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David Romer: The Need for Fiscal Policy

David Romer (March 2011): What Have We Learned about Fiscal Policy from the Crisis?:

Lesson 1: We need fiscal tools for short-run stabilization. The first lesson is straightforward: we need fiscal tools for short-run stabilization. Before the crisis, there was broad agreement among macroeconomists and policymakers that short-run stabilization was almost exclusively the province of monetary policy. Monetary policy is more flexible; it is more easily insulated from political pressures; and it can more easily be put in the hands of independent experts. We thought that the zero lower bound would bind infrequently and not sharply; and that in the unlikely event that it did bind sharply, monetary policymakers had other tools they would use in place of reductions in the policy interest rate.

We now know that this view was wrong. We suffered shocks larger than what almost anyone thought was within the realm of reasonable possibility. The constraint imposed by the zero lower bound turned out to be huge (for example, Rudebusch, 2009). And central banks did not use tools other than the policy rate on a scale even remotely close to large enough to make up for the loss of stimulus caused by the zero lower bound.

Perhaps this lack of aggressiveness in using those tools reflects an understanding of the costs of using them that has eluded conventional analyses. But central bankers have yet to provide evidence of such costs. A more likely possibility, in my view, is that the culture of central banking makes it much easier to take unusual steps when the financial system is at risk than when the threat is “merely” one of years of exceptionally high unemployment. But regardless of the reason, monetary policy was not used aggressively enough to prevent very large demand shortfalls.

So, countries needed other tools. And the alternative to monetary tools is fiscal ones. For that reason, almost every major country adopted substantial discretionary fiscal stimulus in the crisis (U.S. Council of Economic Advisers, 2009). Given that we could face another major demand shortfall in the future, it follows that we need instruments of discretionary fiscal stimulus as part of the macroeconomic toolkit...