taxes." Quarterly Journal of Economics 126 (February): 51-102.

Blanchard, Olivier, and Roberto Perotti. 2002. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output." Quarterly Journal of Economics 117: 1329-68.

Blanchard, Olivier, and Lawrence Summers. 1986. "Hysteresis and the European Unemployment Problem." NBER Macroeconomics Annual 1: 15-90.

Davis, Steven, and Till von Wachter. 2011. "Recessions and the Cost of Job Loss." BPEA, no. 2: 1-72.

Eggertsson, Gauti. 2001. "Real Government Spending in a Liquidity Trap." Working paper. Federal Reserve Bank of New York.

Gordon, Robert J., and Robert Krenn. 2010. "The End of the Great Depression: VAR Insight on the Roles of Monetary and Fiscal Policy." Working Paper no. 16380. Cambridge, Mass.: National Bureau of Economic Research (September).

Hall, Robert E. 2011. Comment on "Recessions and the Cost of Job Loss" by Steven Davis and Till von Wachter. BPEA (Fall): 56-61.

Lucas, Robert E. 1976. "Econometric Policy Evaluation: A Critique." Carnegie-Rochester Conference Series on Public Policy 1: 19-46.

Ramey, Valerie A. 2011. "Identifying Government Spending Shocks: It's All in the Timing," Quarterly Journal of Economics 126 (February): 1-50.

--. 2012. "Government Spending and Private Activity." Working Paper no. 17787. Cambridge, Mass.: National Bureau of Economic Research.

GENERAL DISCUSSION Robert Hall observed that a better title for the paper would be "Eta," since the paper's surprising results all stem from the authors' beliefs about the value of their hysteresis parameter [eta]. The other parameter values the authors used for their simulations seemed mostly reasonable and uncontroversial to Hall. He noted that although Valerie Ramey had estimated a relatively low value for the multiplier on fiscal spending, the standard error on her estimate was large and did not rule out the possibility that the authors' baseline value of 1.5 was correct. Hall also observed that some alternative ways of analyzing government spending data from World War II generated higher estimates of the multiplier. He found the authors' value for the growth rate reasonable, and although he shared Ramey's concern about the authors' real interest rate assumptions, he thought their baseline value might be reasonable as well.

For the most important parameter, q, however, Hall felt that much more work was needed to arrive at a credible estimate. He noted that for the interesting cases in the authors' analysis, r - g is small, which makes the present value of extra output due to avoided hysteresis significant for decades into the future. In such cases, then, the appropriate value for [eta] would be an average not just over the next decade but over many decades.

Econometrics, however, simply cannot answer the question of whether hysteresis effects, or the effects of avoided hysteresis, are significant far into the future, Hall argued. The "unit root" literature of the late 1980s had found that it was impossible to precisely estimate the persistence of shocks to GDP, yet small differences in the persistence of government spending shocks had very different implications for the analysis. And even if it were possible to estimate the long-run effects of such a shock, the United States has not experienced a government purchases shock in many years. The 2009 stimulus package did not constitute such a shock, as the positive effect of the package on government purchases was slightly more than offset by negative effects from other sources. Hall was skeptical of the suggestion of using CBO revisions to GDP estimates as a source for estimating [eta], since these revisions were not made in response to fiscal shocks.

Finally, Hall thought that in their discussion of [eta], the authors had written with great enthusiasm about the forces that might make [eta] strongly positive while neglecting forces that might make it less positive or negative.

Eric Swanson thought the authors were correct to use the long-term interest rate at which businesses and households can borrow as the relevant one for their analysis of the fiscal multiplier. However, he felt that the authors' view of monetary policy was too narrow in that it equated the stance of monetary policy with the current level of the federal funds rate. In his view a better measure was a medium-term interest rate such as the two-year Treasury yield, which reflects not just where the federal funds rate is at present, but also where it is expected to go over the next several quarters. This view was shaped by discussions Swanson had had with Brian Sack and research he had conducted with Sack and Refet Gurkaynak, in which they found that Federal Open Market Committee statements had large effects on the yield curve above and beyond the direct effect of changes in the federal funds rate. These effects seemed to be driven by changes in financial market expectations about the future path of the funds rate in response to forward-looking language in the FOMC statement. Thus, the FOMC appeared to have the ability to directly affect medium-term interest rates such as the two-year Treasury yield through its statements, consistent with the Eggertsson-Woodford view of monetary policy.

