This won’t be the last downturn in the history of the world, I’m pretty sure of that, and how monetary and fiscal policymakers react and the difference it makes – if any – will be studied carefully and used to guide our response the next time something like this happens.
So we need to do this right. With respect to monetary policy, I think we have learned that monetary policy loses its punch as interest rates get stuck at or near zero. Not everyone agrees – some people argue that unconventional monetary policy can still be used effectively – but even if that’s true, I don’t think that monetary policy alone can stop the downturn and turn things around.
That leaves fiscal policy. I believe that fiscal policy can help people during downturns like we are in now. I could be wrong about that, the evidence just isn’t there to say for sure. But of the two errors, not helping people when help would have mattered, and trying to help but failing to do any good, I’d rather make the second mistake.
But as we try to help, there are two ways in which we could make fiscal policy less attractive as a stabilization tool in the future.
First, the political process could render fiscal policy too weak to be effective. If tax cuts and government spending are directed mostly toward political goals, that could water the policy down so much that it does little good.
In the stimulus package just enacted, politicians did direct tax cuts and spending towards political ends, and they had enough success to make the policy far less effective than it might have been. But let’s hope there’s enough useful policy measures left to make a difference, and I think there are, and that the evidence is clear enough so that we are able to learn what works and what doesn’t. That way, the lesson going forward will be about how to do fiscal policy better next time – which mix of policies works best – rather than that politicians can’t be trusted to do it at all.
Second, we could fail to reduce the budget deficit once the economy turns around. Done correctly, stabilization policy does not add to the long-term budget problems of an economy. During the bad times, the troughs of the business cycle are filled by running deficits (either tax cuts or increased government spending), and during the good times the peaks of the cycle are shaved as these policies are reversed. By filling the troughs during the bad times with the shaved peaks from the good times, the economy is more stable since we are moving resources from times when the economy is overheated to times when it is running cold. And since the peak to trough transfers are one-to-one, there is no net change overall in the size of the government debt (the size of government could go up or down in the process, or it could stay the same, that depends upon the particular mix of tax and government spending changes that politicians choose, it has nothing to do with stabilization).
We’re pretty good at giving away the goodies when things get bad, and I’m glad we are generous enough to do that, but we haven’t been as good at paying the bills when times get better. If we are going to try fiscal policy, and as I said above I don’t think we have any choice but to run a budget deficit right now, we have to find a way to pay the deficit off once things improve (but not before). If we don’t, if this ends up adding substantially to our long-run debt, then the lesson will be that changes in taxes or government spending are too sticky to be used effectively as a stabilization tool. Taxes can be cut easily, but raising them again later is a lot harder, and the same goes for spending – it’s easier to add to spending than to cut it back. If the lesson is that we cannot overcome this resistance to paying for stabilization policy, and there are plenty of people who cannot wait to make that point – in many cases the same people who are all too ready to argue that the increased debt necessitates cuts in key social programs – then fiscal policy will not look very attractive the next time the economy goes into a recession so deep that monetary policy alone is not enough to save the day.
In the short-run, the first problem is the worry, i.e. that the bill that was enacted is too watered down to be effective (and that another round won’t be possible if things don’t turn around), but over the longer run it’s the second problem that is of concern. If it was up to me – and many of you will be happy it isn’t – I’d put parts of fiscal policy in the hands of an independent Fed like structure and charge it with stabilizing fluctuations in the economy over the business cycle while retaining a long-run balanced budget (perhaps even implementing Andrew Samwick’s idea of having a predetermined list of infrastructure projects on the shelf and ready to go if a recession hits). But that’s not going to happen, so it’s up to the political process to make fiscal policy work as a stabilization tool and, while there have been some good signs from the administration along these lines, I can’t say I’m overly confident that politicians are up to the task.