Lessons for Macroeconomic Policy from the Great Recession’s Policy Challenges Eskander Alvi edited the piece. W. E. Upjohn Institute for Employment Research, Kalamazoo, MI, 2017, 137 pages., $28.32 hardback
The collapse of the U.S. housing market in 2007 triggered a series of negative economic events, including a financial crisis, high unemployment, a weakening international economy, and, ultimately, the Great Recession of 200709, the greatest post-World War II economic disaster. The housing bubble burst as a result of banks’ aggressive lending, easy credit, and mortgage securitization. The practice of pooling and repackaging financial instruments, such as mortgages, and selling them to investors is known as securitization. Lenders would securitize and sell mortgages after making loans to home buyers, obtaining more capital for lending. The subprime mortgage crisis predicted the ensuing upheaval in the banking system, most notably Lehman Brothers’ demise. Because so many industries were affected by these developmentsand because the global economy is so intertwinedthe consequences were disastrous.
Editor Eskander Alvi and his team of economists examine the tactics employed by policymakers to tackle the Great Recession in Confronting Policy Challenges of the Great Recession: Lessons for Macroeconomic Policy. Alvi forecasts the recession’s devastating economic impacts in the book’s first chapter, including huge layoffs, unpredictable financial markets, investment cutbacks, and a sinking gross domestic product. In reaction to the crisis, which resembled the Great Depression, authorities attempted to build on what had succeeded in the 1930s while also correcting what had gone wrong. Despite the fact that the Great Recession did not approach the depths of the Great Depression, it was followed by a delayed recovery and policy mistakes in fiscal and monetary policy. Alvi and his coauthors analyze the triumphs and failures of legislators who dealt with the crisis and its aftermath, the reasons for the adoption of various fiscal and monetary policy measures, and the elements for the slow recovery throughout the book.
In the aftermath of the Great Recession, the Great Depression loomed big. Emergency aid in the form of bank bailouts, as well as fiscal stimulus, were top priorities. Many common anti-recessionary policies were implemented by Congress, including tax cuts and increases in unemployment insurance and food stamp payments, which helped to prevent the crisis from extending further. Despite reaching an exceptionally high rate of 10%, unemployment was still significantly lower than the 24-percent rate seen in the 1930s. While Congress’ response to the recession was better in many ways, it also replicated several previous policy blunders. The authorities’ decision to let Lehman Brothers fail, according to one of the book’s writers, was the “one incident that most undermined the stability of global financial markets.” The choice was similar to Henry Ford’s decision to let his Guardian Group of banks to fail in the 1930s, and both incidents wreaked havoc on the financial markets. In 2010, Congress passed the DoddFrank Wall Street Reform and Consumer Protection Act in an effort to regulate lenders and safeguard customers, although this policy didn’t go nearly as far as the GlassSteagall Act, which was passed during the Great Depression. The fact that the worst-case scenario was avoided may have deterred Congress from taking additional steps to boost the economy and regulate the financial sector. Another possible contributor was public pressure on politicians as the country struggled to negotiate its way out of the recession. As Eichengreen points out, public criticism frequently influences policy decisions due to the “dominance of ideology and politics over economic research.”
After repeated criticism of the bank bailouts and mounting concerns about the national debt, fiscal stimulus came to an end. Given the severity of the recession, the lack of enthusiasm for additional fiscal policy intervention resulted in a substantially slower recovery. This inaction was the “single worst miscalculation in macroeconomic policymaking following the financial crisis in 2008,” according to Gary Burtless, who wrote one of the book’s chapters. In a similar spirit, authors Laurence Ball, J. Bradford DeLong, and Lawrence H. Summers contend that to supplement the Federal Reserve’s (Fed) attempts to raise aggregate demand, a more aggressive fiscal policyprimarily more tax cuts and government expenditure on public projectswas required. Despite popular belief that expansionary fiscal measures increase the national debt and exacerbate the problem, the authors argue that, during a recession, such programs increase the national debt in the short run but have no impact in the long run due to increased employment and output. As a result, fiscal contractions during recessions exacerbate the debt problem, prolonging the economic downturn. In the end, public pressure restricted fiscal policy during the Great Recession in numerous ways.
