Zombie Arguments Against Fiscal Stimulus

Busy days. I just want to drop a quick note on a piece just published on the Financial Times that is puzzling on many levels. Ruchir Sharma pleads against Joe Biden’s stimulus on the ground that it risks “exacerbating inequality and low productivity growth”. The bulk of the argument is in this paragraph:

Mr Biden captured this elite view perfectly when he said, in announcing his spending plan: “With interest rates at historic lows, we cannot afford inaction.”

This view overlooks the corrosive effects that ever higher deficits and debt have already had on the global economy. These effects, unlike roaring inflation or the dollar’s demise, are not speculative warnings of a future crisis. There is increasing evidence, from the Bank for International Settlements, the OECD and Wall Street that four straight decades of growing government intervention in the economy have led to slowing productivity growth — shrinking the overall pie — and rising wealth inequality.

If one reads the two papers cited by Sharma, they say, in a nutshell, (a) that expansionary monetary policies have deepened income inequality via an increase in asset prices (while for low interest rates and bond prices there is no clear link); (b) that the increasing share of zombie firms drags down the performance of more productive firms thus slowing down overall productivity growth.

So far so good. So where is the problem? Linking these results to excessive debt and deficit, to the “constant stimulus”, is stretched (and I am being kind). A clear case of Zombie Economics.

Let’s start with monetary policy and its impact on inequality (side note: the effect is not so clear-cut). One may see expansionary monetary policies as the consequence of fiscal dominance, excessive deficit and debt that force central banks to finance the government. But, they can also be seen as the consequence of stagnant aggregate demand that is not properly addressed by excessively restrictive fiscal policies, forcing central banks to step in. Many have argued in the past decade that especially in the Eurozone one of the causes of central bank activism was the inertia of fiscal policies. Don’t take my word. Read former ECB President Mario Draghi’s Farewell speech, in October 2019:

Today, we are in a situation where low interest rates are not delivering the same degree of stimulus as in the past, because the rate of return on investment in the economy has fallen. Monetary policy can still achieve its objective, but it can do so faster and with fewer side effects if fiscal policies are aligned with it. This is why, since 2014, the ECB has gradually placed more emphasis on the macroeconomic policy mix in the euro area.

A more active fiscal policy in the euro area would make it possible to adjust our policies more quickly and lead to higher interest rates.

This is as straightforward as a central banker can be: in order to go back to standard monetary policy making, fiscal policy needs to step up its game. Notice that Draghi also hints to another source of problems: the causality does not go from expansionary policies to low interest rates, but the other way round. We have been living in a a long period of secular stagnation, excess savings, low interest rates and chronic demand deficiency which monetary policy expansion can accommodate by keeping its rates close to “the natural” rate, but not address. Once again, fiscal policy should do the job.

Regarding zombie firms, it is unclear, barring the current and very special situation created by the pandemics, why this would prove that stimulus is unwarranted. The paper describes a secular trend whose roots are in insufficient business investment and a drop in potential growth rate (that in turn the authors link to a drop in multi-factor productivity). The debate on the role of fiscal policy in these matters is as old as macroeconomics. In the past ten years, nevertheless, the cursor has moved against the Sharma’s priors and an increasing body of literature points to crowding-in effects: especially when the stock of public capital is too low (as is the case in most advanced countries), an increase of public investment — “constant stimulus”– has a positive impact on private investment and potential growth (see for reference the most recent IMF fiscal monitor and the chapter by EIB economists of the European Public Investment Outlook). Lack of public investment is also widely believed to be one of the factors keeping our economies stuck in secular stagnation.

Fifteen years ago one could have read Sharma’s case against fiscal policy on many (more or less prestigious) outlets. Even then, it would have been easy to argue that it was flawed and fundamentally built on an ideological prior. Today, it seems simply written by somebody living in another galaxy.