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In-Depth: St. Louis Fed President James Bullard Explores the “Death of a Theory”

Sunday, April 1, 2012

More than three years ago, St. Louis Fed President James Bullard discussed “Three Funerals and a Wedding”—ideas about how the financial crisis (up to that point) had changed the conventional wisdom on some critically important macroeconomic issues facing the nation.

Bullard’s “funeral” category had several items, but the “wedding” category had just one rising idea: fiscal policy as a business cycle stabilization tool. Now, in his new research paper titled “Death of a Theory,” Bullard concludes that the turn in recent years toward fiscal approaches to stabilization policy has run its course and that the conventional wisdom of the past several decades is reasserting itself. (See the brief description on Page 9 of fiscal vs. monetary stabilization policy.)

Over the two decades leading up to the financial crisis, the conventional wisdom was that fiscal policy was not a good tool for macroeconomic stabilization—that is, not a good way to attempt to react to shocks that buffet the economy, says Bullard. Conventional wisdom suggested that shorter-run stabilization issues should be handled by the monetary authority (e.g., the Federal Reserve) and that fiscal authorities (e.g., the president and the Congress) should focus on a stable taxing and spending regime to achieve economic and political goals over the medium and longer run. This state of affairs lasted, broadly speaking, until the fall of 2008.

At that point, the short-term nominal interest rate targeted by the FOMC (Federal Open Market Committee) was pushed nearly to zero, where it remains to this day. This led many to conclude that the burden for short-term macroeconomic stabilization had, as a result, shifted to fiscal policy. Indeed, over the past three years, we have seen numerous attempts at stabilization policy by fiscal authorities in the U.S. and around the globe, Bullard says.

However, Bullard argues that the net effect of these attempts has been to confirm much of the conventional wisdom regarding fiscal stabilization policy that existed prior to the financial crisis.

Addressing the Case for the Fiscal Approach

Much research has been published on when the fiscal approach to business cycle stabilization would be useful and effective. In “Death of a Theory,” Bullard cites a paper by economist Michael Woodford in which Woodford notes that “while a case for aggressive fiscal stimulus can be made under certain circumstances, such policy must be designed with care if it is to have the desired effect.”[1]

This line of research assumes that monetary business cycle stabilization policy is ineffective and unable to influence real interest rates once the policy rate is near zero. In addition, the types of policy experiments considered in this research involve extra government spending and taxation only during the period when the policy rate is near zero and financial markets are in considerable turmoil, and not any longer than that. (See Figure 1 for a measure of financial stress during the crisis.)

Figure 1

The St. Louis Financial Stress Index

Figure 1

SOURCE: Federal Reserve Bank of St. Louis

The St. Louis Financial Stress Index was essentially off the charts during the winter of 2008-2009. A reading of zero would mean normal stress levels and a reading of 2 would be exceptionally high by historical standards; during the crisis, readings of 5 or higher were observed. By 2010, however, stress had returned to more normal levels, and so the case for continued increases in government spending at that point had diminished, says St. Louis Fed President James Bullard in “Death of a Theory.” See more on the St. Louis Financial Stress Index at on FRED (Federal Reserve Economic Data).

Three key issues related to the assumptions in Woodford’s paper lead Bullard to doubt the merits of possible fiscal stabilization programs for the present circumstances:

First, the types of fiscal policy interventions recommended in the research are fairly intricate and must be designed carefully if they are to have the desired effect. However, the conventional wisdom on fiscal stabilization policy emphasizes that political processes in the U.S. and elsewhere are not well-suited to make timely and subtle decisions like these.

Second, monetary stabilization policy has been quite effective, even while the policy rate has been near zero, Bullard emphasizes. This is because the monetary policy authority can use many other tools to influence inflation and inflation expectations. Thus, a turn toward fiscal stabilization policy is not necessary.

Third, although the research says that taxes should be collected simultaneously with the increase in government spending, the actual fiscal stabilization policy for many countries has involved heavy reliance on government borrowing. This increased debt would be interpreted as promised future taxes. However, shifting the taxes into the future can undo most or all of the benefits that might otherwise come from the fiscal stabilization program, Bullard explains.

In Summary

Bullard concludes that the conventional wisdom on stabilization policy is being re-established in the U.S. Stabilization policy should be left to the monetary authority, which can operate effectively even with a near-zero policy rate. Fiscal authorities should set the tax and spending programs in a way that makes economic and political sense for the medium to longer term. In particular, a stable tax code that is aligned with a stable plan of government spending would allow businesses and households to plan for the future in the most effective way, Bullard says.



  1. Michael Woodford, “Simple Analytics of the Government Expenditure Multiplier,” American Economic Journal: Macroeconomics 3: 1-35, 2011. [back to text]