The Fed attempted to fill in the gaps created by the current fiscal policy discussion. Many economists feel that the country’s initial financial threat was larger during the Great Recession than it was during the Depression. Recognizing the gravity of the situation, the Fed made a conscious effort to avoid the errors of the 1930s. It lent large sums of money to foreign banks and nonbank institutions such as broker-dealers, money market funds, and buyers of securitized debt to keep credit flowing and boost consumer confidence. With the federal funds rate already near zero, the Fed used large-scale asset purchases to further slash intermediate- and long-term interest ratesa strategy known as quantitative easing. The Fed also utilized forward guidance, stating that interest rates will remain at zero for the foreseeable future. Interest rates have been lowered and asset prices have risen as a result of these efforts, according to most experts. According to the authors, the Fed was nevertheless under to the same forces that prohibited the implementation of new fiscal policy measures, albeit to a lesser extent. Some detractors argued that central bankers had no place in the mortgage-backed securities market, while others warned of hyperinflation. The Fed chairman at the time, Ben Bernanke, attempted to explain the Fed’s actions to Congress and the public, with mixed results. In order to show its independence, the Fed began decreasing its balance sheet sooner rather than later, ignoring the Depression’s lesson. Nonetheless, the authors believe that the Fed aided the economy in avoiding the worst-case scenario by implementing new monetary policy measures that can be depended on in future downturns.
Any reader interested in learning more about the Great Recession can benefit from Confronting Policy Challenges of the Great Recession: Lessons for Macroeconomic Policy. The book describes how Congress, the executive branch, and the Federal Reserve responded to the crisis, as well as the obstacles they encountered. The writers support their argument with historical comparisons (mostly to the Great Depression), visual aids such as charts and graphs, and a wealth of relevant data. While the book delves into a variety of complex economic issues, it is accessible to all readers.
In the 2008 recession, what fiscal policy was implemented?
The Economic Stimulus Act of 2008, a $152 billion stimulus aimed to help avoid a recession, was passed by Congress in 2008 and signed by then-President George W. Bush. The majority of the package was made up of $600 tax rebates for low and middle-income Americans.
The American Recovery and Reinvestment Act of 2009, a $787 billion package encompassing a range of expenditures from tax rebates to corporate investment, integrated various stimulus programs. $184.9 billion would be spent in 2009, $399.4 billion in 2010, and the rest of the bill’s funds would be spread out throughout the rest of the decade. An announcement of a rescue plan was connected with positive returns, whereas a public intervention in favor of a single bank was associated with negative returns.
What role does fiscal policy play during a recession?
- The use of government spending and tax policies to impact economic circumstances is referred to as fiscal policy.
- Fiscal policy is largely founded on the views of John Maynard Keynes, who claimed that governments could regulate economic activity and stabilize the business cycle.
- During a recession, the government may use expansionary fiscal policy to boost aggregate demand and boost economic growth by decreasing tax rates.
- A government may follow a contractionary fiscal strategy in the face of rising inflation and other expansionary signs.
During the 2008 recession, how was monetary policy implemented?
The Federal Reserve System, which is America’s central bank, is the primary governing body tasked with preventing recessions. It is also one of numerous institutions tasked with supervising banks and ensuring the financial system’s stability. As a result, beginning in 2008 and lasting for several years afterward, the Fed was on the front lines of addressing intertwined banking and real-economy problems.
The Fed has used a variety of instruments in its fight against the crisis, including classic monetary policy tactics as well as a variety of unconventional ones. It has received enormous political scrutiny and has been in the public glare like never before.
Despite the Fed’s efforts, unemployment remained high for several years after the crisis began. As a result, the central bank was accused of undue complacency as well as excessive activism.
During inflation, what fiscal policy is used?
We must underline that fiscal policy is the manipulation of the economy through government expenditure and tax policy. All spending is not included in fiscal policy (such as the increase in spending that accompanies a war).
