The commitment to rules-based economic policy seen in the 1980s and 1990s has waned in the last decade. Perhaps an early sign of the change was the George Bush administration’s decision to respond to the economic downturn it confronted in 2001 with a one-time “tax rebate” (in which $300 cheques were sent to about two-thirds of the US taxpayers) intended to stimulate demand. Though one could say this was a down payment on the more permanent 2001 tax cuts that followed, the administration’s move led Milton Friedman to pronounce with regret that “Keynesianism has risen from the dead.”
Clearer signs, however, could be found in monetary policy. Between 2003 and 2005, the Federal Reserve held interest rates far below the levels that would have been suggested by monetary-policy rules that had guided its actions in the previous two decades. The deviation was large—on the order of magnitude seen in the unstable decade of the 1970s. The Fed’s public statements during that time— which asserted that interest rates would be low for a “considerable period” and would rise at a “measured” pace—are evidence that this was an intentional departure from the policies of the 1980s and 1990s.
Ostensibly, that departure was intended to help ward off a perceived risk of deflation, but the extremely low interest rates during these years contributed to the development of the housing bubble that played a central role in the economic crisis from which the US is still recovering. The Bush administration then responded to the downturn that began in December 2007 with another round of exceptionally discretionary fiscal policy. First came a $152 billion stimulus package enacted in February 2008 (that again included cheques to taxpayers). The following month began a series of on-again-off-again bailouts of the creditors of financial firms—on for the creditors of Bear Stearns, off for those of Lehman Brothers, on for those of AIG, and then off again while the Troubled Asset Relief Program was rolled out. During the ensuing panic in the fall of 2008, the government intervened to help the commercial-paper market and money-market mutual funds.
The next year, the Obama administration advanced an $862 billion fiscal stimulus (which included temporary rebates and credits, as well as grants to state and local governments) and the Cash for Clunkers program. The Fed then stepped in with more discretionary policy of its own, most notably its massive quantitative easing policy in 2009 (which included the purchase of $1.25 trillion mortgage-backed securities and $300 billion long-term treasury bonds). The Fed’s second round of quantitative easing in late 2010—which is popularly known as “QE2” and continued in 2011—involved the purchase of another $600 billion in long-term treasury bonds. All told, there can be little doubt that the rules-based economic policies of the 1980s and 1990s are over.
What effect did these policy cycles have on the economy? What can we learn from the effect of these policy cycles on the US’ economic performance—measured through employment, inflation, stability, the nature of recessions and recoveries, and economic growth—as the pendulum swung back and forth between policies governed by rules and those based on discretion?
The three periods in question clearly coincided with dramatically different levels of economic performance. The first swing, towards discretionary policies, aligned with a period of frequent recessions, high unemployment, and high inflation from the late 1960s to the early 1980s. In fact, inflation, unemployment, and interest rates all reached into double digits in this period, and by the late 1970s there was a palpable sense in the US that the economy was out of control, and perhaps headed for an enduring decline.
The second swing, towards more rules-based policies, coincided with a remarkably stable period, frequently called the “Great Moderation”, from the mid-1980s until the early to mid-2000s. Both the levels and the volatility of inflation and interest rates were markedly lower than they had been in the 1970s. The volatility of real gross domestic product, in fact, was reduced by half. Economic expansions in this period were longer and stronger, while recessions were shorter and shallower than they had been in the previous two decades.
Finally, the swing back towards discretion in recent years has coincided with the financial crisis and a recession much deeper than those of the “Great Moderation” period. The recovery, meanwhile, has been much slower than the one the US witnessed after the recession in the early 1980s.
The economic history of the past 60 years thus suggests a connection between rules-based policy and good economic performance. But correlation—even an amazing six-decade-long correlation—does not prove causation. As the wise acknowledge, correlation forms the basis of superstition while causality provides the basis for science. Therefore, we need to investigate further to understand whether the switch between rules-based policy making and discretionary policymaking caused the differences in economic performance.
This is the third part of a four-part series.
Krishnamurthy Subramanian is an assistant professor of finance at the Indian School of Business
Comments are welcome at email@example.com