The stagflation experienced by Western economies in the 1970s was to prove this wrong and lead to a drastic rethinking of macroeconomics. The new paradigm, as proposed by the economist Milton Friedman, was to be found in central banks controlling the money supply – i.e. managing inflation – and not boosting or restricting demand via monetary policy.
A key advantage of this new approach was unlike government spending it was impervious to political pressure for short-term benefits (monetary authorities such as the US Federal Reserve and the European Central Bank are in theory independent from the state’s governance).
This view still held sway in the wake of the 2008 financial crisis. Indeed, even though many major economies around the world pursued demand-side policies in the form of fiscal stimulus packages, these were often shortlived: governments believed monetary policy would pick up the remaining slack.
The Bank of England, for example, cut base rates severely, from 5.75% in December 2007 down to a mere 0.5% in 2009. The US Federal Reserve also lowered its federal funds rate at the end of 2008 to within a target range of between 0.0% and 0.25%.
What has led the mainstream to come round to the view of a few dissident voices in the wake of the crisis (e.g. the economists James Galbraith and Paul Krugman) is not the financial meltdown itself but rather the ineffectiveness of the excessive reliance on monetary policy. In other words, it has failed to raise inflation and kickstart growth – a predicament termed secular stagnation by economist Larry Summers.
This shift has important implications for the EU, whose governments currently have limited room to manoeuvre under the Maastricht deficit and debt limits . Given this, France Stratégie invited Jason Furman, chairman of President Obama’s Council of Economic Advisors (CEA), to discuss his recent paper, “The New View of Fiscal Policy and Its Application”, on this shift in macroeconomic policy.
In his paper he refers to the pre-crisis consensus on fiscal policy as the “Old View”. Under this school of thought, monetary policy is seen as a more effective means than fiscal policy to buoy economies in a downturn. Moreover, the latter is seen as ineffective as it leads to higher interest rates and thus crowds out private investment. In effect, government spending under this view will replace private investment.
What’s more, if the stimulus comes in the form of, say, a tax rebate, there is the argument that citizens will save it in anticipation of future tax hikes rather than spend it (the Ricardian equivalence).
In addition, opponents of fiscal stimulus would argue that often when the government decides to spend the recession is well under way. And by the time the stimulus kicks in it can be over, which means liquidity is injected into an economy on the upswing.
Lastly, the Old View holds that if the state must resort to spending as a policy tool, then the main priority should be to ensure the debt incurred is sustainable through targeted and temporary stimulus. It should be done in the short run, bolstering the economy until monetary policy stimulus kicks in.
The comeback
The shift towards Keynesian policies – essentially the core of what Furman calls the New View – is a reaction to the aftermath of the 2008 financial crisis and “…the increased realization that equilibrium interest rates have been declining for decades.” Pressure has also come from new research “…on the impact of fiscal policy as well as observations of the reaction of sovereign debt markets to the large increases in debt as a share of GDP in the wake of the global financial crisis” in advanced economies.
This New View sees fiscal policy as a beneficial complement to monetary policy during a downturn. One of the main reasons this is the case is simply because, as mentioned, across the advanced economies equilibrium interest rates have been decreasing continually over the past three and a half decades – and this despite the markets and economists predicting the opposite. This has constrained monetary policy’s ability to kick-start investment and economic growth. Regardless of the cause, Furman pointed out in his presentation that interest rates are unlikely to increase any time soon.
The second principle behind the New View is that rather than discouraging investment as monetarists contend, fiscal policy can actually spur investment by raising aggregate demand and growth rates. This is the opposite of monetary policy, which can amount to “pushing on a string”, as Keynes termed it, when rates are low.
Another important point is that contrary to what monetary policy advocates claim, fiscal stimulus can actually reduce the debt-to-GDP ratio and improve fiscal sustainability by increasing output more than it raises debt. Concretely, this means countries may have more leeway to spend during a downturn than previously contended.
Moreover, Furman added that circumstances have changed regarding many countries’ long-run fiscal challenges in the past five years. Not only is growth in healthcare costs lower than expected, but net interest payments on government debt as a share of GDP are quite low across most major advanced economies.
Furman emphasizes in his paper that there is today a disconnect between the growing academic and intellectual consensus around the New View and its application by policymakers. For Europe, he notes that while macroeconomic institutions were created to oversee the EU’s monetary policy, no one body has been created to administer fiscal policy on a European level.
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