Has academic thinking about countercyclical fiscal policy changed recently? I would not say that thinking has changed. I would say that there is a good chance that thinking is changing–that academia is swinging back to a recognition that monetary policy cannot do the stabilization policy by itself, at least not under current circumstances. But it may not be.
If things are swinging back, it is as a result of a whole bunch of extraordinary surprises.
Back in 2007 we thought we understood the macroeconomic world, at least in its broad outlines and essentials. It has become very clear to us since 2007 that that is not the case. Right now we have a large number of competing diagnoses about where we were most wrong. We clearly were very wrong about the abilities of major money center banks to manage their derivatives books, or even to understand to understand what their derivatives books were. We clearly did not fully understand how those markets should be properly regulated.
Right now, however:
- We have people who think the key flaw in the world economy today is an extraordinary shortage of safe assets. Nobody trusts private sector enterprises to do the risk transformation properly. Probably people will not again trust private sector enterprises for at least a generation.
We have those who think the problem is an excessive debt load where–I think we should distinguish between debt for which there is nothing safer, the debt of sovereigns that possess exorbitant privilege, and all other debts.
We have those who think we are undergoing a necessary deleveraging.
We have those who look for causes in the demography.
And then there is Larry Summers, as the third coming of British turn-of-the 20th century economist John Hobson. (The second coming was Alvin Hansen in the 1930s.) And the question: just what is Larry talking about?
- Is Larry talking about the inevitable consequences of the coming of the demographic transition and of the end of Robert Gordon’s long second Industrial Revolution of extremely rapid economic growth?
Or is he talking a collapse of the ability of financial markets to do the risk transformation–to actually shrink the equity risk premium from its current absurd level down to something more normal?
If you look at asset prices now, you confront the minus two percent real return on the debt of sovereigns that possess exorbitant privilege with what Justin Lahart of the Wall Street Journal tells me is now a 5.5% real earnings yield on the U.S. stock market as a whole. That 7.5% per year equity premium is a major derangement of asset prices. It makes it very difficult for us to use our standard tools to think about what good policy would be…