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Fiscal Policy Should Return to Fundamentals

The longstanding argument that go-go Keynesian fiscal stimulus is the answer to every imaginable economic shock has been exposed as bankrupt. Nevertheless, readjustment of both monetary and fiscal policy needs to take place gradually if we are to avoid an epic recession.

CAMBRIDGE – Recent large interest-rate hikes by the US Federal Reserve and the European Central Bank suggest that monetary policymakers are intent on moving forcefully to bring down inflation. But where are the scores of economic commentators who for years have been arguing that fiscal policy – usually meaning deficit spending – needs to play a much more active role in managing business cycles? If it really makes sense to use both monetary and fiscal policy to counter a routine downturn, why are central banks suddenly on their own in attempting to engineer a soft landing with inflation at a four-decade high?

Before the 2008 global financial crisis, the consensus was that monetary policy should take the lead in dealing with ordinary business cycles. Fiscal policy should play a supporting role, except in the event of wars and natural catastrophes such as pandemics. When systemic financial crises occurred, the thinking went, monetary policy could respond immediately but fiscal policy should quickly follow and take the lead over time. Taxation and government expenditure are intensely political, but successful economies could navigate this problem in emergencies.

Over the past decade, however, the view that fiscal policy should also play a more dominant macroeconomic stabilization role in normal times has gained increasing traction. This shift was influenced by the fact that central bank interest rates ran up against the zero-interest-rate bound. (Some, including me, believe that this argument ignores relatively simple and effective options for cutting rates below zero, but I will not take that up here.) But the zero bound was by no means the entire argument.

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