What should have been different this time? The policy response

Eons ago, in blogtime, Ezra Klein wrote an excellent piece on policymaking in the face of the Great Recession and its aftermath. It’s a long piece with plenty to recommend, but I’ll just spend some time lingering over his reliance on the now-famous finding of Carmen Reinhart and Ken Rogoff (and the IMF) that recessions accompanied by financial crises tend to be followed by much slower and less robust recoveries.

This finding is true and useful but far too often misinterpreted. There is nothing inherent in the economics of financial crises that makes slow recovery inevitable – they just require that policymakers figure out how to engineer more spending in their wake, same as in response to all other recessions.

Rather, the real problem they pose to policymakers is that engineering such spending increases in the wake of financial crises often requires policy responses that seem unorthodox or radical relative to the very narrow range of macroeconomic stabilization tools that enjoy support across the ideological spectrum. To put this more simply – they require policymakers do more than watch the Federal Reserve pull down short-term interest rates. For decades, all recession-fighting was outsourced to the Fed’s control of short-term “policy” interest rates – this despite the fact that in the U.S. this recession-fighting tool hasn’t actually been all that successful since the 1980s (see Table 2 in this paper).

The best response to a recession that is either so deep or so infected by debt-overhangs that conventional monetary policy is not sufficient, is simply to engage in lots of fiscal support – think the American Recovery and Reinvestment Act (ARRA) – but (as Ezra notes) much, much bigger in the case of the Great Recession.

But, this kind of discretionary fiscal policy response to recession-fighting (and jobless-recovery fighting) had fallen deeply out of favor in the same decades that saw increasing reliance on conventional monetary policy[1]. In fact, advocating fiscal policy that was up to the task of providing a full recovery in the wake of crises that defanged conventional monetary policy somewhere along the way got labeled radical, rather than simply nuts-and-bolts economics.

Further, this rejection of discretionary fiscal policy was done on very thin analytical reeds – essentially the fear was that it took too long to debate, pass, and see an effect from fiscal policy – and that if the recession was “missed” in real-time by policymakers, we would end up providing lots of fiscal support to an already-recovered economy – and might even cause economic overheating that would lead to runaway inflation and interest rate spikes.

This fear led to the strange mantra in the debate over fiscal stimulus in 2008 that policy had to be targeted, temporary and timely – which basically ruled out most things but tax cuts. But, given that the last three recessions have seen extraordinarily sluggish return to job-creation in their wake, this timely obsession was clearly misplaced (and, plenty argued so in real-time).

So we’ve come to what is, I think, a big gap in Ezra’s piece – the repeated (and correct) insistence that the political system just couldn’t accommodate what nuts-and-bolts economics indicated was needed (i.e., large-scale fiscal support) for a full recovery without examining just how we found ourselves with a political system that has become deeply stupid about fighting recessions and jobless recoveries.

Who is to blame for this intellectual myopia that classified Federal Reserve adjustment of short-term interest rates as the only acceptable way to fight recessions and jobless recoveries? The list is long – and macroeconomists (even many smart ones) belong on it, for sure.

But, I would also want to make sure to include much of the policymaking apparatus of the Democratic Party, who became far too enamored of the unalloyed virtues of deficit-cutting in the past two decades. The excellent labor market performance of the late 1990s, for example, is labeled a pure result rather than an important cause of substantially lower budget deficits during that time. And the regressive and stupid tax cuts pursued under the Bush Administration were generally not fought on the grounds that they were regressive and stupid, but that they would lead to intolerably large deficits – deficits so large they might even lead to Greek-like financial crises when, in fact, deficits as a share of GDP averaged less than 2 percent in 2006 and 2007. To be clear – the Bush tax cuts were expensive as well as regressive and stupid, and letting them (or at the very least the most regressive set of them) expire would be a real policy victory, freeing up public resources for much more valuable ends. But they did not cause deficits in the 2000s to reach terrifying levels.

Sadly, this same Democratic policy apparatus seems to be repeating many of these mistakes, by continually insisting that aggressive maneuvers to help alleviate the jobs-crisis must be done simultaneously with efforts to close what are actually pretty non-scary medium term deficits. Would the “very-big-stimulus-now-cum-progressive-measures-to-bring-medium/long-term-spending-and-revenues -in-balance-when-we-get-back-to-full-employment” plan be the best of all worlds? Sure.

But, these are not symmetric problems, and insisting that they can only be solved in tandem is like insisting that a house with drafty windows that’s also on fire can only have the flames doused if somebody can be found to simultaneously do some caulking.

This is a real problem – by wildly inflating fears about the damage done by budget deficits, we’ve managed to make reasonable responses to very deep recessions politically untenable. And we’ve emerged from this mess without having learned any better.

Maybe this is the real lesson of Reinhart and Rogoff – what is crazy about financial crises isn’t that countries and their citizens often borrow too much, it’s that these countries refuse to use the insights from macroeconomics of the 20th century to make the aftermath of crises much less damaging.


[1] The most stirring recent pre-Great Recession defense of discretionary fiscal policy was actually entitled “The case against the case against discretionary fiscal policy”. And the author reassured his fellow economists that he wasn’t actually going so far as to make the case for these policies.

  • Denis Drew

    just read in Richard C. Koo’s book, “The Holy Grail of Macro
    Economics” (the explanation for our Great Depression) that Milton
    Friedman may have got the cause of the Great Depression right —
    shrunken money supply — but Friedman and everyone else missed the key
    — monetary policy is helpless to maintain (or expand) money supply as
    long as corporations are not borrowing, are paying down the balance
    sheet deficits instead of borrowing, which is what happened here in 1929
    and in Japan in 1990.
    When corporations stop borrowing for
    years while they pay down debt — what Japanese corporations have been
    doing since the real estate crash in 1990; just coming out of the woods
    now — is what happens. If you make 1000 yen and save 100 (typical
    Japanese) the bank normally keeps the 100 yen in circulation by lending
    it — and somebody somewhere earns 1000 yen. If the bank doesn’t,
    somebody somewhere earns only 900 yen and saves 90. Some other body
    earns 810 and saves … etc.
    So the Japanese government has been using fiscal policy since 1990–
    borrowing vast sums and running a vast debt (commercial land prices in
    six major cities dropped 87%), but has avoided 1929; not that the
    Japanese government knew what it was doing according to Koo –to make monetary policy work. Took both Milton. Surprise; Milton was on to something.
    So the way to avoid a depression — in a contraction — is for government to become the borrower of last resort? Hey; that’s Milton Friedman (almost?).