Krugman and Plosser on Deleveraging

On March 6, 2013, Philadelphia Fed President Charles Plosser argued that low interest rates are actually causing people to save more, not less, because the income effect currently outweighs the substitution effect. In his words:

The conventional view is that by lowering interest rates, monetary accommodation tends to encourage households to reduce savings and thus consume more today. However, as I’ve noted, in the current circumstances, consumers have strong incentives to save. They are deleveraging and trying to restore the health of their balance sheets so they will be able to retire or put their children through college. They are behaving wisely and in a perfectly rational and prudent way in the face of the reduction in wealth.

In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small. And large budget deficits suggest to households that they are likely to face higher taxes in the future, which also encourages more saving. In my view, until household balance sheets are restored to a level that consumers and households are comfortable with, consumption will remain sluggish. Attempts to increase economic “stimulus” may not help speed up the process and may actually prolong it.

This reminds me of an article by Paul Krugman last year called Deleveraging Shocks and the Multiplier (Sort of Wonkish).

So, the simple but surely broadly correct story of the mess we’re in is that we had a period of excessive complacency about leverage, which came to a sudden end. Household debt in particular surged, then was suddenly perceived as excessive...

Leveraging up, other things equal, leads to high aggregate demand — but this can be and is in practice offset by the central bank, which can always raise rates. Deleveraging, on the other hand, can’t be offset equally easily; the central bank can cut rates, but only to zero, and unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried).

So far, Plosser and Krugman more or less agree. Households are deleveraging because they really want to deleverage, we're at the zero lower bound, and unconventional monetary policy is iffy. (As Plosser puts it, "We are operating in an uncertain environment and using nontraditional policies with which we have limited experience.")

Here's where the big, big difference comes in. Plosser also said that fiscal stimulus wouldn't work in this scenario because "large budget deficits suggest to households that they are likely to face higher taxes in the future, which also encourages more saving." Let's break this down.

An increase in the deficit raises both current income and expected future taxes. If the government spending multiplier is one, an increase in the deficit is neutral for consumption. So people consume the same amount they otherwise would have, and save the additional income to use to pay future taxes.Yes, large deficits encourage more saving, but without reducing consumption. In other words, they increase the total level of savings people have, but they decrease the rate of saving out of current income. The rate versus level distinction is important. If households follow some heuristic about a minimum theshold level of saving they want to achieve (e.g. make sure to have $5,000 saved in case of emergency), then they could reach that threshold quicker (and stop deleveraging) through fiscal stimulus. And that is just assuming the multiplier is one. Even better if it is larger...which of course brings us back to Krugman:

Now, the same thing that makes deleveraging so hard to handle also makes the fiscal multiplier larger than it is in normal times. Normally, expansionary fiscal policy is offset by monetary tightening, contractionary policy by monetary loosening. Hence the lowish multiplier estimates based on recent history. But if deleveraging has pushed you into a liquidity trap, there are no offsets...Start by provisionally assuming a frictionless world in which consumers have perfect foresight and perfect access to capital markets. In that case the multiplier should be exactly 1...A rise in government spending does mean higher expected future taxes — but it also means higher incomes right now, and those two effects should exactly cancel each other.

Now add in realistic frictions, notably households that are liquidity-constrained and/or use rules of thumb based on current income to make spending decisions. (By the way, as Gauti Eggertsson and I have pointed out, once you’re using a debt/deleveraging model you are already in effect assuming that many households face liquidity constraints). These frictions will mean that a rise or fall in current income due to fiscal policy will lead to at least some movement of consumption in the same direction. So we get a multiplier bigger than 1.

But I would add that this is not just a question of whether the multiplier is bigger than one. Whether or not the multiplier is bigger than one, in fact just as long as it is bigger than zero, fiscal policy will at least help people reach their level-of-savings targets quicker, if that is the way some people decide how much to save (which seems intuitively reasonable.) Unfortunately, as Meryl Motika pointed out in her post yesterday, we don't know enough yet about how people decide to save. And that's getting to be a highly pressing issue for both monetary and fiscal policy.