The Next Fiscal Stimulus

The following come from remarks delivered by Martin Feldstein before the March 2014 Shadow Open Market Committee conference.

I want to look ahead, just for a couple of minutes, about future

cyclical downturns and ask what mix of fiscal and monetary policy should then be appropriate.

As you know the potential use of Keynesian fiscal stimulus has waxed and waned since World War II. The deficient spending to aid our allies in the late 1930s and to finance all-out mobilization during the war raised real GDP by more than spending itself. 

The increase in real GDP during and after the war confirmed the potential usefulness of the Keynesian multiplier, and that lead enthusiastic Keynesian macroeconomists in the 1950s and 60s to imagine using fiscal policy and econometric models to fine tune the economy, virtually eliminating the business cycle. But the actual experience lead economists to abandon the hope of such fiscal fine-tuning. Primarily, I think, because of the long lags in the use of fiscal policy and the relatively short duration of business cycle downturns, historically about ten months.

So by the 1970s, I, and most others who taught about monetary policy, said that the tool for limiting inflation and for dealing with cyclical downturns should be limited to monetary policy. When I lectured about that I would say that using fiscal policy to stimulate demand should be limited to those rare circumstances like the 1930s when the downturn was so deep and so prolonged that timing would not be a problem. 

But in 2007, I reached the painful conclusion that we were heading into a deep recession, and that conventional monetary policy was then ineffective because of the dysfunctional character of financial markets, and therefore that we needed a fiscal stimulus. That was a painful decision, on my part to make, because it went against everything that I had been teaching and had learned in previous years. But I supported, therefore, the tax rebates proposed by President Bush, even though I should have realized that a one shot rebate would be mostly saved. So that a use of fiscal stimulus in that form was going to be unsuccessful, simply adding more to the national debt than it did to GDP.

The Obama Administration’s so-called stimulus package, enacted in early 2009, was so poorly designed—a grab bag of transfers to state governments, some temporary tax cuts, and almost none of the shovel-ready projects of real government spending as opposed to budget outlays—that it, too, probably added more to the national debt than it did to GDP.

But looking ahead, when should we go beyond an exclusively monetary policy response to use fiscal policy in a downturn? I think a prerequisite should be the existence of real government spending programs, not just transfers and other outlays, but incremental purchases of goods and services. Fiscal policy should only be used when monetary policy cannot be effective.

So here’s my list of five reasons, suggested by our recent experience, when monetary policy may not be effective in some future downturns.

First when financial markets are dysfunctional, as they were in 2007 and 2008—banks unwilling to lend to each other or commercial borrowers because they couldn’t value the assets on their balance sheets.

Second, a downturn that wasn’t caused by high real interest rates, and therefore couldn’t be reversed by lowering rates—as Paul Volcker was able to do in the early 1980s.

Third, and closely related, a situation where the short term interest rate is at the zero lower bound

Fourth, an economy in which house prices are falling, so that the part of the economy that is potentially most responsive to lower interest rates, house building, will not respond.

And fifth, a downturn that will be deep and protracted so that the accuracy of timing is not necessary

Now, all five of those conditions I just mentioned prevailed in the recent downturn. A better fiscal policy of well-designed spending could have produced a stronger recovery.

Not all five are necessary to justify the use of fiscal policy. But I think we should be ready with some serious spending programs on the shelf if we do need to use fiscal policy.

Martin Feldstein is the George F. Baker Professor of Economics at Harvard University and the president emeritus of the National Bureau of Economic Research.

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