Traditionally, macroeconomic policy has been divided into two distinct types. The first type, stabilization policy, attempts to keep output and employment as close to their full employment levels as possible. The idea behind these policies is to minimize, or even eliminate, short-term boom-bust cycles around the natural rates of output and employment caused by fluctuations in aggregate demand.
The second type of policy, growth policy, works on the supply-side and attempts to keep the long-term natural rates of output and employment growing as fast as possible. Thus, if the long-term natural growth rate of output is, say, 2.5 percent, supply-side policy would try to increase this rate, while demand-side stabilization would try to keep us from deviating from it, whatever it might be.
Importantly, these policies were believed to be independent. Monetary and fiscal policy used to stabilize the economy could change how fast the economy returns to the natural rate after a positive or negative shock, but the policy would have no impact at all on the natural rate itself.
But what if this is wrong, as data from the Great Recession suggests? What if demand-side policies impact the natural rate after all? What does this mean for monetary and fiscal policy? It turns out to have important implications.
The belief that monetary policy cannot affect the natural rate of output led to the compartmentalization of stabilization and growth policy. Monetary policy was used to manage aggregate demand and stabilize the economy, while fiscal policy was mainly devoted to supply-side policies to enhance growth. Fiscal policy was used for stabilization at times, but the difficulty in getting fiscal policy through Congress quickly enough and of sufficient size to be useful for stabilization made it convenient to leave this job to monetary authorities where political gridlock is not a problem.
A full telling of this story would also note the degree to which Republicans used the promise of growth from supply-side policies to implement legislation such as tax cuts for the wealthy that were more about ideological concerns and allegiance to political campaign donors than growth. But I don’t think it’s a stretch to say that fiscal policy was used to try to boost investment and saving, eliminate distortions that inhibit growth, and so on to a much greater degree than it was used as a stabilization tool.
The Great Recession brought about two changes in the view of how monetary and fiscal policy should be conducted. First, as I and others have noted many times, it is now clear that in a deep recession monetary policy alone is not enough to stabilize the economy, fiscal policy is also needed. During the period of mild fluctuations in output and employment from 1982 through 2007 known as the Great Moderation monetary policy could do the job by itself, and to a large extent we forgot about fiscal policy as a stabilization tool.
But the Great Recession made it clear that monetary policy can only do so much, and fiscal policy has an important role to play in deep economic downturns. We didn’t fully exploit the potential of fiscal policy during the Great Recession, and the turn to austerity in 2010 was a mistake that worked against the recovery, but the lesson is there to be learned for those willing to take off their ideological blinders and see it.
The second way the Great Recession changed the view of how monetary and fiscal policy should be conducted is based upon recent work by Olivier Blanchard, Eugenio Cerutti, and Larry Summers, along with related work by Antonio Fatás and Larry Summers. This research, which continues earlier research on this question, shows that deep, prolonged recessions can have a lasting negative impact on the natural rate of output. This research strengthens and clarifies previous work on this issue to the extent that these results can no longer be set aside as interesting, but inconclusive.
The research has important implications for policy. Monetary and fiscal policy used to stabilize the economy can, contrary to the standard assumption in the macroeconomics literature, affect the long-term natural rate of the economy. According to this research, the longer a recession lasts, the more it drags down the natural rate. Since stabilization policy can shorten the recovery time from a recession, it can also reduce the impact of deep downturns on our long-term productive capacity.
This changes the tradeoff between inflation and output stabilization. If aggressive policy during a deep downturn can both stabilize the economy and raise the long-term natural rate, then the benefits of stabilization are much larger than we thought. On the cost side, the Great Recession showed that the potential costs of stabilization – inflation from monetary policy or interest rate spikes from fiscal policy – are much smaller than we thought. Some still claim, as they have for years, that these problems are just around the corner, but the evidence speaks clearly at this point. The benefits of stabilization policy are higher than we realized, the costs lower, and the conclusion is obvious. We should not shy away from using both monetary and fiscal policy aggressively during deep recessions.
Republicans often complain that social insurance, taxes, and government involvement in the economy destroy the incentive to work and invest, create economic distortions, and inhibit long-term growth. However the evidence indicates that to the extent these effects exist at all, they are not very big.
These are important stabilization tools. Government spending, as noted above, is essential in deep recessions, and social insurance and taxes act as “automatic stabilizers” as taxes fall and the use of social services goes up. Using these tools won’t inhibit economic growth; the failure to attack recessions aggressively with all the tools at our disposal in both the short term and long term will.
The GOP’s opposition to demand-side stabilization policies based upon their supply-side impacts is not supported by the evidence, but it does bring up an important point. Fiscal policy generally has both supply and demand side effects. One of the two is generally small, and hence ignored, but there is one case where both types of impacts are potentially large, infrastructure spending.
This type of spending can stabilize the economy in a recession by providing jobs and boosting demand in the short term; it can spark important supply-side growth over and above the benefits discussed above from shortening recessions.
Republicans have stood in the way of infrastructure spending based upon ideology or the false belief that stabilization policy is detrimental to long-term growth. But we could have our cake and eat it too – stabilize the economy and promote long-term growth. If only they’d go along.