Taking the correct view of monetary policy mattered, Swanson continued, because if it was true that a better measure of monetary policy is the two-year Treasury yield, it was unclear that the zero lower bound was a meaningful constraint on monetary policy in 2008, 2009, and much of 2010, since yields at that maturity were consistently between 80 and 100 basis points during that period. Away from the zero lower bound, government spending can crowd out private investment by raising interest rates. Indeed, in a recent working paper with John Williams, Swanson had found that between 2008 and 2010, two-year Treasury yields were just as sensitive to economic announcements as they had been in the 1990s, when the zero bound was clearly not a constraint. Thus, the fiscal multiplier was likely to have been no larger than normal during this period. By late 2011, two-year Treasury yields had fallen below 30 basis points and were then, according to the same working paper, about half as sensitive to economic news as in the 1990s, suggesting that crowding-out effects were half as important as usual. Even in late 2011, however, corporate yields remained as sensitive to economic news as in earlier years, suggesting that crowding out might be as important as ever. What appeared to be driving this effect was that until very recently, the private sector appeared resolute in its belief that a recovery or inflation or both would occur within the next few quarters, forcing the Federal Reserve to raise interest rates. The most recent FOMC commitments to keeping rates low through mid-2013 and late 2014 appeared to have finally altered those beliefs.

Arvind Krishnamurthy, citing work he had done with Annette Vissing-Jorgensen, thought one reason Treasury yields were currently so low was that a global shortage of safe and liquid assets had led investors to place a high safety and liquidity premium on Treasury bonds. Krishnamurthy warned that this premium could easily disappear in the next few years, which made it risky for the government to finance significant new spending with short-term bonds. Financing with long-term bonds would avoid this risk but would command higher interest rates, reflecting market expectations that the safety and liquidity premium on Treasury bonds would disappear over time. These higher rates, he thought, were the ones the authors ought to consider in their analysis. Pointing to his work with Vissing-Jorgensen on estimates of the elasticity of interest rates to the size of the government's debt, Krishnamurthy suggested that the authors should account for the likelihood that increasing government debt would push up interest rates.

Justin Wolfers endorsed Hall's view that [eta] was the paper's key parameter. He noted that the economics profession knows amazingly little about the degree and extent of hysteresis and that exploring the policy implications of this uncertainty was itself an interesting exercise. He thought that the nonzero probability of 13 being positive made Summers and DeLong's analysis worthwhile. Today's high long-term unemployment rate made Wolfers worry that [eta] was indeed positive, although he felt the paper should equally consider forces that might make [eta] low or negative, including those identified by Ramey.

Wolfers also suggested that uncertainty about q had equally large implications to explore for monetary policy. Economists have changed their thinking about monetary policy after realizing that inflation can cast a long shadow as it shifts markets' long-run inflation expectations, and the potentially long shadow of unemployment and other forms of hysteresis could be similarly important.

Martin Baily hoped the authors would do more to tie their analysis to the current situation in the United States. Specifically, he wondered whether their model implied that the federal government ought to undertake more stimulus now, even though politics made that possibility extremely unlikely. Baily had been worried that more spending would push the nation over a fiscal cliff, and he was therefore intrigued by DeLong and Summers's suggestion that more spending today could actually reduce future deficits.

Baily also said that he agreed that the stimulus had improved the economy relative to the outcome with no stimulus, but it was surprisingly hard to show that the 2009 stimulus bill had been instrumental in turning the economy around from a decline in annualized GDP growth of 8.9 percent in the fourth quarter of 2008 to almost 4 percent positive growth in the fourth quarter of 2009. The automatic stabilizers, he thought, might have played at least as large a role in the turnaround, and growing exports and inventories had also contributed substantially. Meanwhile government purchases had not increased much over that period, and disposable income, which the stimulus bill had explicitly sought to boost, had continued to fall.

Ricardo Reis agreed strongly with Hall and Wolfers that this was a paper about [eta]. Most macroeconomists who had studied the unit root literature of the late 1980s equated that root with technology shocks. But Reis saw little to no evidence that the sole determinant of long-run GDP was technology. He viewed [eta], then, as a parameter that could capture the effects of various short-run interventions on long-run output, where different types of interventions have different values of [eta], and the higher its [eta], the larger an intervention's impact. He thought the authors should do more to explain their view that government spending, in general, has a high [eta], and that they would do well to differentiate among the [eta]s of different types of government spending, such as tax rebates, infrastructure spending, or investment in science research.