Fiscal policy, whether through changes in spending or taxation, drives aggregate demand outward in expansionary fiscal policy and inward in contractionary fiscal policy, as shown graphically. In a rising economy, Figure 1 shows the process using an aggregate demand/aggregate supply diagram. At an output level of 200 and a price level of 90, the initial equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0.
In the process of long-term economic growth, aggregate supply has shifted to the right to SRAS1, and aggregate demand has shifted to the right to AD1, maintaining the economy operating at the new level of potential GDP. The new equilibrium (E1) has a level of output of 206 and a level of price of 92. After another year, aggregate supply has migrated to the right, this time to SRAS2, and aggregate demand has shifted to AD2. The current equilibrium is E2, with a 212 output level and a 94 price level. In summary, the graph depicts an economy that grows smoothly year after year, producing at or near its potential GDP each year, with only minor price increases.
The aggregate demand and supply do not necessarily move in lockstep. For a variety of reasons, aggregate demand may fail to expand in lockstep with aggregate supply, or may even shift left: consumers become hesitant to consume; firms decide not to spend as much; or demand for exports from other countries declines. For example, in the late 1990s, private sector investment in physical capital in the US economy soared, going from 14.1 percent of GDP in 1993 to 17.2 percent in 2000 before declining to 15.2 percent in 2002. In contrast, if changes in aggregate demand outpace increases in aggregate supply, inflationary price increases will ensue. Shifts in aggregate supply and aggregate demand cause recessions and recoveries in business cycles.
Monetary Policy and Bank Regulation demonstrates how a central bank might utilize its regulatory powers over the banking system to take countercyclical (or “against the business cycle”) policies. When a recession is on the horizon, the central bank employs an expansionary monetary policy to boost money supply, increase loan volume, lower interest rates, and move aggregate demand to the right. When inflation looms, the central bank employs contractionary monetary policy, which involves reducing money supply, reducing the quantity of loans, raising interest rates, and shifting aggregate demand to the left. Fiscal policy, which uses either government spending or taxation to influence aggregate demand, is another macroeconomic policy instrument.
What are the two alternatives for fiscal policy in a recession?
Governments often engage in expansionary fiscal policy during recessions and contractionary fiscal policy when inflation is a concern.
What role does fiscal policy play in stimulating demand?
The term “expansionary fiscal policy” is defined as “fiscal policy that is designed The government is attempting to stimulate aggregate demand by increasing government expenditure and/or lowering taxes.
Increased government borrowing and the sale of bonds to the private sector are typically used to fund expansionary fiscal policy.
When there is unemployment, surplus savings, and falling real output, Keynes believes that expansionary fiscal policy should be adopted. He maintained that by increasing government spending, the economy would be stimulated and jobless resources would be put back to work. This allows the economy to recover faster than if it were left to its own devices.
How expansionary fiscal policy works
If the government lowers income taxes, consumers will have more discretionary money and will be able to spend more. Higher consumption will boost aggregate demand, resulting in faster economic development.
Alternatively, if the government expanded its investment in public works programs, this would result in more jobs, higher salaries, and more aggregate demand.
This influx of cash into the economy has the potential to have a positive multiplier effect. Builders who get a job, for example, will spend more money elsewhere in the economy to create other jobs. The end gain in real GDP from the government’s first injection will be greater than the initial investment.
Because of the increased demand in the economy, expansionary fiscal policy can also lead to inflation.
Paradox of thrift
One argument for fiscal policy is that the government should spend more to compensate for increased private sector saving and decreased private sector spending.
As consumers cut back on spending at the outset of the recession in 2009, the saving ratio increased quickly. This resulted in a decrease in demand. This increase in saving can be used by fiscal policy to increase spending.
Expansionary fiscal policy and government borrowing
Expansionary fiscal policy may have the unintended consequence of increasing the size of a government’s budget deficit.
- Financial suffocation. Increased deficits could frighten investors, causing interest rates on government debt to rise. (This occurred in the Eurozone without the Central Bank purchasing bonds, while bond yields decreased in the United Kingdom and the United States due to robust demand for bonds.)
