1.2 Module 84: The Modern Macroeconomic Consensus

White House Photo/Alamy

Consensus and Conflict in Modern Macroeconomics

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 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 84-1. (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.

Question 1: Is Expansionary Monetary Policy Helpful in Fighting Recessions?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.

Question 2: Is Expansionary Fiscal Policy Effective in Fighting Recessions?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.

Question 3: Can Monetary And/Or Fiscal Policy Reduce Unemployment in The Long Run?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.

Question 4: Should Fiscal Policy Be Used in A Discretionary Way?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. They believe that 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.

Question 5: Should Monetary Policy Be Used in A Discretionary Way?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:

• Monetary policy should play the main role in stabilization policy.
• The central bank should be independent, insulated from political pressures, in order to avoid a political business cycle.
• Discretionary fiscal policy should be used sparingly, both because of policy lags and because of the risks of a political business cycle.

However, the Great Moderation was up-ended by events that posed very difficult questions. We’ll now examine what happened and why the ongoing debate is so fierce.

Crisis and Aftermath

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:

1. They argued that discretionary fiscal expansion was needed because the usual tool for stabilizing the economy, monetary policy, could no longer be used now that interest rates were near zero.
2. They argued that one normal concern about expansionary fiscal policy—that deficit spending would drive up interest rates, crowding out private investment spending—was unlikely to be a problem in a depressed economy. Again, this was because interest rates were close to zero and likely to stay there as long as the economy was depressed.
3. Finally, they argued that another concern about discretionary fiscal policy—that it might take a long time to get going—was less of a concern than usual given the likelihood that the economy would be depressed for an extended period.

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

1. They argued that households and firms would see any rise in government spending as a sign that tax burdens were likely to rise in the future, leading to a fall in private spending that would undo any positive effect. (As you will recall, this is the Ricardian equivalence argument.)
2. They also warned that spending programs might undermine investors’ faith in the government’s ability to repay its debts, leading to an increase in long-term interest rates despite loose monetary policy.

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 at the time.

One might have hoped that events would resolve this dispute. But the debate continues to rage today. At the time, critics of fiscal stimulus pointed out that the U.S. stimulus had failed to deliver a convincing fall in unemployment; stimulus advocates, however, had warned from the start that this was likely to happen because the stimulus was too small compared with the depth of the slump. Meanwhile, austerity programs in Britain and elsewhere had also failed to deliver an economic turnaround and, in fact, had seemed to deepen the slump; supporters of these programs, however, argued that they were nonetheless necessary to head off a potential collapse of confidence.

In 2008, the Fed took a series of unconventional monetary policy actions in response to the deepening financial crisis.

AP Photo/Carolyn Kaster

One thing that was clear, however, was that those who had predicted a sharp rise in U.S. interest rates due to budget deficits, leading to conventional crowding out, were wrong: by the fall of 2011, U.S. long-term rates were hitting record lows despite continuing large deficits. Interest rates remained low through 2013, even as the budget deficit declined.

The Debate over Monetary Policy

As we’ve seen, 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 that involved 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 the Fed was doing too much and from those who believed it wasn’t doing enough. Those who thought 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.

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.

© Gahan Wilson The New York Collection www.cartoonbank.com

Many of those calling for even more active policy advocated an official rise in the Fed’s inflation target. Recall 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.

These same debates continue to rage today, and it seems unlikely that a new consensus about macroeconomic policy will emerge any time soon.

!world_eia!AN IRISH ROLE MODEL?

Over the course of 2010 and 2011 a fierce debate raged, among both economists and policy makers, about whether countries suffering large budget deficits should move quickly to reduce those deficits if they were also suffering from high unemployment. Many economists argued that spending cuts and/or tax increases should be delayed until economies had recovered. As we explained in the text, however, others argued that fast action on deficits would actually help the economy even in the short run, by improving confidence—a claim that came to be known as expansionary austerity.

How could this dispute be settled? Researchers turned their attention to historical episodes, in particular to cases in which nations had managed to combine sharp reductions in budget deficits with strong economic growth. One case in particular became a major intellectual battleground: Ireland in the second half of the 1980s.

Panel (a) of Figure 84-1 shows why Ireland’s experience drew attention. It compares Ireland’s cyclically adjusted budget deficit as a percentage of GDP with its growth rate. Between 1986 and 1989 Ireland drastically reduced its underlying deficits with a combination of spending cuts and tax hikes, and the Irish economy’s growth sharply accelerated. A number of observers suggested that nations facing large deficits in the aftermath of the 2008 financial crisis should seek to emulate that experience.

Sources: International Monetary Fund; Roberto Perotti, “The ‘Austerity Myth’: Gain Without Pain?”, NBER Working Paper 17571 (2011).

A closer look, however, suggested that Ireland’s situation in the 1980s was very different from that facing Western economies in 2010 and 2011. Panel (b) of Figure 84-1 shows two other economic indicators for Ireland from 1986 to 1990: short-term interest rates and export growth. Ireland entered into fiscal austerity with high interest rates, which fell sharply between 1986 and 1988 as investors gained more confidence in its solvency (although they rose thereafter).

At the same time, Ireland had a major export boom, partly due to rapid economic growth in neighboring Britain. Both factors helped offset any contractionary effects from lower spending and higher taxes.

The point was that these “cushioning” factors would not be available if, say, the United States were to slash spending. Short-term interest rates were already near zero and couldn’t fall further, and America had no booming neighbors to export to.

By the end of 2011 careful study of the historical record convinced most, though not all, economists studying the issue that hopes for expansionary austerity were probably misplaced. However, the debate about what the United States and other troubled economies should do raged on.

Module 84 Review

Check Your Understanding