At present and going forward, activist fiscal policy is likely to be essential for the American economy to operate near potential levels of output and employment. This conclusion is a substantial change in view from the near-consensus of economists that monetary policy alone could and should be left to carry out the stabilization policy mission, a view that prevailed for nearly a generation prior to the 2008 financial crisis.
As of 2007, what was then called the “Great Moderation” in the United States had lasted for 20 years. Since 1984 fluctuations in output and unemployment had been modest and seemed to even out over time, and confidence grew that the business cycle had been largely tamed. Much of the credit for this experience went to monetary policy, which had learned how to coarsely tune if not fine-tune the economy. In 1997, it was Paul Krugman who said, “the unemployment rate will be what Alan Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” The Federal Reserve appeared to have the tools to successfully manage aggregate demand to achieve the maximum levels of employment and production consistent with rough price stability.
As of 2007, a near-consensus of economists likewise agreed that fiscal policy should not be a tool for smoothing the business cycle. Instead, the focus of good fiscal policy was the right-sizing of government spending and the control of budget deficits. Preventing excessive deficits was essential to maintaining confidence and avoiding unduly high interest rates that would slow economic growth. Adding an unnecessary stabilization policy mission to fiscal policy, so the near-consensus went, could only create distraction and confusion to no benefit.
But in 2008 the Great Moderation came to an abrupt close, as the financial crisis that started in 2007 ushered in the Great Recession. On December 5, 2008, the Federal Reserve lowered the federal funds rate below 20 basis points (0.2 percent), using up all its conventional monetary policy ammunition. Since then, the Federal Reserve has sought to boost aggregate demand through the unconventional policies of forward guidance and quantitative easing. Yet in spite of this monetary stimulus, the recovery that technically began in the second half of 2009 has been dismal in terms of moving output and employment toward their pre-2008 trends, and in comparison with previous recoveries from deep recessions.
In some ways, the end of the Great Moderation and the onset of the Great Recession have had remarkably little impact on public policy debates. The most discussed economic issue in Washington over the last four years has been the need for strong action to achieve fiscal consolidation, not the urgency of restoring full employment. Despite the fact that inflation and employment are both well below target, the vast majority of criticism directed at the Fed has been claims that its policy has been too lax.
If there has been a change in public discourse, it has been a shift from the optimism of the Great Moderation to a growing belief that the damage to the labor force and economy from the Great Recession is permanent, that we are settling into a “new normal” in which employment levels easily reached before 2008 are now unattainable.
But while the new economic conditions of the post-Great Moderation era do require substantially new economic thinking, they do not warrant an attitude of resignation about a semi-stagnant new normal. Ironically, the appropriate new thinking is largely old thinking: traditional Keynesian ideas of the 1930s to 1960s that were largely downplayed in the wake of the stagflation of the 1970s and the accompanying “New Classical” revolution in macroeconomic theory. The most important of these ideas are these three concepts: Keynes’s view that the liquidity trap, or zero bound on short-term nominal interest rates, can sharply limit the efficacy of monetary stabilization policy; President Kennedy’s “Economics 101” view of the desirability of fiscal stimulus during a slump; and the possibility that a prolonged episode of weak demand and high unemployment in an economy may have destructive consequences for aggregate supply.
After outlining these ideas in the pages that follow, we discuss policy implications. In an economy with a depressed labor market and monetary policy constrained by the zero bound, there is strong case for a fiscal expansion to boost aggregate demand. The benefits from such a policy greatly exceed traditional estimates of fiscal multipliers, both because increases in demand raise expected inflation, which reduces real interest rates, and because pushing the economy toward full employment will have positive effects on the labor force and productivity that last for a long time.
We argue that in a liquidity trap environment like the one we are experiencing at present, properly designed fiscal stimulus is likely to reduce rather than increase the long-run debt burden. This outcome reflects a combination of (1) the direct benefits of stimulus in raising revenues; (2) the favorable impact of increased gross domestic product (GDP) in reducing the debt/GDP ratio; (3) the possibility that fiscal stimulus today reduces future spending burdens, such as the cost of deferred maintenance; (4) favorable supply impacts of public investments; and (5) possible reductions in real interest rate costs that come from increases in expected inflation.
We also present new evidence derived from recent research at the Federal Reserve. Reifschneider et al. introduce “hysteresis” on the supply side into the Federal Reserve’s principal macroeconomic model. Hysteresis refers to a situation in which cyclical economic downturns diminish the economy’s ability to produce output in the future. The finding from this exercise is that a sustained increase in government purchases can reduce the long-run debt/GDP ratio, even in the absence of direct supply-side benefits from government purchases, and even in the absence of any impact of current purchases on future needs for government spending.