Reis also agreed with Ramey that the authors ought to develop a model of what determines [eta], although he was indifferent as to whether this model was a dynamic stochastic general equilibrium model or something else. He noted that in recent years Philippe Aghion had made some progress in this area, modeling the mechanism through which recessions can induce lower research and development spending and so reduce potential output, as well as empirically measuring the long-run scars of recessions through R&D spending.

Christopher Carroll agreed with Hall that it was impossible to test for the existence of long-run hysteresis effects in aggregate data but was optimistic about the possibility of measuring it at the micro level. As an example, Steven Davis and Till von Wachter, in a paper in the previous issue of the Brookings Papers, had found that individuals laid off during recessions suffer long-run earnings losses over 50 percent larger than those experienced by individuals laid off during expansions. Carroll found this result suggestive of important long-run hysteresis effects. Hall disagreed, however, saying his view was that the result was driven by selection effects.

Carroll also singled out a result from the Stock and Watson paper, presented before the Panel the previous day, that he found striking: One of the major reasons the recent recession appeared different from previous ones was that the economy effectively suffered a major negative monetary policy shock when interest rates hit the zero lower bound. Because of this practical barrier to negative interest rates, the federal funds rate remained stuck at a value that was two or three percentage points too high. Once one accounted for this shock, the macrodynamics of the economy were similar to those of previous recessions.

This result led Carroll to wonder whether automatic fiscal stabilizers had played a more important role than previously understood in minimizing the long-term damage from economic downturns, and if so, whether in light of the recent experience it would make sense to put even more of these stabilizers in place, to further reduce the odds of hitting the zero bound. Additional automatic stabilizers might also help circumvent the political challenges of passing one-time stimulus bills in a timely manner.

Olivier Blanchard agreed with Hall that the Congressional Budget Office's revisions to its economic forecasts could shed no light on hysteresis. In fact, all these revisions meant was that the CBO had discovered that the economy had experienced supply shocks, which affect long-run GDP growth, not that transitory shocks were having permanent effects. Blanchard also thought that pure time-series econometric techniques could not, on their own, be used to test for the existence of hysteresis, since they cannot distinguish between the effects of permanent shocks, such as a permanent increase in the price of oil, and the permanent effects of a transitory shock, such as an increase in consumption due to rising animal spirits. Finally, Blanchard thought it was a misnomer to call [eta] a "hysteresis" parameter, since hysteresis implies a permanent effect, whereas the authors' analysis would still hold if the effects of [eta] were long-lasting but not permanent.

Betsey Stevenson concurred with Reis that different types of government spending could have very different effects and that it was important to distinguish among them. Building on Carroll's point about automatic stabilizers, she wondered what types of stabilizers might be most desirable. For example, should education spending rise automatically when unemployment rises? Or would it be a better idea to spend more on highways?

Michael Woodford agreed with Blanchard that it was impossible to isolate evidence of hysteresis in revisions to potential output during recessions. He saw the problem as fundamentally an issue of signal extraction: Even if short-run deviations from potential output had no effect on long-run potential output, one would expect to find a correlation between short-run deviations below full output and lower long-run potential output. And even if deviations from potential output really did cause long-run potential output to fall, government purchases during a recession would not necessarily prevent that. The channel through which deviations from potential output decrease long-run output might, for example, be decreased investment, in which case more government purchases would not improve long-run potential output; indeed, if these purchases negatively impact private investment, they might lower potential output. Finally, Woodford thought the authors were wrong to assume that hysteresis effects, if they exist at all, are permanent. He encouraged the authors to test the sensitivity of their results to different lengths of persistence of hysteresis.

David Romer agreed with those panelists who thought the authors should develop a more fully specified model, and he cited an example of an aspect of the economy that their model ignored that could affect their results. The authors had not specified what determines the rate of inflation. Suppose that it is determined by an accelerationist Phillips curve. In that case, higher output today would lead to higher inflation in the long run unless the Federal Reserve restricted output at some point in the future, and that, Romer suspected, would undermine the authors' result that fiscal spending at the zero lower bound has long-run benefits. Romer doubted that, in fact, an accelerationist Phillips curve characterized the U.S. economy today, but the example indicated that it would be prudent for the authors to lay out a fuller set of assumptions about the structure of the economy. Without a more complete model, readers are left to guess about the conditions under which the paper's results apply.

