The 1970s and the first half of the 1980s were a stormy period for the U.S. economy (and for other major economies, too). There was a severe recession in 1974–1975, then two back-to-back recessions in 1979–1982 that sent the unemployment rate to almost 11%. At the same time, the inflation rate soared into double digits—and then plunged. As we have seen, these events left a strong mark on macroeconomic thought.

After about 1985, however, the economy settled down. The recession of 1990–1991 was much milder than the 1974–1975 recession or the double-dip slump from 1979 to 1982, and the inflation rate generally stayed below 4%. The period of relative calm in the economy from 1985 to 2007 came to be known as the Great Moderation. And the calmness of the economy was to a large extent marked by a similar calm in macroeconomic policy discussion. In fact, it seemed that a broad consensus had emerged about several key macroeconomic issues.

The Great Moderation was, unfortunately, followed by the Great Recession, the severe and persistent slump that followed the 2008 financial crisis. We’ll talk shortly about the policy disputes caused by the Great Recession. First, however, let’s examine the apparent consensus that emerged during the Great Moderation, which we call the Great Moderation consensus. It combines a belief in monetary policy as the main tool of stabilization, with skepticism toward the use of fiscal policy, and an acknowledgement of the policy constraints imposed by the natural rate of unemployment and the political business cycle.

To understand where the Great Moderation consensus came from and what still remains in dispute, we’ll look at how macroeconomists have changed their answers to five key questions about macroeconomic policy. The five questions and the various answers given by schools of macroeconomics over the decades are summarized in Table 18-1. (In the table, new classical economics is subsumed under classical economics, and new Keynesian economics is subsumed under the Great Moderation consensus.) Notice that classical macroeconomics said no to each question; basically, classical macroeconomists didn’t think macroeconomic policy could accomplish very much. But let’s go through the questions one by one.

As we’ve seen, classical macroeconomists generally believed that expansionary monetary policy was ineffective or even harmful in fighting recessions. In the early years of Keynesian economics, macroeconomists weren’t against monetary expansion during recessions, but they tended to believe that it was of doubtful effectiveness. Milton Friedman and his followers convinced economists that monetary policy is effective after all.

Nearly all macroeconomists now agree that monetary policy can be used to shift the aggregate demand curve and to reduce economic instability. The classical view that changes in the money supply affect only aggregate prices, not aggregate output, has few supporters today. The view held by early Keynesian economists—that changes in the money supply have little effect—has equally few supporters. Now it is generally agreed that monetary policy is ineffective only in the case of a liquidity trap.

Classical macroeconomists were, if anything, even more opposed to fiscal expansion than monetary expansion. Keynesian economists, on the other hand, gave fiscal policy a central role in fighting recessions. Monetarists argued that fiscal policy was ineffective if the money supply was held constant. But that strong view has become relatively rare.

Most macroeconomists now agree that fiscal policy, like monetary policy, can shift the aggregate demand curve. Most macroeconomists also agree that the government should not seek to balance the budget regardless of the state of the economy: they agree that the role of the budget as an automatic stabilizer helps keep the economy on an even keel.

Classical macroeconomists didn’t believe the government could do anything about unemployment. Some Keynesian economists moved to the opposite extreme, arguing that expansionary policies could be used to achieve a permanently low unemployment rate, perhaps at the cost of some inflation. Monetarists believed that unemployment could not be kept below the natural rate.

Almost all macroeconomists now accept the natural rate hypothesis. This hypothesis leads them to accept sharp limits to what monetary and fiscal policy can accomplish. Effective monetary and fiscal policy, most macroeconomists believe, can limit the size of fluctuations of the actual unemployment rate around the natural rate, but they can’t be used to keep unemployment below the natural rate.

As we’ve already seen, views about the effectiveness of fiscal policy have gone back and forth, from rejection by classical macroeconomists, to a positive view by Keynesian economists, to a negative view once again by monetarists. Today most macroeconomists believe that tax cuts and spending increases are at least somewhat effective in increasing aggregate demand.

Many, but not all, macroeconomists, however, believe that discretionary fiscal policy is usually counterproductive, for the reasons discussed in Chapter 13: the lags in adjusting fiscal policy mean that, all too often, policies intended to fight a slump end up intensifying a boom.

As a result, the macroeconomic consensus gives monetary policy the lead role in economic stabilization. Some, but not all, economists believe that fiscal policy must be brought back into the mix under special circumstances, in particular when interest rates are at or near the zero lower bound and the economy is in a liquidity trap. As we’ll see shortly, the proper role of fiscal policy became a huge point of contention after 2008.

Classical macroeconomists didn’t think that monetary policy should be used to fight recessions; Keynesian economists didn’t oppose discretionary monetary policy, but they were skeptical about its effectiveness. Monetarists argued that discretionary monetary policy was doing more harm than good. Where are we today? This remains an area of dispute. Today, under the Great Moderation consensus, most macreconomists agree on these three points:

However, the Great Moderation was upended by events that posed very difficult questions—questions that were still being debated as this book went to press. We’ll now examine what happened and why the ongoing debate is so fierce.

