RDP 2014-02: Fiscal Policy and the Inflation Target 2. The New Regime of Fiscal Activism

The United States has had two recent encounters with the zero bound on interest rates, in the early 2000s and following 2008. Both have been accompanied by large fiscal stimulus. This relationship is illustrated in Figures 1 and 2, which show interest rates and Congressional Budget Office (CBO) estimates of the budgetary costs of major legislation intended to boost aggregate demand. Figure 1 shows CBO estimates of the budgetary cost of the Economic Growth and Tax Relief Reconciliation Act, or EGTRRA, of 2001, and the Jobs and Growth Tax Relief Reconciliation Act, or JGTRRA, of 2003. Figure 2 shows CBO estimates of the budgetary cost of the stimulus Acts of 2008, 2009 and 2010 (formally, the Economic Stimulus Act of 2008; the American Recovery and Reinvestment Act, or ARRA, of 2009, and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act, or TRUIRJCA, of 2010). These comprise the main stimulus legislation enacted through mid 2011, with estimated effects shown through fiscal 2012. As discussed in Appendix B, I subtract the contribution of the alternative minimum tax from the CBO estimates. For comparison, the figures also show estimates of a Taylor-type rule, described below, using estimates of the output gap from CBO (2011).

Figure 1: Fiscal Stimulus near the Zero Bound
Figure 2: Fiscal Stimulus near the Zero Bound

Figures 1 and 2 also show that, in each episode, fiscal stimulus was delivered in a succession of distinct packages. So, although the number of observations is small, there has been a pattern of countercyclical activism. Furthermore, stimulus has been enacted during both Republican and Democratic administrations.

Discretionary fiscal policy has also been strongly countercyclical in other countries. The recent global recession was accompanied by discretionary fiscal measures in OECD economies averaging 3.4 per cent of annual GDP between 2008 and 2010 (OECD 2009, Table 3.1).

The turn to fiscal activism in the United States is new. In contrast to the two most recent business cycles, fiscal policy was neutral to contractionary in previous US recessions. Auerbach, Gale and Harris (2010) provide a narrative description of this shift, noting the explicit decisions of Congress to tighten fiscal policy in 1982 and 1990. A quantitative measure of the shift can be seen, for example, in Follette and Lutz's (2010, Table 6) estimates of fiscal impetus, an impact-weighted measure of the stance of fiscal policy. In the three years following the business cycle peaks of 1969, 1973, 1980, and 1990, federal fiscal impetus averaged 0.1 per cent of GDP, near its ‘neutral’ benchmark of about 0.2 per cent. In contrast, it averaged almost one per cent of GDP after the peaks of 2000 and 2007, using data through 2009.

One reason for considering the new fiscal activism to be structural is that it has been accompanied by a parallel change in policy advice. Many economists have explained that whereas they used to be sceptical of fiscal intervention, they now view it as desirable at the zero bound. Examples include DeLong (2011) and Krugman (2011). Surveys of the state of academic thought, such as Blanchard et al (2010) or David Romer (2011) suggest this change is widespread. In the words of Becker (2009), ‘there appears to have been a huge conversion of economists toward Keynesian deficit spenders’. The evolution in advice partly represents new circumstances rather than a change in opinion. According to Summers (2010), ‘[m]ost economists across a broad spectrum’ simultaneously believe that fiscal stimulus is effective at the lower bound but that it is not effective in normal circumstances.

Given these developments, it would now seem sensible to consider the likely effects of large fiscal stimulus when the economy next approaches the zero bound. That requires modifications to the models used to estimate the effect of the zero bound, which do not include active countercyclical fiscal policy.