Macroeconomic Policy after the Crash

The story of monetary policy during the financial crisis is one of experimentation with unconventional tools and unexpected macroeconomic developments. We begin with the conventional tool of monetary policy and the tale of official interest rates. It is often said central banks hit the zero lower bound (ZLB) on official interest rates during the crisis and were then forced to turn to those unconventional tools to continue injecting stimulus into the economy. However, the story is a little more complicated than that: in practice, some central banks stopped cutting the policy rate above zero (and started doing something else) whilst others managed to eventually push through zero into negative rate territory. This section explains what happened where and why. But before we turn to explain the unconventional conduct of monetary policy during the crisis—the experimentation with negative interest rates, asset purchases and forward guidance—we will first recap the conduct of conventional monetary policy: how central banks set interest rates, and how changes in the stance of monetary policy influence activity and inflation.

Having discussed the BOE’s monetary policy response during the opening years of the post-crisis period, we now turn to discuss some of the key puzzles which shaped the monetary policy debate during this period. We begin with the behaviour of inflation.

We now turn to the other great macroeconomic puzzle of the post-crash era: why the supply side of the economy appears to have been so badly damaged by the financial crisis. This issue is typically referred to as the productivity puzzle because the anomalous behaviour of supply is easiest to observe in the data on labour productivity.

In addition to deciding to keep the target for the federal funds rate at 1 % at its August 2003 meeting, the FOMC chose to provide guidance about the future path of interest rates to market participants and households and companies in the wider real economy: that rates were likely to remain low for a ‘considerable period’ (FOMC 2003):

When the Bank set sail on its forward guidance adventure in summer 2013 it might reasonably have expected that by the time the unemployment rate had reached 5½ % the Committee would have begun raising interest rates. However, any plans for lift-off were derailed by a marked deterioration in the inflation outlook during the two years that followed. Oil prices and the currency did what a major financial crisis could not: tip the UK economy into deflation.

The MPC stopped cutting interest rates and started purchasing assets in Spring 2009. At that time, market participants anticipated that that the Committee’s stay at the effective lower bound would be relatively short-lived. By May 2009, market prices implied rates would start to rise in 2010. However, Bank Rate would remain rooted to the lower bound for years to come.

We begin our discussion of fiscal policy in the post-crash period with some preliminaries—a review of the headline data on deficits and debt, a more comprehensive treatment of the state of the public sector balance sheet and how the state of the business cycle and financial cycle can distort the underlying state of the public finances—before turning to discuss the evolution of policy over this period.

If you have followed the discussion of austerity economics in the popular press you could be excused for thinking that the primary goal of fiscal policy was to stabilise the economy—to lean against the volatility in output and employment over the business cycle. But of course that is not the primary goal of fiscal policy; for example, the Charter for Budget Responsibility makes clear, the Treasury’s objectives for fiscal policy are to:

One of the central questions that this section of the book tries to answer is whether the decision by many of the world’s finance ministries to embrace austerity in the aftermath of the financial crash was wise or not. In order to answer that question we need to think about the likely impact of fiscal consolidation on aggregate demand and employment. This chapter reviews theory and evidence on the likely impact of changes in the fiscal stance in normal times. The following chapter will discuss whether the conventional wisdom in normal times applies in a crisis.

Our discussion of the macroeconomic impact of changes in the fiscal stance has taken place in a monetary vacuum. Any assessment of the likely impact of changes in the fiscal stance which does not take account of the monetary policy reaction function is almost certainly flawed. As we will go on to discuss there is a concern in some academic quarters that in extreme circumstances central banks might lose control of the inflation outlook given a chronic failure of fiscal policy—so-called fiscal dominance. For the time being, our working hypothesis should instead be monetary dominance: that central banks have the capacity to achieve their price stability mandates, and will adjust the stance of monetary policy to prevent a persistent imbalance between aggregate demand and supply in order to do so. In this section we rectify this sin of omission and explain the implications for the fiscal multiplier: actual or counterfactual changes in the stance of monetary policy should neutralise the macroeconomic impact of changes in the stance of fiscal policy, We will then go on to discuss possible exceptions to the rule—the circumstances under which fiscal consolidation could still depress demand when we switch monetary policy on—and whether the post-crash UK economy qualifies as one of those exceptions.

This section is about what happens when the public finances deteriorate to the point that market participants or even the general public reach the conclusion that debt may be on an unsustainable path and something needs to be done—whether that be fiscal consolidation, financial repression, inflating away debt or a formal restructuring. There is little agreement on where this point lies for an advanced economy like the UK, or how policymakers should respond if the public finances approach that danger zone, and in what follows we shall review the key issues.

We have explored how in extreme circumstances the seemingly secure position of sovereigns in financial markets can start to slip away: given a sufficiently large shock, positive feedback can propel the government away from a sustainable low-risk, low-yield equilibrium towards a far more fragile high-risk, high-yield equilibrium and ultimately the markets closing on the government when investors expect a restructuring. In this section we will discuss the policy responses and potential end games in a debt crisis.

In this chapter, we turn to discuss the politics of fiscal policy—namely the reason why the democratic process might not deliver optimal outcomes—and the proposals that economists have made for how to address these deficiencies.