1. The Limits of Fiscal Policy

"When the Fed lowered its key policy rate essentially to zero, many people thought it was out of policy options and that fiscal authorities would have to step in to provide short-term stabilization policy. Jim Bullard argued in his 2012 'Death of a Theory' paper that central banks can still be effective by using unconventional tools and can usually act faster than fiscal authorities can." 

—David Wheelock, Group Vice President and Deputy Director of Research

James Bullard shared some reflections on his first 10 years as Bank president during recent conversations with staff. The following are excerpts from those discussions.

Stabilization policy means reacting to data and changing the direction of policy in a timely manner in response to changing economic circumstances. Before the financial crisis, the conventional wisdom suggested that fiscal policy was not very effective as a macroeconomic stabilization tool. Although calls for fiscal approaches to stabilization policy gained popularity during the crisis, the precrisis lesson has been borne out in the past 10 years. Namely, it is difficult in Western democracies to ask the political process to bear the burden of providing day-to-day stabilization policy. This type of policy intervention should remain in the realm of monetary policy.

Why was this the conventional wisdom? In the U.S., the FOMC can meet every six or eight weeks, or more often if necessary. Decisions and adjustments to policy can be made fairly quickly in response to changing economic conditions. One could argue about whether the FOMC made the right decisions at various junctures, but it is at least in position to take those kinds of quick actions. In contrast, going through the political process to change the tax code or government spending plans can be very complicated. It is doubtful that such a process could be completed in a timely manner and in a way that reacts to current developments in financial markets and the economy as a whole.

Thus, for the two decades before the crisis, the idea was that fiscal policy should be set over longer time horizons (e.g., five or 10 years) and that monetary policy should be used to make the day-to-day adjustments through interest rate policies.

In December 2008, the FOMC reduced the federal funds rate to a target range of 0 to 0.25 percent—the so-called zero lower bound. Many people said this meant that the FOMC couldn't do anything else to provide short-term stabilization for the macroeconomy and that, consequently, fiscal policy would have to fill that role.

The G-7 countries lowered their policy rates to near zero in late 2008 and early 2009. Some central banks, including the Fed, used unconventional tools to provide additional stabilization policy.
SOURCE: Haver Analytics.

However, the FOMC was not out of ammunition after hitting the zero lower bound. The FOMC used unconventional policy—QE and, to some extent, forward guidance—to provide stabilization policy. Other central banks also turned to unconventional policy, including QE in the U.K., Japan and the eurozone.

To the extent those ways of carrying out monetary policy are effective, this means that the monetary authority can still run stabilization policy and that going through the fiscal channel is unnecessary. My 2012 paper "Death of a Theory" argued that stabilization policy should be viewed the same way after the crisis—i.e., that monetary policy should still be used to respond to short-term fluctuations in the economy.

The older, precrisis idea about how to divide the responsibility for stabilization between monetary policy and fiscal policy remains valid today. Given the difficulty of going through the political process, the central bank should continue to have primary responsibility for stabilization policy even when the policy rate is at or near the zero lower bound. On the other hand, fiscal authorities should focus on tax and spending programs that will achieve medium- or long-term goals.

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