Home > Real-World Economics Review > RWER issue 56: Pavlina Tcherneva

RWER issue 56: Pavlina Tcherneva

Fiscal policy effectiveness: Lessons from the Great Recession

Pavlina R. Tcherneva   [Levy Economics Institute of Bard College, USA]

 Abstract

This paper reconsiders fiscal policy effectiveness in light of the recent economic crisis. It examines the fiscal policy approach advocated by the economics profession today and the specific policy actions undertaken by the Bush and Obama administrations. An examination of the labor market renders the contemporary aggregate demand–management approach wholly inadequate for achieving certain macroeconomic objectives, such as the stabilization of investment and investor expectations, the generation and maintenance of full employment, and the better distribution of incomes. The paper reconsiders the policy effectiveness of alternative fiscal policy approaches, and argues that a policy that directly targets the labor demand gap (as opposed to the output gap) is far more effective in stabilizing employment, incomes, investment, and balance sheets.

 

Keywords: The Great Recession; Fiscal Policy; Macroeconomic Stabilization; Employment

JEL Classifications: E24, E25, E65, J08, J6

 

 

Introduction

 

            To many economists the swift and unequivocal support of the profession for fiscal activism during the Great Recession has been somewhat of a surprise. After all, since the late 1970s, most mainstream economists had completely abandoned faith in fiscal policy effectiveness, largely because of the empirically dubious Ricardian Equivalence Hypothesis (see Barro 1974). Nevertheless, here we are, more than two years after the global financial meltdown of September 2008, in a position to reconsider the role and place of fiscal policy in stabilizing a devastated economy.

The economist who provided the raison d’être for countercyclical fiscal policy was John Maynard Keynes, whose revolutionary theory (1964 [1936]) transformed the way we understand the functioning of the economy. In reassessing the proper role of fiscal policy today, it should be remembered that Keynes inextricably linked the goal of macroeconomic stabilization to the goal of full employment. He had a very narrow definition of full employment and argued that policymakers had a responsibility to ensure that “everything that could humanly be done has been done by the state … [to produce] a reduction of the unemployed to the sort of levels we are experiencing in wartime…that is to say, an unemployed level of less than 1 per cent unemployed” (Keynes 1980: 303). This is the definition of full employment that will be used in this paper and I shall argue that achieving and maintaining this level, while simultaneously stabilizing the business cycle, is possible if we carefully heed the Keynesian message.

The principle objective of fiscal policy according to Keynes was to solve “the real problem, fundamental yet essentially simple… [namely] to provide employment for everyone” (Keynes 1980: 267). This objective was nevertheless gradually abandoned by the political process and much of academic economic analysis. Instead, the goal of modern fiscal policy has largely been confined to stabilizing incomes, consumption, and investment, whereas employment stabilization is left to be determined as a byproduct of these policies. Keynes, by contrast, believed that the unemployment problem should be solved speedily and directly by one primary method—direct job creation through public works.

This paper argues that the original Keynesian message can provide both a crucial tool for dealing with the Great Recession and a policy for addressing the unemployment problem at all phases of the business cycle. In particular, it makes the case that conventional aggregate demand management policies are inadequate for dealing with the unemployment problem during recessions and incapable of achieving true full employment in expansions. The paper will examine the kinds of fiscal responses that are generally favored by modern economists and policymakers today, as well as the specific policy actions that were undertaken in the United States to deal with Great Recession after the September 2008 financial meltdown. Next, it will overview briefly the labor market conditions in the United States to underscore the inadequacy of the current response. Finally, it will raise and answer the question “what is to be done?” While there are good reasons to believe that the fiscal push was too small, this paper will argue that aggregate demand management cannot establish what Keynes called “a closer approximation of full employment as nearly as is practicable” (Keynes 1964 [1936]: 378–79). Instead, it suggests that what is required is a fundamental reorientation of fiscal policy from one that attempts to close the output gap to one that aims to close the labor demand gap. This approach circumvents a series of shortcomings associated with the aggregate demand management approach. It is a direct approach that delivers macroeconomic stability and addresses the problems of urban blight and rural poverty with its strong regional emphasis. It is a policy that solves the unemployment problem over the long run because it specifically tackles its cyclical, structural, and seasonal components, as well as the problems of the long-term unemployed, the unemployable, the working poor, and the new entrants in the labor market.

You may download the whole paper at: http://www.paecon.net/PAEReview/issue56/Tcherneva56.pdf

 

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