Rediscovering Fiscal Policy at the G7

ALGIERS – As G7 leaders convene in Ise-Shima, Japan, the global economy’s fragility is a top concern. But instead of focusing on currency wars, the leaders of the major developed economies should be discussing fiscal policy, which under current conditions would be a more powerful tool than monetary policy for boosting economic activity. After all, today, unlike in normal times, the effects of fiscal policy would not be limited by too-high interest rates, inadequate private demand, strict capacity constraints, or excessive inflation.

Economists dismiss fiscal policy largely because it is “politically constrained.” But that is not a good reason to give up on it. On the contrary, if the political process is producing problematic fiscal policies, as it is today, that is all the more reason for economists to voice their concerns.

The heyday of activist fiscal policy was a half-century ago. Most advanced countries pursued a countercyclical approach, reining in spending or raising taxes during periods of economic expansion and enacting stimulus policies during recessions. The saying “we are all Keynesians now,” attributed to Milton Friedman in 1965 and Richard Nixon in 1971, captured the economic zeitgeist.

But, after 2000, some began to pursue pro-cyclical budgetary policies. When the economy was booming, they implemented fiscal stimulus, thereby reinforcing the upswing. When the economy experienced a downturn, they pursued fiscal austerity, exacerbating the recession.