Posted by: Dirk | January 24, 2014

DSGE models and effects of high government debt levels

The Journal of the European Economic Association has published its latest issue. It carries an article that reminds me why neo-classical economists need (!) to prove that higher government debt to GDP levels are bad. If it would be otherwise, than fiscal expansion would – in a liquidity trap – always increase GDP! Erceg and Lindé from the FED ask ‘Is there a Fiscal Free Lunch in a Liquidity Trap?’. Their 2010 working paper with the same title has the following abstract (my highlighting):

This paper uses a DSGE model to examine the effects of an expansion in government spending in a liquidity trap. If the liquidity trap is very prolonged, the spending multiplier can be much larger than in normal circumstances, and the budgetary costs minimal. But given this fiscal free lunch, it is unclear why policymakers would want to limit the size of fiscal expansion. Our paper addresses this question in a model environment in which the duration of the liquidity trap is determined endogenously, and depends on the size of the fiscal stimulus. We show that even if the multiplier is high for small increases in government spending, it may decrease substantially at higher spending levels; thus, it is crucial to distinguish between the marginal and average responses of output and government debt.

It is crucial for the DSGE model community to show that the multiplier will be lower the higher government debt to GDP levels are. If this would not be the case, then fiscal expansion would provide a free lunch. It is now clear why the neo-classical DSGE community invested some much work into “proving” that reality features falling fiscal multiplicators. If it would not, then expanding government spending would always lead to higher incomes and more GDP. So, from the DSGE perspective, losing the argument of falling multiplicators – as they did – would mean that their model is wrong. Either that, or reality is the problem and the data must be tortured until it confesses.

If we assume that the DSGE model is wrong, is the result of the argument lost that now Keynesians walk around saying that an increase in government spending will always increase GDP and hence it is good economics to increase government spending? No. Why not? Because (Post-)Keynesian economists know that this is not correct. There are things that can go wrong. Here is a list of issues why not to increase government debt even if there is no falling multiplicator when government debt to GDP hits three digit levels:

  1. You do not want to increase government debt in some instances (while having a negative current account, for instance) if you do not have a sovereign currency (like in the euro zone, or dollarized economies like Ecuador).
  2. You do not want to increase government debt if the result in GDP growth leads to a negative current account, which might lead to more debt, which eventually might be denominated in foreign currency. You don’t want to borrow in foreign currencies because you are then exposed to bankruptcy. This might first affect the private sector, but if the government is forced to take over private debts (like in Ireland) then the public sector will be affected as well.
  3. Your economy is at full employment and an increase in government debt would lead to inflation. Technically, this is a bit complicated because the idea of the fiscal free lunch, as presented by the authors above, only applies in a liquidity trap. However, even outside a liquidity trap the argument that government debt should be stagnant applies at full employment.

So whoever thinks that if DSGE models are given up the barbarians will take over, be assured: the barbarians are actually quite civilized. They worry about inflation, they do not advocate more government spending in all situations, and they look not only at the private and public but also at the external sector. There is no reason to assume that with DSGE models gone from policy-making, the result is a complete change in policy. In a depressed economy (which some call a liquidity trap) more fiscal spending would be advocated to increase incomes and GDP, thus allowing the private sector to pay off some debt more easily. Apart from that (which would be quite helpful), I cannot see any big changes.

If the barbarians are let into policy-making with their non-DSGE models I would expect evolution and not revolution.

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