The recovery of output and employment from the Great Recession has been far too slow, in part because of the failure of both monetary and fiscal policy authorities to pursue sufficiently aggressive policies. But there is reason to be hopeful that policy will improve as some of the worst ideas fade, and better ideas take their place.
For monetary policy, one of the worst developments in 2012 was the over-reliance and overconfidence in the Fed’s ability to help the economy. The Fed is far from powerless even when we are in a deep recession, but there are limits to the Fed’s ability to help the economy recover in these circumstances. By focusing too much on the Fed’s role in the recovery, and not enough on the failure of Congress to implement the necessary fiscal policy actions—for example, an aggressive program of infrastructure development to take advantage of low interest rates and provide employment—fiscal policymakers have been let off the hook. It’s unlikely that a stronger focus on fiscal policy would have resulted in more expansionary policy, political gridlock stood in the way. But a more intense focus on fiscal policy issues might have helped to prevent one of the worst ideas about fiscal policy not just in 2012, but ever—that austerity can be expansionary in a deep recession—from taking hold.
On the other side, the best development in monetary policy is the realization among policymakers that their inflation fears have been overblown and they can adopt more aggressive policies to fight unemployment than they thought. This is reflected, for example, in the Fed’s recent change in policy to make explicit the Fed’s intention to remain focused on the unemployment problem even if long-run inflation projections drift above target. There is still a limit to how much drift in the inflation projections they are willing tolerate, a half percent above their two percent inflation target is as far as they will to go for now—I believe their tolerance should be higher—but this is progress.
There is also progress in fiscal policy. Deficit fears continue to stand in the way of the expansionary policy that is needed to boost the recovery; too few people understand that the deficit problem is mainly a health care cost problem, and I’ve already noted the worst idea in fiscal policy, expansionary austerity, that took hold over the last few years.
The good thing, however, is that people appear to be realizing that the embrace of austerity as an expansionary policy was foolish. For example, the fear that we will go back into recession instead of being propelled to prosperity if policymakers allow us to go over the fiscal cliff (which reduces the deficit through spending cuts and tax increases) is an example of this. Unfortunately, people still haven’t realized the flip-side of this, that if contractionary fiscal policy hurts an economy in a deep recession then expansionary policy can help—again, undue fears about our short and medium term debt problem stand in the way—but at least the harmful idea that austerity is expansionary is beginning to fade.
Click here for more from our Fellows: Best and Worst Policy of 2012.