Kicking the tyres of fiscal stimulus

Did it work?

We rarely see articles that provide a balanced view about the effects of the stimulus, and when Daryl Montgomery wrote his a week ago here, that was no exception. The article simply needs a response.

The need for stimulus
Fiscal stimulus is helpful stabilizing and economic downturn, especially when other policy measures (that is, monetary policy) have largely been exhausted. With interest rates essentially at zero, the latter is undoubtedly the case.

That is, monetary policy has a habit of losing much of its traction, and this is exactly what happened in the aftermath of the financial crisis. In the famous words of Richard Koo from Nomura, if central banks cut interest rates to zero and nothing happens, it’s not an ordinary world. This world is in a liquidity trap (described here).

The ineffectiveness of monetary policy in the aftermath of a financial crisis isn’t that hard to understand. Balance sheets of households are ravished because their assets (mainly housing) have reduced in value while the debt remains. They’re repairing their balance sheets by spending less and saving more, irrespective of interest rates. That is, the private sector (savings minus investment) moves into huge surplus (see figure below). [Read on here]