- Overcrowding of resources. When private investors buy government bonds, they have less money to invest in the private sector.
Evaluation of expansionary fiscal policy
1. Is there anything else going on in the economy?
- Lowering income taxes may not be enough to improve AD if house prices are declining and confidence is low.
- In 2008, for example, the United States attempted to slash taxes in the hopes of increasing spending. However, the economy was also suffering from declining home values, a lack of confidence, and a credit scarcity; as a result of all of these issues, expansionary fiscal policy proved ineffectual in encouraging quick economic growth.
2. Overcrowding
- When the government spends more, but borrows from the private sector, the private sector invests less, and government expenditure ‘crowds out’ private sector spending.
- Private saving rates, on the other hand, climb rapidly during a liquidity trap/recession. As a result, expansionary fiscal policy serves to counteract the increase in private sector saving, injecting money into the circular flow while avoiding crowding out.
3. Fiscal policy timing – the amount of spare capacity
- The state of the economy is a major concern of expansionary fiscal policy. Increased government borrowing is likely to produce crowding out and/or lead to higher inflation if expansionary fiscal policy is undertaken while the economy is close to full capacity (e.g. AD3 to AD4). However, there will be minimal rise in real GDP.
- In a deep recession, when the economy has spare capacity, expansionary fiscal policy will not result in crowding out or inflation. (From Y1 to Y2, real GDP rises due to AD1 to AD2.)
Supply side effects of fiscal policy
- Increased government spending on education and training could boost long-term labor productivity and help the economy grow at its long-term trend rate.
- Government spending, on the other hand, could be inefficient and wasteful, depending on what the government spends the extra money on.
Automatic vs Discretionary fiscal policy
- Fiscal stabilizers that work on their own. The government will automatically spend more on jobless compensation during a recession (because more people will be unemployed). People also pay less income tax during a recession (because they earn less)
- Fiscal stabilizers with discretion. This happens when the government raises or lowers tax rates or spends more or less money.
Different views on fiscal policy
- When there is an increase in demand-deficient unemployment and surplus savings, Keynesians say that fiscal policy should be adopted. If the economy is below full capacity, Keynesians maintain, there will be no crowding out.
- Monetarists are more critical of fiscal policy, believing that increased government borrowing will lead to crowding out, as increased government expenditure will only lead to a decrease in private sector spending.
- Theoretical Economics in the Twenty-First Century (MMT). This argument claims that printing money can be used to fund expansionary fiscal policy as long as inflation stays within a reasonable range.
- Equivalence in Ricardian terms. This argument claims that expansionary fiscal policy does not result in an increase in demand because consumers expect taxes to rise in the future to pay off the increased government debt.
What role does fiscal policy play in boosting economic growth?
Government policies aimed at boosting economic growth are divided into two categories: increasing aggregate demand (demand side policies) and increasing aggregate supply/productivity (supply side policies) (supply side policies)
- Deregulation, tax cuts, and free trade agreements are all examples of privatization (free market supply side policies)
- Infrastructure improvements, as well as enhanced education and training. (supply-side interventionist policies)
During a recession or a period of economic stagnation, demand-side strategies are critical. Supply-side policies are important for enhancing long-term productivity growth.
How does the government employ fiscal and monetary policy to maintain economic stability?
During an economic slump, fiscal policy can help to maintain aggregate demand and private sector incomes, while also reducing economic activity during periods of robust expansion.
The so-called “automatic fiscal stabilisers” play a significant role in fiscal policy stabilization. These take into account the impact of economic swings on the government budget and do not need policymakers to make any short-term decisions. For example, the quantity of tax collections and transfer payments is closely related to the economy’s cyclical situation and adjusts in a way that helps stabilize aggregate demand and private sector incomes. Automatic stabilizers have a variety of appealing characteristics. First and foremost, they respond in a predictable and timely manner. This makes it easier for economic agents to create accurate expectations and boosts their confidence. Second, they react with a level of intensity that is proportional to the magnitude of the economic divergence from what was anticipated when budget plans were authorized. Third, automatic stabilizers work in a symmetrical manner throughout the economic cycle, preventing overheating during booms and boosting economic activity during downturns without jeopardizing the underlying integrity of budgetary positions as long as fluctuations are balanced.