Martin Feldstein agreed with the authors that some aspects of cyclical weakness could have a negative influence on long-run potential output. For example, workers' skills might decay when they are out of work, and business productivity might be harmed when their capital is underutilized. However, he thought it important also to consider aspects of cyclical weakness that might work to increase long-run potential output. In the current economy, for example, one reason for the persistently low labor force participation rate was that many younger people were staying in school and presumably building human capital. There was also evidence that many businesses, after realizing the downturn would last a long time, had taken the opportunity to figure out how to produce more with fewer workers, which could translate into long-run productivity gains.

Responding to the discussion, Lawrence Summers said he was well aware of the costs of long-run budget deficits that Feldstein had stressed in his formal comment, and he underlined that the key to his and DeLong's argument was that, if their model is correct, short-run fiscal expansion actually reduces, not increases, the long-run deficit. He thought that investors in southern European countries appeared to be placing real stock in such a possibility today: concerns about long-run growth and competitiveness, which could be improved by fiscal expansion--and not concerns about fiscal profligacy--seemed increasingly to be a factor driving up interest rates on government bonds in the region. The fact that Spain had a smaller budget deficit than Germany just four years ago also lent support to the view that the prospect of weaker long-run growth, not deficits, was weighing most heavily on the minds of investors these days.

Summers also clarified that he and DeLong had not meant to argue that, so long as the interest rate is less than the growth rate, government ought to spend limitlessly--a view that Summers saw as akin to the fallacy that since stocks, on average, return more than bonds, one ought to try to borrow without limit to buy stocks. Rather, he and DeLong had tried to demonstrate that a combination of hysteresis and multiplier effects made government spending look attractive under economic conditions like those prevailing today. Responding to Krishnamurthy, Summers said that he and DeLong had not intended to suggest a permanence to the liquidity premium on government bonds as grounds for fiscal expansion.

Summers said that he and DeLong would certainly study Ramey's work on estimating the fiscal multiplier. However, he questioned how well the multiplier could be identified by examining the World War II period, since so much was going on in the economy alongside the burst of government spending at that time.

Summers agreed with Swanson that the federal funds rate is not a sufficient statistic for monetary policy and that, in theory, if the Federal Reserve responds to expansionary fiscal policy by doing less quantitative easing or less forward-looking signaling, it will offset expansionary policy much as it does in normal times. Summers thought that he and DeLong should consider the evidence Swanson had referenced suggesting that monetary offsetting of fiscal expansion was a real concern.

Summers agreed with the panelists who had suggested that the parameter [eta] was of central importance to the paper. Responding to Reis and Stevenson, he did not doubt that the marginal productivities of, for example, investing in infrastructure and investing in the National Science Foundation differ in interesting and important ways, but he thought it beyond the scope of the paper to compare their long-run supply-side effects. The real impetus for the paper, Summers said, was to explore the implications of loosening an assumption that had become popular following the unit root debate, which was that only technology shocks have permanent effects on long-run potential output. An alternative view, that reductions in aggregate demand could also have protracted effects, seemed to have substantial enough implications for optimal fiscal policy that it was worth modeling more carefully.

On whether it made sense to use revisions to CBO forecasts to test for hysteresis, Summers thought that if one added the identifying assumption that fluctuations in output between 2007 and 2010 were driven by aggregate demand shocks and not aggregate supply shocks, one could then develop an estimate of the hysteresis parameter using the CBO revisions. One might develop such an identifying assumption by more carefully specifying resource strengths.

Summers thought it reasonable to question the permanence of hysteresis effects and appreciated the skepticism that panelists had expressed about results that hinged on the weight of outcomes 75 years in the future. In fact, he and DeLong had included a decay rate on the effects of [eta] in earlier drafts of the paper and might in the final draft either reinstate it or include an examination of debt-to-income ratios after 15 years.

Finally, Summers disagreed with Feldstein's view that current deficits could significantly reduce private investment by making investors worry about higher future taxes on corporate profits and personal income. The value of new capital investment is closely related to the value of existing capital, and the strong growth in market value of existing capital over the past two years made it seem implausible to Summers that concerns about tax hikes were reducing investors' expectations about the future profitability of capital.

J. BRADFORD DELONG

University of California, Berkeley

LAWRENCE H. SUMMERS

Harvard University

(1.) of course, this case is strengthened and the long-term benefits of debt-financed government purchases at the zero bound are amplified if the government purchases themselves are directly productive and so boost the economy's stock of public capital or private human capital.

(2.) This point was made a generation ago by Blanchard and Summers (1987). As Erceg and Linde (2010) recently put it, there could then be a "fiscal free lunch."