The Great Recession shattered any sense among macroeconomists that they had entered a permanent era of agreement over key policy questions. Given the nature of the slump, however, this should not have come as a surprise. Why? Because the severity of the slump arguably made the policies that seemed to work during the Great Moderation inadequate.

Under the Great Moderation consensus, there had been broad agreement that the job of stabilizing the economy was best carried out by having the Federal Reserve and its counterparts abroad raise or lower interest rates as the economic situation warranted. But what should be done if the economy is deeply depressed, but the interest rates the Fed normally controls are already close to zero and can go no lower (that is, when the economy is in a liquidity trap)? Some economists called for the aggressive use of discretionary fiscal policy and/or unconventional monetary policies that might achieve results despite the zero lower bound. Others strongly opposed these measures, arguing either that they would be ineffective or that they would produce undesirable side effects.

The Debate over Fiscal Policy In 2009 a number of governments, including that of the United States, responded with expansionary fiscal policy, or “stimulus,” generally taking the form of a mix of temporary spending measures and temporary tax cuts. From the start, however, these efforts were highly controversial.

Supporters of fiscal stimulus offered three main arguments for breaking with the normal presumption against discretionary fiscal policy:

These arguments generally won the day in early 2009. However, opponents of fiscal stimulus raised two main objections:

In fact, by 2010 a number of economists were arguing that the best way to boost the economy was actually to cut government spending, which they argued would increase private-sector confidence and lead to a rise in output and employment. This notion, often referred to as the doctrine of expansionary austerity, was especially popular in Europe, where it was supported by officials at the European Central Bank and became the official policy of the Cameron government in Britain, which took office in the spring of 2010.

As is often the case with major disputes in economics, the argument over fiscal policy went on for years, with some critics of fiscal policy still defending their position when this book went to press. It seems fair, however, to say that among economists a more or less Keynesian view of the effects of fiscal policy came to prevail. Careful statistical studies at the International Monetary Fund and elsewhere showed that austerity policies have historically been followed by contraction, not expansion. Recent experience, in which countries like Spain and Greece that were forced into severe austerity also experienced severe slumps, seemed to confirm that observation.

Furthermore, it was clear that those who had predicted a sharp rise in U.S. interest rates due to budget deficits, leading to conventional crowding out, had been wrong: U.S. long-term interest rates remained near record lows even during the years from 2009 to 2012, when the government ran very large deficits.

The Debate over Monetary Policy As we’ve learned, a central bank that wants to increase aggregate demand normally does this by buying short-term government debt, pushing short-term interest rates down and causing spending to rise. By the fall of 2008, however, this conventional form of monetary policy had already reached its limit because the relevant interest rates were close to zero. The question then became whether there were other things the Federal Reserve and other central banks could do.

In 2008–2009 and again in the fall of 2010, the Fed pursued one such alternative, known as quantitative easing, which involved buying assets other than short-term government debt, notably long-term debt whose interest rate was still significantly above zero. For example, in November 2010 the Fed began buying $600 billion worth of longer-term U.S. debt in a program generally referred to as “QE2” (quantitative easing 2). The idea was to drive down longer-term interest rates, which arguably matter more for private spending than short-term rates. In September 2011 the Fed announced another program, this time one that would involve selling shorter-term assets with interest rates already near zero and buying longer-term assets instead.

The policy of quantitative easing was controversial, facing criticisms both from those who believed that the Fed was doing too much and from those who believed it was doing too little. Those who believed that the Fed was doing too much were concerned about possible future inflation; they argued that the Fed would find its unconventional measures hard to reverse as the economy recovered and that the end result would be a much too expansionary monetary policy. Opponents of quantitative easing were not shy about making their views heard: in October 2010 a Who’s Who of conservative economists and major investors issued an open letter calling on Ben Bernanke to call off the policy, which they warned could lead to a “debased” dollar.

Critics from the other side argued that the Fed’s actions were likely to be ineffective: long-term interest rates, they suggested, mainly reflected expectations about future short-term rates, and even large purchases of long-term bonds by the Fed would have little impact.

Many of those calling on the Fed for even more active policy advocated an official rise in the Fed’s inflation target. Recall from Chapters 8 and 10 the distinction between the nominal interest rate, which is the number normally cited, and the real interest rate—the nominal rate minus expected inflation—which is what should matter for investment decisions. Advocates of a higher inflation target argued that by promising to raise prices over, say, the next 10 years by an annual average rate of 3% or 4%, the Fed could push the real interest rate down even though the nominal rate was up against the zero lower bound.

Such proposals, however, led to fierce disputes. Some economists pointed out that the Fed had fought hard to drive inflation expectations down and argued that changing course would undermine hard-won credibility. Others argued that given the enormous economic and human damage being done by high unemployment, it was time for extraordinary measures, and inflation-fighting could no longer be given first priority.

At the time of writing, these disputes were still raging, and it seemed unlikely that a new consensus about macroeconomic policy would emerge any time soon.