Stabilization can theoretically also be achieved by discretionary fiscal policy, in which governments actively choose to modify spending or taxes in response to fluctuations in economic activity. However, as previous attempts to manage aggregate demand using discretionary fiscal measures have frequently proved, discretionary fiscal policies are not typically suitable for demand management. First, discretionary policies can jeopardize the fiscal health of governments, since it is simpler for governments to lower taxes and increase expenditure during periods of low growth than it is to do the opposite during periods of high growth. As a result, the public debt and tax burden are likely to continue to rise. As a result, high taxes may have a negative impact on the economy’s long-term growth prospects, as they limit incentives to labor, invest, and innovate. Second, many of the positive characteristics of automatic stabilizers are nearly impossible to mimic by policymakers’ discretionary reactions. Tax adjustments, for example, must usually be approved by Parliament, and their implementation typically lags behind the budget-setting process. As a result, discretionary fiscal measures aimed at managing aggregate demand have historically tended to be pro-cyclical, frequently becoming effective after cyclical conditions have already reversed, worsening macroeconomic swings.
Clearly, fiscal policy’s short-term stabilizing function is especially crucial for nations that are members of a monetary union, because nominal interest rates and exchange rates do not adapt to the condition of a single country, but rather to the union’s overall position. Fiscal policy, which remains in the hands of individual governments, can then become a critical tool for stabilizing domestic demand and output. At the same hand, when there is more uncertainty about future income trends, the restrictions of active fiscal policy may be larger. This is the case in many European countries today, where public pension and health-care systems are facing increasing difficulties as a result of demographic trends. In these circumstances, today’s cyclically-oriented tax cuts and spending increases may simply result in greater taxes or reduced spending tomorrow. With this in mind, the public may respond to fiscal increases by boosting precautionary savings rather than consumption.
What is the scope for discretionary fiscal policy in light of the previous discussion? Discretionary policies are required to execute long-term structural changes in public finances as well as to cope with exceptional circumstances, such as when the economy is subjected to extreme shocks. Discretionary policies, in reality, reflect shifting preferences on the size of the government that is desirable, the priorities of public spending, and the quantity and characteristics of taxation. These policies shape the structure of government finances and have a significant impact on the economy’s performance, as well as the characteristics of a country’s automatic stabilizers. Discretionary fiscal policy decisions are also required to ensure the medium-term viability of governmental finances. This is a requirement for automatic stabilisers to function freely, as fiscal policy can only function as an effective stabilizing tool if there is sufficient room for maneuvering.
The experience of industrialised countries over the last few decades clearly demonstrates that persistent budget imbalances hinder fiscal policy’s ability to stabilize the economy. During downturns, imbalances frequently demand stringent fiscal policies to avoid unsustainable deficits and debt growth. As a result, when the economy’s long-term viability is in question, expansionary policies and even automatic stabilizers may not have the desired effect on output as people modify their behavior. Consolidation actions may then re-establish confidence and raise expectations about the public finances’ long-term prospects. These ‘non-Keynesian’ consequences may have the unintended consequence of fiscal consolidation having an expansionary influence on the economy. When budgetary circumstances are seen to be risky or when fiscal sustainability is threatened by excessive debt and future fiscal obligations, active fiscal consolidation with discretionary actions is appropriate. Finally, while automatic fiscal stabilisers are excellent at mitigating regular cyclical variations, there may be times when active policy actions are required. When economic imbalances do not come from normal cyclical conditions or are regarded irreversible, automatic stabilisers alone may not be adequate to stabilize the economy. However, in a recession, the benefits of expansionary measures must be weighed against the dangers of long-term sustainability or long-term negative consequences on the structure of government finances, such as a permanently higher tax rate, as well as the economic costs of reversing policy.