(3.) Most estimates of Federal Reserve reaction functions suggest that, if it were possible to have negative short-term safe nominal interest rates, such rates would have been chosen in recent years. This fact indicates the relevance of our analysis. See Rudebusch (2009) and Taylor (2010).

(4.) It is worth stressing that with current real Treasury interest rates near zero (some estimates are provided later in this section), even if additional spending had no impact on current GDP, every government investment project that promises a positive real rate of return of any magnitude would boost the present value of future real GDP.

(5.) In the main text of this paper, r refers to both the social rate of time discount and the government's borrowing rate. The appendix considers the case when these two need to be distinguished.

(6.) For a somewhat different argument that austerity worsens the government's budget balance, see Denes, Eggertsson, and Gilbukh (2012).

(7.) This point is by no means new: see Lerner (1943). Wray (2002) argues that Milton Friedman's post-World War II proposal for stabilization policy achieved through a money supply provided by countercyclical deficit financing and 100 percent reserve banking is in its essence the same idea.

(8.) How is it that a government can borrow at less than the social rate of time discount? Perhaps because government debt has unique collateralization properties that make it in some sense "money-like" (see Krishnamurthy and Vissing-Jorgensen 2012). In this case the wedge between the government borrowing rate and the social rate of time discount captures a real service flow provided to the economy by the provision of extra government debt. To the extent that the government can borrow unusually cheaply because investors are making mistakes, the welfare economics becomes complex.

(9.) See, among many, many others, Ramey and Shapiro (1998), Blanchard and Perotti (2002), Gordon and Krenn (2010), Suarez Serrato and Wingender (2010), Clemens and Miran (2010), Barro and Redlick (2011), Nakamura and Steinsson (2011), Chodorow-Reich and others (2011), Romer (2011). Mendel (2012), and Ramey (2012). Moretti (2010) estimates a local multiplier that is explicitly a supply-side economic-geography concept rather than a demand-side macroeconomic concept. The relationship between economic-geography local multipliers and macroeconomic local multipliers is not clear to us.

(10.) See Parker (2011) on the importance of nonlinearities and on the difficulty of picking out the depressed-economy multiplier of interest here. Hall (forthcoming), however, cautions that Auerbach and Gorodnichenko's finding "has little to do with the current thought that the multiplier is much higher when the interest rate is at its lower bound of zero ... [for their] ... sample surely includes only a few years when any country apart from Japan was near the lower bound."

(11.) There remains some uneasiness about the interpretation of local multiplier estimates. The presence of demand spillovers across regions tends to bias such estimates down, as does the possibility that higher expected inflation rates, in the manner of Christiano, Eichenbaum, and Rebelo (2011) and Eggertsson and Krugman (2011), are a channel of transmission. Moreover, consider a permanent increase in government purchases in one region financed by taxes on all regions. Under a full Ricardian regime, such a permanent increase in spending would have no effect at all on demand and output. Yet a local multiplier study would show a considerable multiplier in both the short and the long run--an economic-geography parameter: the inverse of 1 minus the share of regional demand spent on locally produced commodities. As Mendel (2012) points out, local multiplier studies not only hold monetary and financial conditions constant; they also hold constant future fiscal conditions in the form of expectations of future broad-based taxes. To the extent that the argument against the effectiveness of expansionary fiscal policy relies on present-day reductions in spending stemming from anticipated future tax burdens, local multiplier studies will overstate the policy-relevant concept.

(12.) Christiano and others (2011), Eggertsson and Krugman (2012), and others point out that the impact of upward price pressure expected from expanded aggregate demand on real interest rates at the zero bound could have substantial quantitative significance. Earlier the same point had been phrased in reverse, as a fear of the potentially catastrophic consequences of deflation. See Fisher (1933).

(13.) The effects on duration premiums are less clear. One potential channel is that, in a depressed economy, with short-term safe nominal interest rates at their zero lower bound, if monetary authorities are willing to commit to keeping them there for a considerable period, the framework-relevant reduced-form multiplier is likely to be even larger to the extent that inflation is inertial: higher inflation in the short run due to fiscal expansion will raise expected inflation and thus lower the real interest rates expected for future periods as well. With a product-market equilibrium condition IS slope [alpha] of -0.6 as in Hall (2012), an expected duration of the zero lower bound of 3 years could double the policy-relevant reduced-form multiplier relative to the constant-monetary-and-financial-conditions multiplier.

(14.) Such calibration efforts are hazardous. The potential for selection effects to confound estimates is large. There is little warrant for believing that the difference between income losses following layoffs in low- and those in high-unemployment periods in the past corresponds to the effects of a shock outside the previous range like the one the U.S. economy is now experiencing.

