The Fall and Rise of Keynesian Fiscal Policy

• DOI: http://doi.org/10.1111/j.1748-3131.2012.01228.x
• Date: 01 December 2012
• Published date: 01 December 2012
• Author: Alan J. Auerbach

The Fall and Rise of Keynesian Fiscal Policy

Alan J. AUERBACH†

University of California, Berkeley

This paper reviews the recent evolution of thinking and evidence regarding the effectiveness of

activist fiscal policy, including how policy multipliers might vary with respect to economic condi-

tions. Like many other countries that were hit by the “Great Recession,”the USA responded ini-

tially with active fiscal policy measures. But a more positive view of fiscal intervention appears to

have developed earlier in the decade, and estimated decision rules confirm that there was an

increase in policy activism. While this positive view has been tested by the unclear effects of fiscal

policy during the Great Recession, recent evidence does suggest that fiscal policy may be especially

effective in recession. Fiscal policy activism has also been tempered by recent concerns about

growing government debt, a development which potentially might also undercut the effectiveness

of expansionary fiscal policy.

Key words: American Recovery and Restoration Act, discretionary policy, multiplier, recession,

stabilization policy

JEL codes: E62, E65, H12, H62

1. Introduction

Like many other countries that were hit by the recent “Great Recession,” the USA

responded initially with active fiscal policy measures. US actions actually began early in

the recession (which was dated by the National Bureau of Economic Research to have

begun in December, 2007), with temporary tax cuts enacted in the last year of the Bush

administration in February 2008, followed by a first-time homebuyers’ tax credit enacted

in July 2008. The largest single action in the USA, adopted in February 2009 shortly after

the accession of President Obama, was the American Recovery and Reinvestment Act

(ARRA). The ARRA was a combination of tax cuts, transfers to individuals and states,

and government purchases estimated to have increased budget deficits by a cumulative

amount equal to 5.5% of 1 year’s gross domestic product (GDP) over a period of a few

years.

Smaller attempts at fiscal stimulus continued thereafter with more targeted measures,

notably the temporary “cash for clunkers” program in summer 2009 aimed at stimulat-

ing the replacement of old cars with new ones, and an extension and expansion of the

homebuyers tax credit in November 2009 and July 2010. Accompanying these fiscal

efforts were the Troubled Asset Relief Program (TARP), enacted in fall 2008 to address

This paper was prepared for the Asian Economic Policy Review Conference, “Fiscal Policy and

Sovereign Debt,” Tokyo, March 25, 2012. I am grateful to conference participants for comments

on an earlier draft.

†Correspondence: Alan J. Auerbach, Department of Economics, University of California, Berkeley,

CA 94720-3880, USA. Email: auerbach@econ.berkeley.edu

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doi: 10.1111/j.1748-3131.2012.01228.x Asian Economic Policy Review (2012) 7, 157–175

© 2012 The Author

Asian Economic Policy Review © 2012 Japan Center for Economic Research 157

the financial crisis, and a continuing array of interventions by the Federal Reserve Board

that aimed to stabilize credit markets and stimulate the economy. Finally, at the end of

2010, a deal between the President and Congress led to a 1-year reduction of 2 percent-

age points in the social security payroll tax, with this tax cut being extended further in

late 2011 and again in early 2012.

Many other countries also pursued active fiscal measures during this period. The

prevalence of fiscal policy interventions reflects the severity of the recession and also

perhaps at least a temporary optimism with regard to the potential effectiveness of activ-

ist fiscal policy. Yet the variety of approaches adopted suggests uncertainty about which

approaches might have been most effective, and the overall perspective on the effective-

ness of fiscal policy as a tool for stabilization is still debated, even as the focus in many

countries, including the USA, has begun to shift away from fiscal stimulus to fiscal

balance, with another controversial view, that fiscal contractions may in certain circum-

stances stimulate economic activity, coming in conflict with the traditional Keynesian

perspective.

This paper reviews the recent evolution of thinking and evidence regarding the effec-

tiveness of activist fiscal policy, including how policy multipliers might vary with respect

to economic conditions, such as the very low interest rates that were central features of

the Great Recession.

2. The Evolution of Theory and Policy

From its heyday several decades ago, discretionary fiscal policy had until relatively

recently come to be viewed with considerable skepticism. Those studying economics

would start with the classical argument against short-term policy interventions – the lags

in the making of economic policy and further lags in the implementation and effects

after the policy is enacted, which make it difficult for policymakers to time fiscal policy

actions to stabilize the economy. Added to the problem of policy lags are the difficulties

posed by policy uncertainty (Brainard, 1967) and the devastating Lucas (1976) critique,

which implies that a policy’s stabilizing effects can be undercut by the expectations and

actions of rational agents who observe the government’s policy process. For example,

investment might actually drop more during a recession in anticipation of a countercy-

clical investment incentive to be enacted in the near future; consumption might not

respond much to a countercyclical reduction in income taxes, as the wealth effects of

such tax reductions are small when the reductions are seen as temporary. Indeed,even if

such tax reductions are of longer duration, concerns about future generations could still

neutralize wealth effects on consumption, as exposited by the notion of Ricardian

equivalence (Barro, 1974). Finally, with the automatic stabilizers already built into the

government’s tax and transfer systems, fiscal policy could be used even without active

intervention. Moreover, the growing independence of central banks and advances in

monetary theory and practice had strengthened confidence in the use of interest-rate

interventions as tool not only for controlling inflation but also for the stabilization of

economic fluctuations.

Keynesian Fiscal Policy Alan J. Auerbach

© 2012 The Author

Asian Economic Policy Review © 2012 Japan Center for Economic Research

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