Death of a Theory

The author discusses the effectiveness of fiscal approaches to stabilization policy. The conventional wisdom before 2007 was that fiscal policy intervention as a stabilization tool had little to recommend it, mostly due to political constraints and to the unlikely effectiveness of many types of temporary fiscal policy actions. However, with short-term nominal interest rates near zero, attention turned again toward fiscal stabilization policy. The author describes and critiques two theories of how fiscal policy might be viewed as effective in such circumstances. One, heavily studied, is that a tax-financed increase in government expenditures would temporarily increase total output in the economy. The other, lightly studied but rhetorically forceful, is that increased government expenditures may inspire confidence. Both theories have drawbacks, but the author argues the first is dying because of three considerations: (i) actual political systems are ill-suited to implement the advice from the theory; (ii) monetary stabilization policy has been quite effective, making fiscal experiments redundant; and (iii) governments pushed distortionary taxes into the future, which in the theory reduces or eliminates the desired effects. Reprinted by permission of the Federal Reserve Bank of St. Louis