Rethinking Stabilization Policy: Evolution or Revolution?
The obvious lesson from the Great Financial Crisis is that the financial system matters and financial crises will probably happen again. The second, more general, lesson is that the economy is often not self-stabilizing. These two lessons, together with an environment where neutral interest rates are likely to remain low, have clear implications for the design of stabilization policies.
At a minimum, they suggest that policies may need to become more aggressive, both ex-ante and ex-post, with a rebalancing of the roles of monetary, fiscal and financial policies. In particular, while low neutral rates decrease the scope for using monetary policy, they increase the scope for using fiscal policy. Think of such rebalancing as evolution. If however, neutral rates become even lower, or financial regulation turns out to be insufficient to prevent crises, more dramatic measures, including larger fiscal deficits, revised monetary policy targets, or sharper restrictions on the financial system, may be needed. Think of this as revolution. Time will tell.
Thanks to Vivek Arora, Ben Bernanke, Giovanni dell'Ariccia, Bill Cline, Stanley Fischer, Morris Goldstein, Greg Ip, Colombe Ladreit, Thomas Pellet, Lukasz Rachel, Martin Sandbu, Andrei Shleifer, Robert Solow, Anna Stansbury, Nicolas Veron, and David Vines for comments. Thanks to Andrew Sacher for research assistance. Prepared for the “Rethinking macro policy” conference at the Peterson Institute for International Economics, October 2017. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. The papers presented at the conference and podcasts of the presentations are available at https://piie.com/events/rethinking-macroeconomic-policy