Ask Not What Your Government can do for You: Macro Policy in the Current Environment Rik Hafer Distinguished Research Professor Southern Illinois University Edwardsville February 3,2012

Prologue  What are your objectives in classroom?  What is the “take away”?  Plug-and-chug vs. Policy debate February 3, 2012

A story about fiscal policy…  How has the conventional wisdom of fiscal policy changed?  Does reality match what we teach? February 3, 2012

Conventional wisdom, pre-1970 “But quibbles about exact timing aside, the potency of fiscal policy…has been demonstrated time and again in the past couple of decades.” Walter Heller (1969) A caricature Fiscal policy as a stabilization tool  Change G, change T and change Y February 3, 2012

The Monetary vs. fiscal policy debate  St. Louis position Fiscal policy affects economy  Transitory Monetary policy affects economy  Lasting effects on nominal GDP and inflation  Fiscal policy without monetary support? February 3, 2012

Fiscal policy fails: New conventional wisdom “Dubious Keynesian Proposition #4: Fiscal policy is a powerful tool for economic stabilization, and monetary policy is not very important.” Mankiw (1992)  Political barriers Inability to deal with deficits Lack consensus on countercyclical policy February 3, 2012

“New” role for fiscal policy? February 3, 2012  Spending/tax programs affect current behavior Deficits signal higher future taxes Fiscal policy is complicated (Woodford, 2011)  Tax structure, spending, debt within dynamic time dimension  Set policy for medium and longer term

Success of new conventional wisdom?  Tax policy Predictable tax structure?  Federal income tax code: > 45,000 pages  Mid : 7,000 federal tax code changes  Debate over marginal rates in election February 3, 2012

Success of new conventional wisdom?  Spending policy  Unpredictability of deficits Politics? Economics? CBO January 2011 projections (billions) Low $429 $429 High $969 $1,422 February 3, 2012

Great Recession derails new conventional wisdom  Spending (Bullard, 2012) February 3, 2012

Unpredictability of debt  (Leeper, 2010) February 3, 2012

Back to old conventional wisdom (pre-GR)?  Is debt sustainable?  Bullard’s (2012) two worlds  Increased deficits/debt signal expectation of stronger future growth Business react and growth occurs  Increased deficits/debt signal expectation of weaker future growth  Probably in world #2 February 3, 2012

Stories we tell students  Government spending multiplier Concept or algebraic exercise? Wide range of estimates  IMF (2009) review of studies One-year spending multiplier  Range: -0.1 to 1.4 February 3, 2012

Stories we tell students  Crowding out February 3, 2012

Should we ignore deficits/debt?  Deficit has not crowded out private investment doesn’t meant it could not happen Bond downgrades?  Gov’s taxing and spending choices affect us personally  Size of government debate What is government’s role Economic freedom February 3, 2012

If not fiscal policy, what?  Monetary policy re dux Zero Lower Bound (ZLB) issues February 3, 2012

Monetary policy at ZLB  Bullard (2012) “In reality, the Committee has been able to run an effective countercyclical monetary policy during the last three years via “unconventional” policy. In the theory, this makes fiscal stabilization policy ineffective.”  QE policies Not limited to financial assets Section 13.3 of Federal Reserve Act February 3, 2012