Academic journal article National Institute Economic Review

Lessons from Failure: Fiscal Policy, Indulgence and Ideology

Academic journal article National Institute Economic Review

Lessons from Failure: Fiscal Policy, Indulgence and Ideology

Article excerpt

Macroeconomic theory clearly suggests that at the zero lower bound, fiscal contraction will reduce output and slow any recovery. Yet in 2010 the focus of fiscal policy in many countries switched from supporting activity to reducing debt, despite the fact that the recovery from recession often appeared weak. While high levels of public debt can explain this switch in some countries, it does not provide a satisfactory account in others. In addition, the possibility of using balanced budget fiscal expansion or tax switches that bring forward spending remain largely unexplored. This paper suggests that policy has been influenced by an opposition to countercyclical fiscal policy which has ideological roots.

Keywords: Countercyclical fiscal policy; government debt; deficit bias; balanced budget fiscal expansion

JEL Classifications: A14; E62; E63: E65; H63

I. Introduction

"The tragedy of our current economic mess is that the solution to our problems is not, in fact, mysterious--basic macroeconomics, macroeconomics that has worked quite well in the last two years, shows the way. But the men in suits have decided that they know better. "

Paul Krugman, 13/09/10

Over the past thirty years, macroeconomics has made tremendous progress in knowing how to deal with modest macroeconomic shocks. The great moderation period demonstrated that an active monetary policy, coupled with explicit or implicit inflation targets and operated by independent central banks, could stabilise both output and inflation. (1) Unfortunately what is now becoming increasingly clear is that policymakers are not able to deal with large negative macroeconomic shocks.

During the first phase of the current recession, the prognosis about how macroeconomic policy responds to a large negative shock looked more optimistic. Monetary policy cut interest rates rapidly and as far as possible (although with hindsight US policymakers did rather better than those in Europe), and fiscal policy was actively used both in the US, the UK, China and other countries. Lessons from the 1930s appeared to have been learnt. However the use of discretionary countercyclical fiscal policy was opposed by many. Partly as a result, fiscal action was insufficient to prevent large falls in output across the globe.

In 2010 the view of policymakers (the 'men in suits' referred to in Krugman's quote above) changed decisively towards the need for austerity to reduce public debt. The likely consequence is that in many countries the recovery will not close the output gap for a number of years. This will waste a huge amount of resources, and cause widespread unhappiness. So we have a failure of macroeconomic policy: not on the same scale of the 1930s, but a failure of substantial proportions nevertheless. This paper is about why that has occurred.

For many economists policy failure can be put down to the inability of politics to control public debt during the period before the recession: what is often called deficit bias. This is the indulgence referred to in the title. It is clearly the case that past deficit bias has made fiscal expansion more difficult, and for a few countries it has become impossible. However, is high debt a sufficient explanation for why fiscal expansion has been abandoned? This paper makes two points which suggest it is not.

1) Not all countercyclical fiscal policy needs to involve an increase in debt. A failure to use balanced budget fiscal expansions has to be explained some other way.

2) The debt situation has not been a critical problem (a problem that has to be addressed immediately) for many countries. In those countries fiscal expansion today, followed by austerity tomorrow, is technically both feasible and probably optimal from a macroeconomic point of view. It may not be feasible politically, but those who oppose it have not generally focused on this political constraint. …

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