Active and passive fiscal policies

Fiscal policy has changed radically since the 1960s and 1970s when it tried to micro-manage, if not fine-tune, all aggregate demand and assumed an accommodating monetary policy; and it changed from the 1980s when it was passive, but was used to strengthen the economy's supply-side responses while monetary policies actively pursued low inflation and stable growth.

The 1990s saw a return to more activist fiscal policies. But this time the policies were designed together with equally active monetary policies to gain a series of medium- to long-term objectives – low public debt, the provision of a certain level of public services and investment, and social equality and economic efficiency. The income-stabilizing aspects of fiscal policy were left largely passive, to act through the automatic stabilizers which are the endogenous part of any fiscal system. Monetary policy, meanwhile, was designed to take care of short-run stabilization around the cycle; that is, beyond what, predictably, would or could be achieved by automatic stabilizers.

The recent financial crisis has again introduced the need for active fiscal policy to complement monetary policy, but in a sense opposite to that traditionally advocated – that is, in the form of austerity policies to remove excess fiscal deficits and reduce public debt. This was based on an undervaluation of the size of the spending multipliers, which have been shown to be quite large in a situation of generalized low demand and low interest rates (and crucially greater than one, so that each deficit reduction leads to a larger loss in national output and hence rising deficit and debt ratios).

The kind of coordination to be sought between fiscal and monetary policy is one of the issues we discuss in this chapter. We suggest that an improved performance can be obtained if fiscal policy “leads” an independent monetary policy. The form of leadership implied here derives from the fact that fiscal policy typically has long-run targets (sustainability, low debt) and is not easily reversible. In fact, it aims to ensure sustainable public services, social equity, and other long-term goals, which often makes it an ineffective stabilizer. Nevertheless, there are also automatic stabilizers in any fiscal policy framework, implying that monetary policy must condition itself on the fiscal stance at each point. This automatically puts the latter into a follower's role.