(15.) Ball (1997, p. 168). See, in addition, Stockhammer and Sturn (2012), who also conclude that the degree of labor-side hysteresis is likely to have only weak connections with labor market institutions but a rather strong association with the persistence of high unemployment and the failure of activist stabilization policies to quickly fill the output gaps created by downturns. In their results, hysteresis has "strong [associations with] monetary policy, and ... [perhaps] the change in the terms of trade, but weak (if any) effects of labour market institutions during recession periods. Those countries which more aggressively reduced their real interest rates in the vulnerable period of a recession experienced a much smaller increase in the NAIRU...."

(16.) Also consistent is Romer (1989), who argues that the output effects of demand shocks are very long lasting.

(17.) An alternative also put forward by Blanchard and Summers (1986) focuses on how the long-term unemployed become detached from the labor market. See Granovetter (1973) and especially Layard, Nickell, and Jackman (2005).

(18.) See Daly, Hobijn, and Valetta (2011). There is a potential argument for an interaction effect, however: perhaps the older labor force of today is more likely to be induced into early retirement by the experience of unemployment.

(19.) The CBO's estimates are found in its Budget and Economic Outlook, various issues; those of the Federal Open Market Committee in its Summary of Economic Projections, various issues; and those of the Survey of Professional Forecasters in Federal Reserve Bank of Philadelphia (2011).

(20.) The IMF is relatively strident on this point. It writes of "sobering implications" of the analysis and praises "forceful macroeconomic policy response[s] ... in the form of substantial fiscal and monetary stimulus."

(21.) Note that Gordon and Krenn (2010) find a multiplier of 1.88 for the pre-Pearl Harbor mobilization for World War II at the zero nominal bound when they end their sample in the still demand-constrained first half of 1941, but of only 0.88 when they end their sample at the end of 1941, when supply constraints begin to bite. This feature does not make it into modern models. As Hall (forthcoming) comments. "The simple idea that output and employment are constrained at full employment is not reflected in any modern model that I know of. The cutting edge of general-equilibrium modeling--seen primarily in the DSGE models popular at central banks around the world--incorporates price and wage stickiness that makes supply quite elastic both above and below full employment."

(22.) See Erceg and Linde (2010) on the nonlinearity of responses to fiscal expansion at the zero bound.

(23.) The change in the present value of output can, of course, be questioned as a welfare measure. In contexts like the present, however, we suspect that the social value of the leisure of the currently unemployed is low, and that society attaches a high value to the extra output gained in the future by, for example, avoiding cutbacks to innovation spending or by avoiding labor force withdrawal by those who after a long spell of unemployment retire or apply for disability. See Krueger and Mueller (2011), Gordon (1973), Granovetter (1973), and Gordon (2011).

(24.) In this equation and throughout the appendix we suppress a "length-of-short-run" parameter in order to make the notation less cumbersome.

Table 1. Parameter Values for the Base Case

Parameter Interpretation Assumed value

[mu] Present-period government spending 0-2.5
 multiplier

r Real government borrowing rate and social 0.025-?
 rate of time discount, per year

g Trend growth rate of potential GDP, per 0.025
 year

[tau] Marginal tax-and-transfer rate 0.333

[xi] Disincentive effect: reduction in 0.25-0.5
 potential output from raising additional
 tax revenue

[eta] Hysteresis effect: proportional reduction 0-0.2
 in potential output from a temporary
 downturn

Table 2. Critical Values of the Real Treasury Rate for Fiscal
Expansion to Be Self-Financing

 Critical real Treasury interest rate
 for indicated value of multiplier
 [mu] (percent per year) (a)

Hysteresis [eta] [mu] = 0 [mu] = 0.5 [mu] = 1.0

0 2.50 2.50 2.50
0.025 2.50 2.99 3.73
0.050 2.50 3.49 4.96
0.100 2.50 4.48 7.43
0.200 2.50 6.45 12.35

 Critical real Treasury
 interest rate for
 indicated value of
 multiplier [mu] (percent
 per year) (a)

Hysteresis [eta] [mu] = 1.5 [mu] = 2.5

0 2.50 2.50
0.025 4.95 14.29
0.050 7.40 26.07
0.100 12.30 49.64
0.200 22.10 96.97

Source: Authors' calculations.

(a.) The critical rate is the highest rate that satisfies
expression 7 in the text. Other parameters take the values
assumed in table 1.