How much of a boost to economic activity will a fiscal stimulus provide? For those who believe that we have entered a Keynesian world of shortage of aggregate demand--me included--the answer depends on the Keynesian multiplier. The size of this multiplier depends in turn on three things in particular, the marginal propensity to consume (c), the marginal tax rate (t), and the marginal propensity to import (m). If c=0.8, t=0.2, and m=0.2, the Keynesian multiplier is 1.8 (=1/(1-c(1-t)+m)). A $1 trillion fiscal stimulus would increase GDP by $1.8 trillion.
Now suppose that we had a way to raise the multiplier by more than half, from 1.8 to 2.8. The same fiscal stimulus would now produce an increase in GDP of $2.8 trillion--quite a difference. Nice deal if you can get it.
In fact you can. It is pretty easy to increase the multiplier; just raise import tariffs by enough so that the marginal propensity to import out of income is reduced substantially (to zero if you want the multiplier to go all the way to 2.8). Yes, yes, import protection is inefficient and not a very neighborly thing to do--but should we really care if the alternative is significantly lower growth and higher unemployment? More to the point, will Obama and his advisers care?
Being the open economy that it is, I fear that the U.S. will have to confront this dilemma sooner or later. In an environment where the dollar has already appreciated against the Euro and even more significantly against emerging market currencies, fiscal stimulus here will produce an even larger current account deficit. If American consumers decide to spend 40 cents of a dollar of additional income on cheap imports from China and other foreign countries, the multiplier will be a mere 1.3. How long will it take before politicians of all stripes cry foul over the leakage through the trade account and the "gift to foreigners" that this represents? And they will have Keynesian logic on their side.
The way out of this dilemma is to get the rest of the world to engage in fiscal expansion at the same time--so that the gift is returned. The good news here is that China is playing along and hopefully the Europeans will too (if they can convince Germans to get over their weird obsession with fiscal conservatism).
But most developing nations are constrained by weak fiscal fundamentals. They cannot play the fiscal stimulus game because their borrowing capacity is limited: external finance is drying up and domestic financial markets cannot absorb the increase in public debt without a sharp rise in interest rates.
So unless we come up with a solution to the credit constraints in the developing world, we are going to either endanger the effectiveness of Keynesian policies in the U.S. and other advanced nations, or risk a sharp increase in protectionism. Not a pleasant choice.
Two solutions suggest themselves. One is to enlarge global liquidity by creating new SDR allocations and handing them over to developing nations to increase their spending. The other is to institute a Tobin tax on foreign currency transactions and pass the proceeds on to the developing nations.
Exceptional times, exceptional measures.