What we know, or think we know, about fiscal policy five years after the global recession started isn’t all that different from what we knew, or thought we knew, back in 2008. It boils down to two points. One, fiscal stimulus is essential when conventional monetary policy is powerless. Two, fiscal stimulus may be impossible even when it’s essential.
Most economists agree that changes in interest rates are usually a better way to regulate demand than discretionary changes in taxes and public spending. But interest rates can’t fall to less than zero. When that limit is reached – as it was in this recession – fiscal policy must carry a bigger load.
In economies with a lot of slack, fiscal multipliers (the change in output that follows from any change in the fiscal balance) are more powerful than usual. This recession, because of its unusual depth, has supplied new evidence to back up this rule, and the U.K.’s attempt to refute the logic with “expansionary austerity” is widely seen as a failure despite some recent tentative signs of recovery.
Moreover, unconventional monetary policy, the other alternative to changes in short-term interest rates, can’t yet be called a success. Only when the Federal Reserve and other central banks end their vast asset-purchase programs will it be possible to render a verdict on quantitative easing as a partial substitute for fiscal stimulus. So far, it looks as though it has helped. Let’s see how the exit goes before we declare it a triumph.
But fiscal stimulus isn’t always an option. Governments can’t do it if investors are unwilling to buy their debt. Greece and other European Union economies discovered this in 2010. Theirs was hardly a new experience.
A country such as Greece can find itself literally unable to service its debts. The U.S. or the U.K., which borrow in their own currencies, could never be forced into that corner. They can simply print the money if need be. Or so it’s argued.
Countries that borrow in their own currency can, in fact, default. Put to one side the periodic threats from the U.S. Congress to repudiate debt as an act of policy. Beyond that, countries may resort to inflation as a way to lighten their debts, and investors are aware of the possibility. A surge in bond yields that would require sudden fiscal contraction is therefore possible even for a country like the U.S.