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Laura D'Andrea Tyson: Lessons on Fiscal Policy Since the Recession

Laura D'Andrea Tyson:

Lessons on Fiscal Policy Since the Recession: In late 2008, the United States economy was caught in the midst of what proved to be its longest and deepest recession since the end of World War II. Frightened by steep and self-reinforcing declines in output and employment, both the Federal Reserve and the federal government responded quickly and boldly. The Federal Reserve dropped the federal funds rate to near zero, where it remains today, and began its controversial “quantitative easing” purchases of long-term government securities to contain long-term interest rates. Fueled by the 2009 federal stimulus package, discretionary fiscal policy was also expansionary in 2009-10, adding to growth during the first year of the recovery at roughly the same pace that fiscal policy had achieved during previous recoveries. Then, in a sharp break with history, fiscal policy became a drag on growth in the second year of recovery, and since then the drag has intensified.

What explains the premature and counterproductive turn toward fiscal austerity despite the high unemployment rate and the large gap between actual and potential output?

Before the Great Recession, there was a near consensus among economists that monetary policy by itself could stabilize aggregate demand…. Under normal economic conditions, countercyclical fiscal policy was thought to be unnecessary…. But the conditions confronting fiscal policy in late 2008 were anything but normal…. At least in the short term, conventional monetary policy alone could not stabilize the economy…. Subsequent empirical analysis indicates that the stimulus worked. New research confirms that the multipliers for fiscal policy are significantly larger during downturns when there is considerable excess capacity and when interest rates are at or near their lower bound. They are also larger when private actors are credit-constrained, so their spending depends more on current income than on future expected income. These were the conditions in 2010-11. Even using a range of lower multiplier estimates consistent with more normal conditions, the Congressional Budget Office found that the effects of the stimulus on output and employment were in the predicted range….

There was a strong case for additional fiscal stimulus in 2011, and that is what President Obama proposed. But this time Congress rebuffed most of his recommendations, and since then fiscal policy has shifted to even more contraction…. Since 2011, proponents of fiscal austerity have repeatedly raised concerns that the large increases in the government deficit caused by both the recession itself and discretionary fiscal stimulus would lead to a spike in long-term interest rates…. But long-term interest rates did not spike…. When not fixated on bond-market anxieties, proponents of fiscal austerity have focused on variants of the “crowding out” argument that a high and rising government debt crowds out private investment and reduces economic growth. But this argument does not apply under current conditions….

[W]hat about evidence of a possible negative relationship between the ratio of public debt to G.D.P. and economic growth – evidence that burst into fiscal debates in 2010 with the publication of the paper by Carmen M. Reinhart and Kenneth S. Rogoff purporting to show that over the long term, growth declines sharply when public debt tops 90 percent or more of G.D.P.? As the authors themselves acknowledge, the relationship between public debt and growth is one of correlation, not causality…. [T]here is no threshold debt ratio beyond which growth drops precipitously. Despite the warnings of fiscal austerians, Mr. Bernanke is right: “Neither experience nor economic theory clearly indicates the threshold at which government debt begins to endanger prosperity and economic stability.”…

A growing number of European political and business leaders are warning that harsh fiscal contraction is consigning Europe to prolonged stagnation or worse. Even Mr. Gross is now asserting that bond markets do not want severe belt-tightening and that austerity is not the way to promote growth. Unfortunately, Congress is not listening…