In recent posts (e.g. here) I have been rather pessimistic about what might happen the next time we have a large negative demand shock that puts interest rates to their zero lower bound (ZLB). In theory fiscal policy can come to the rescue, and we can avoid a severe recession. But many of the reasons that did not happen this time persist. The political right will see rising debt as a chance to shrink the state. The financial sector will argue a funding crisis (the ‘bond vigilantes’) are just around the corner. Central banks will do what central banks have nearly always done: advise either privately or publicly that we need fiscal restraint.
We can hope that, as recent lessons are learnt, economists speak with more of one voice on what should happen. I like to think this will occur to some extent, as the influence of the anti-Keynesians fades, but the importance of ideology in the discipline is such that economists will never be united on this issue. And in any case, will the majority of economists have more influence than the financial sector and the central bank? I think not, particularly if there is another Greece.
What I think macroeconomists can do is start talking about fiscal rules, and the importance of fiscal councils. This is what Jonathan Portes and I try to do in a new paper (here or here). The paper discusses a number of issues involved in formulating fiscal rules (which I will write about in subsequent posts), and it also stresses the importance that fiscal councils can have in supporting (or modifying) these rules. It also has something very clear to say about what should happen the next time we experience a large negative demand shock. (With unchanged inflation targets and perhaps a lower natural real interest rate, this may happen rather more often than we would like.)
Suppose, for the sake of argument, that the fiscal rule involves some target for the deficit in five years time. A negative demand shock hits, and the central bank judges there is more than a 50% chance that interest rates could end up at the ZLB. At that point, the deficit target would no longer apply. Instead the central bank and fiscal council would be obliged to cooperate in formulating a fiscal stimulus package that would enable interest rates to rise just above this lower bound. Both institutions would then recommend this package to the government. The central bank and fiscal council would continue to cooperate in this way (suggesting modifications to the package as new data became available) until the central bank expected interest rates to rise. Call this the ZLB procedure.
Why do we propose cooperation between the central bank and fiscal council? The central bank should be involved for four reasons. First, they probably have more resources working on short term forecasting. Second, they could help design a package that was effective at raising demand, rather than one that pandered to political preferences. (Fiscal councils on their own would be wise to avoid making judgements about how deficit targets should be achieved.) Third, a government would find it difficult to go against these two institutions acting together. Forth, the central bank would also probably want to implement some form of unconventional monetary policy, and the size of any fiscal stimulus would need to allow for that.
Now you could say that a central bank would be reluctant to make this call, for the reasons I gave at the beginning of this post. However, the central bank bears responsibility here. If interest rates did go to zero, they will clearly have made a mistake, and can be held accountable for that. And once interest rates had hit the lower bound, the ZLB procedure would operate anyway.
Why should the fiscal council be involved? Because part of the package would be an assessment by the fiscal council of what should happen to deficits and debt once interest rates did rise above the lower bound. The previous deficit target would have to be revised. A government that accepted the stimulus package would be asked to sign up to meeting any new deficit target after the recession was over.
This ZLB procedure should be part of any ‘fiscal rule’. This may seem odd, because it is really an account of how the normal rule should be suspended and what should replace it in ‘exceptional’ circumstances. Why not instead simply say that the normal rule should no longer apply when interest rates hit the ZLB and leave it at that? The reasons are those given at the start of this post. Making up policy in a crisis is fraught with dangers, and macroeconomic rationality can easily give way to vested interests and biases, as we discovered in 2010. The whole point of fiscal rules and fiscal councils is to overcome those interests and biases, and they apply at least as much in a crisis as in normal times.