In late 2008, the United States economy was caught in the midst of what proved to be its longest and deepest recession since the end of World War II. Frightened by steep and self-reinforcing declines in output and employment, both the Federal Reserve and the federal government responded quickly and boldly. The Federal Reserve dropped the federal funds rate to near zero, where it remains today, and began its controversial “quantitative easing” purchases of long-term government securities to contain long-term interest rates.
Perspectives from expert contributors.
Fueled by the 2009 federal stimulus package, discretionary fiscal policy was also expansionary in 2009-10, adding to growth during the first year of the recovery at roughly the same pace that fiscal policy had achieved during previous recoveries.
Then, in a sharp break with history, fiscal policy became a drag on growth in the second year of recovery, and since then the drag has intensified. What explains the premature and counterproductive turn toward fiscal austerity despite the high unemployment rate and the large gap between actual and potential output?
Before the Great Recession, there was a near consensus among economists that monetary policy by itself could stabilize aggregate demand and keep the economy on its potential growth path. Under normal economic conditions, countercyclical fiscal policy was thought to be unnecessary. It was also thought to be both ill timed, because of lags in Congressional decision-making, and wasteful, because choices among fiscal measures were driven by politics and rent-seeking rather than cost-benefit considerations.
Most economists also believed that changes in discretionary fiscal policy would have small effects on aggregate demand and output — that the multipliers for such changes were small — and this belief was supported by empirical research based on “normal economic conditions.”