There is no longer any doubt that monetary policy, whether conventional or unconventional, will be found wanting in the face of the next global recession.
A cut in interest rates of several percentage points will be needed to handle a major downturn in the economy, but across the yield curve — which shows both short-term policy rates and bond yields of longer duration — interest rates are far too close to their effective lower bound, just below zero, to permit this.
Central bankers now admit that they will need help from fiscal policy in such circumstances. However, in the past, discretionary budgetary injections have usually been implemented with long delays, and political wrangling has resulted in tax and spending measures that have failed to stabilise demand in the economy.
An example of these problems came after the financial crash in 2008. Although there was budgetary action in many economies, including US President Barack Obama’s 2009 American Recovery and Reinvestment Act, stiff political resistance limited the effectiveness of fiscal reflation.
The eventual ARRA stimulus was not large enough to stabilise the US economy and was reversed too quickly during the recovery. It prevented a financial collapse, but it did not avoid high and persistent unemployment. Even having Democratic control of the White House and Congress did not stop political roadblocks hindering the fiscal stimulus from shortening the recession.
Meanwhile, in the eurozone, meaningful fiscal response was prevented by the absence of a mechanism that allowed significant risk-sharing among member states.
In both the US and Europe, monetary stimulus therefore remained essential.
The proven disadvantages of discretionary budgetary changes to cushion a recession explain why there is growing interest in enhancing the so-called automatic fiscal stabilisers. Macroeconomists have argued for decades that the scale and effectiveness of built-in methods to raise spending or cut tax revenue should be increased to make fiscal policy more successful.
In a recession, tax receipts tend to fall more than household and corporate income, so the government budget cushions the private sector from loss of disposable income. In addition, higher welfare payments to unemployed workers help them maintain their spending in bad times. All this takes effect quickly, as an automatic result of the structure of the tax and spending system in an advanced economy (see graph).
A 2016 paper by Alisdair McKay and Ricardo Reis shows that automatic stabilisers can be very effective in limiting the depth of recessions when monetary policy is restricted by the lower bound on interest rates. They also conclude that welfare payments are more successful than tax adjustments in stabilising demand by boosting the disposable income of the poorest households.
In the 2007-9 US recession, automatic stabilisers added about 2.0 per cent to real gross domestic product at the low point for the economy, slightly more than the impact of the discretionary fiscal boost from the ARRA. Furthermore, their impact lasted several years longer than that of the discretionary stimulus, making them more important overall in smoothing the cycle.
This suggests that appropriate fiscal stabilisers could work automatically to replace the missing monetary stimulus in the next recession. There are basically two ways this effect could be strengthened.
The first is to change the entire structure of the public finances by raising the share of both tax and spending in GDP. But governments are extremely unlikely to be willing to make such fundamental changes before they see an urgent need to do so. It would involve higher and more progressive tax regimes, and larger welfare payments, all of which would be political dynamite.
An alternative is to design a new system of automatic additional spending that only kicks in when the economy heads into recession. A recent publication by the Brookings Institution Hamilton Project and the not-for-profit Washington Center for Equitable Growth puts forward several practical ideas for this. Among these, Claudia Sahm, an economist at the Federal Reserve board of governors, has suggested a programme to be triggered when a recession is signalled by the unemployment statistics. It would send out direct payments to qualified households to increase consumer spending during the recession.
This “Sahm rule” would offer a fiscal alternative to the Taylor rule that has been used to inform monetary policy, and would circumvent many of the political problems that have dogged discretionary fiscal policy. It could have a very useful role to play.
Central bankers will argue strongly that this type of enhancement to fiscal stabilisers should be legislated immediately. However, it seems rather unlikely that today’s politicians will have the foresight to design and implement an effective fiscal stimulus in advance of future trouble, so that it is “oven ready” when a recession hits.
It seems far more likely that they will do too little, too late, as usual.
A recent research paper by Christina and David Romer argues that policymakers in finance departments and the IMF are influenced by high public debt/gross domestic product ratios when they decide whether to ease fiscal policy in response to an impending recession. Higher debt leads to a smaller fiscal response, and a deeper recession.
Part of this behavioural tendency is “rational”, in the sense that countries with high debt ratios may find it difficult to access the bond markets to finance larger budget deficits, at least without large and counter-productive increases in interest rates.
However, the authors show that the most important part of the explanation is less rational. Policymakers make a voluntary decision to avoid raising budget deficits by enough to stabilise demand, even when they can readily fund their deficits in the bond markets. It seems that the size of the discretionary fiscal response is limited by an “irrational” fear of higher debt in the political system.