Rethinking Stabilization Policy. Back to the Future

Nearly ten years after the onset of the Great Financial Crisis, both researchers and policy makers are still assessing the policy implications of the crisis and its aftermath. Previous major crises, from the Great Depression to the stagflation of the 1970s, profoundly changed both macroeconomics and macroeconomic policy. The question is whether this crisis should and will have similar effects.

We believe it should, although we are less sure it will. Rather obviously, the crisis has forced macroeconomists to (re)discover the role and the complexity of the financial sector, and the danger of financial crises. But the lessons should go largely beyond this, and force us to question a number of cherished beliefs. Among other things, the events of the last ten years have put into question the presumption that economies are self stabilizing, have raised again the issue of whether temporary shocks can have permanent effects, and have shown the importance of non linearities.

These call for a major reappraisal of macroeconomic thinking and macroeconomic policy. As the paper is a curtain raiser for a conference that will look in more detail at the implications for specific policies, we make no attempt at being encyclopedic and feel free to pick and choose the issues which we see as most salient. In Section 1, we review the response to two previous major crises, the Great Depression of the 1930s, and the stagflation of the 1970s. The first led to the Keynesian revolution, a worry about destabilizing processes, a focus on aggregate demand and the crucial role of stabilization policies. The second led instead to the partial rejection of the Keynesian model, a more benign view of economic fluctuations and the self-stabilizing properties of the economy, and a focus on simple policy rules. The question is then what this crisis should and will do.

– Peterson Institute for International Economics

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