Fiscal Policy Reconsidered

By Blinder, Alan S. | Policy Brief Series (Hamilton Project), May 1, 2016 | Go to article overview

Fiscal Policy Reconsidered


Blinder, Alan S., Policy Brief Series (Hamilton Project)


The lengthy Struggle to emerge from the Great Recession has led to a serious rethinking of a previous verdict: that the job of stabilization policy, with its goal of achieving full employment and low inflation, could and should be left exclusively to monetary policy. Fiscal policy, it had previously been concluded, was too slow, too clumsy, and too political to be relied on, and central banks were ready, willing, and able to do the job.

This view has since been challenged. In a new Hamilton Project policy proposal, Alan S. Blinder of Princeton University reassesses the role of fiscal policy, proposing a series of reforms and best practices to guide the use of fiscal stimulus, or tax cuts and additional government spending, during the next economic downturn. Noting that conventional monetary policy, which consists chiefly of manipulating interest rates, would be relatively ineffective in the event of a new recession given the very low interest rates now prevailing, Blinder argues that policy makers will have little choice but to consider fiscal stimulus. He also points to evidence that monetary and fiscal tools amplify each other's effects, strengthening the argument for using both to alleviate a recession.

In his proposal, Blinder identifies opportunities for improving fiscal stimulus on both the tax side and the spending side. When cutting taxes to stimulate the economy, Blinder calls for Congress to make income andbusinesstaxcutstemporary, encourage statesto implement temporary sales tax cuts, and make tax cuts automatic to reduce the lag time between recessions and stimulus. When increasing spending, Blinder proposes that Congress expand targeted transfer programs, grants to states and municipalities, and infrastructure spending (with a focus on shovel-ready projects and bonds that make it easier for states to finance new development). He also calls for Congress to encourage more consumer-directed discretionary spending, similar to the successful Car Allowance Rebate System, known as the Cash for Clunkers program. Finally, Blinder emphasizes that Congress should deploy fiscal policy quickly after a recession starts, and wind it down only when the economy is well on its way to recovery.

The Challenge

Conventional thinking holds that monetary policy is typically better equipped than fiscal policy to stimulate the economy during a recession because it can be deployed quickly and with precision. A fiscal stimulus, by contrast, requires Congressional authorization and can take months to develop and debate before being enacted into law. Stimulus funding must then be distributed to approved projects and spent by the recipients, adding additional delays before it results in actual economic activity.

However, the severity of the Great Recession demonstrated that monetary policy alone might not always be enough. Despite lowering the federal funds rate-the overnight interest rate paid by banks- from roughly 5 percent to almost zero over the course of the recession, the economy remained tepid. Typically, a reduction in the federal funds rate lowers interest rates throughout the economy, encouraging businesses to invest and employ more workers and encouraging consumers to spend more, consequently lowering the unemployment rate. Though this did occur after the Great Recession, the recovery was unusually slow, and Federal Reserve officials had to resort to unconventional tools to further stimulate the economy and put it on to a path to recovery.

The Federal Reserve still faces limits to its principal tool for responding to recessions: as of May 2016 the federal funds rate sits below 0.5 percent. Should the economy weaken or slip into recession, the Federal Reserve would not be able to cut the funds rate much further to stimulate the economy. If monetary policy is of limited use during the next recession, alternative policies would be needed.

Fortunately, policy makers may also deploy fiscal policy to alleviate a recession. …

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