The Incompetent Central Bank Case for Fiscal Stimulus

Keynesianism has made a roaring comeback in the aftermath of the Great Recession. No matter what ideological leaning different world leaders had at the time the crisis struck, they all threw their ideologies out of the window and implemented massive fiscal stimulus measures. A big reason Keynesianism was brushed aside in the past couple of decades is that the contractionary part of it more often than not simply does not happen, mainly for political reasons. And as far as the expansionary side of the coin is concerned, opponents of Keynesianism rightly point out that it is unnecessary and even counterproductive in times where our economies are running at something close to full employment. Even without fully rational expectations, the effects expansionary policy can have on the Philips curve are very real. Yet the whole edifice of Keynesian stimulus actually working at least in bad times is built on shaky ground as well – it is made under the assumption that a country’s central bank simply drops the ball when it is needed the most.

Inflation targeting as a monetary regime has been adopted by nearly every central bank in the world. In a way, it was first tried by the German Bundesbank and the Swiss National Bank in the late 1970s, even though the first country to explicitly adopt such a framework was New Zealand. It is a very compelling framework, and one much more flexible than the name itself suggests at first glance. Particularly, even though the explicit target is often just inflation, there is considerable discretionary room to accommodate other variables such as the output gap through e.g. a Taylor-rulesque approach. But enough of basic theory on modern central banks, let’s get to the interesting part.

As pointed out above, central banks have more or less flexible targets with regards to certain economic variables that they aim to hit. A central bank not hitting its target is a central bank not doing its job. Sure, there are severe complications to monetary policy that makes it a hard issue. Changes in policy affect the economy with a lag, there are considerable information problems, and the danger of good people being assimilated by the Borg (more seriously known as “Groupthink”) also seems very real, for instance. But just assuming that an incredibly powerful institution fails is certainly a bad starting point for a theory of monetary policy. And indeed, as  pointed out by Brad DeLong and Larry Summers, two stern proponents of Keynesianism, “ the policy-relevant multiplier [is] near zero” during normal times due to the central bank offsetting any effects of fiscal movements on real GDP. Fiscal policy might possibly have an effect on nominal GDP by increasing the velocity of circulation, but that’s pretty much it (and a fairly tricky topic). If the economy is where the central bank wants it, an increase in government expenditure will force the central bank to act in a contractionary way and vice versa. The reasonable consensus seems to be that when stuck in depression, things change. Particularly, awful things start happening when we are stuck in what is generally known as a liquidity trap – a situation where short-term interest rates are stuck at or close to zero.

The whole concept, however, is based around the idea that once short-term interest rates run up to the zero lower bound, a central bank is rendered useless. Big asset purchases, part of what is generally referred to as “unconventional monetary policy”, shows this is clearly wrong. That these interventions have a very real effect is well documented. And while there is a strong case to be made that such actions indeed have diminishing marginal returns, the returns are still positive. In other words, even at the zero lower bound, central banks can influence the economy. And even if they do not do so directly, there is still the powerful channel of expectations (e.g. through forward guidance about the future path of policy) which they can make use of. What’s the point of all the credibility central banks worked so hard on building if they don’t use it to credibly promise to be “irresponsible” when they really need to? Once the economy moves into “normal” territory again, all the extra liquidity in the system has to be removed at an adequate rate, of course. Yet concerns that this may not be possible seem vastly exaggerated.

Even in a liquidity trap, the central bank has powerful tools to get the economy to where its mandate requires it. It is a highly complex and difficult job to do, but that does not mean we should just let central bankers off the hook. If they are failing to hit their target, they are failing to do their job – plain and simple. Fiscal policy is very relevant, in a sense that it is essentially the result of a democratic process, which central bank policy is not. It can be used to redistribute within the economy in a way consistent with what is demanded of the system by voters. Automatic stabilizers are crucial in attenuating the effects of business cycles and ensuring every citizen has access to some sort of safety net in case things go wrong. Yet discretionary stimulus is only necessary if central banks prove to be incompetent. And while this clearly is the case at the moment, it shouldn’t be so. It is time central banks around the world get their act together and start doing what we pay them to do: get us out of this recession and keep politics out of our stabilization process.


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