Oxford Review of Economic Policy, Volume 26, Number 1, 2010, pp.

7186

Macroeconomic policy in light of the credit

crunch: the return of counter-cyclical
scal policy?

Abstract This paper begins by arguing that the 2007/8 credit crunch does not require a fundamental reevaluation of monetary policy. The crunch occurred because regulation was too lax, and we need to develop
new and more effective tools of regulatory control. To focus on current account imbalances or mistakes in
setting interest rates as a prime cause of the credit crunch is unconvincing, and has the danger of diverting
attention away from the need to increase financial regulation. The current recession does require a re-evaluation
of the role fiscal policy can play when interest rates hit a zero bound. An expansionary fiscal policy is required
because monetary policy-makers are reluctant to promise higher future inflation, and the impact of quantitative
easing is likely to be small. Although rising debt may place a limit on how much conventional fiscal policy
can do, not all expansionary fiscal measures require additional borrowing. There are two important lessons for
the future. First, although monetary policy should remain the primary tool to stabilize the business cycle, the
combination of fiscal implementation lags and uncertainty means that some precautionary fiscal action may be
appropriate during the early phase of some economic downturns. Second, to play this backstop stabilization
role effectively, a policy that results in the government debt-to-GDP ratio declining (albeit gradually and
erratically) in normal times seems appropriate.
Key words: credit crunch, fiscal policy, government debt, conventional assignment
JEL classification: E61, E62, E65

I. Introduction
What implications do recent events have for the conduct of macroeconomic policy? This
paper argues that the major lessons concern fiscal policy. To some this may seem to be a
rather surprising view: surely, they might suggest, the credit crunch has profound implications
for how we conduct monetary policy, and how we regard and tackle global imbalances in
Economics

Department and Merton College, University of Oxford, e-mail: simon.wren-lewis@economics.

ox.ac.uk
I am grateful to Chris Adam, Chris Allsopp, Andrea Boltho, Tim Jenkinson, Campbell Leith, David Vines,
Martin Weale, and Peter Westaway for helpful comments on an earlier draft. Joint work with Tatiana Kirsanova
and Campbell Leith, with financial assistance from ESCR grants No. RES-156-25-003 and No. RES-062-23-1436,
underlies some of the points made here. However responsibility for the views expressed is mine alone.
doi: 10.1093/oxrep/grp034

C The Author 2010. Published by Oxford University Press.
For permissions please e-mail: journals.permissions@oxfordjournals.org

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Simon Wren-Lewis

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Simon Wren-Lewis

II. Did macroeconomic policy cause the credit crunch?

The current recession originated in the financial markets, and is far more severe and coordinated than earlier recessions because of the behaviour of financial institutions. There is
abundant evidence that banks and other financial companies took excessive risks in the years
leading up to the credit crunch, and that innovations in financial instruments allowed this risk
to be spread around in ways that intensified rather than reduced the vulnerability of the system
as a whole. The lessons that we draw from this episode are therefore primarily about how
we regulate the financial sector, and there appear to be good economic arguments that such
regulation should include incentive structures within the industry (see Thanassoulis, 2009).
However, there is an alternative narrative, which looks in a very different direction. It
focuses on the macroeconomic situation that preceded the recession, and in particular global
current account imbalances. It seeks to criticize macroeconomic policy actions before the
crisis and draw conclusions for future macro policy. In this section I want to suggest that this
narrative is unconvincing, and that it is also potentially diversionary. (For a more extensive
analysis of the plausibility of this idea, see Faruqee et al. (2009).)
The macroeconomic story generally goes as follows. We start in China, which in this
case exemplifies policies pursued in many of its neighbours. China used currency undervaluation as a successful aid to rapid development, and as a means of building up foreignexchange reserves. This resulted in a large and steadily growing current account surplus,
which represents a large excess of national savings over investment. Given the importance of
the Far East in the world economy, this played a key role in creating a global savings glut
(see Bernanke, 2005).

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savings and investment. This paper begins by arguing that this view is wrong, because it treats
the pre-crisis level of financial regulation as given. Substantial changes in the regulation of
financial markets are required, and it makes sense to think about macroeconomic policy in
the financial environment to come, rather than the environment that led to the credit crunch.
To some extent the excessive risk-taking that led to the credit crunch was an unforeseen
consequence of the success of monetary policy prior to this recession. Yet that success always
came with a key proviso, which was that the economy would not be hit by a large negative
shock. If the economy is hit by such a shock, and interest rates hit the zero bound, the power of
monetary policy dries up. In theory we can mitigate the impact of the zero-bound constraint
by promising above-target inflation when the constraint no longer binds (for reasons discussed
below), but at present policy-makers are reluctant to follow this strategy. This leaves fiscal
policy to plug the gap.
In the main part of this paper I want to look at two issues involving fiscal policy which
recent events have brought to the fore. The first is what we mean by fiscal policy: there are
many fiscal instruments, and they have very different macroeconomic impacts. Some are
much more suitable as stabilization tools than others. The second is the issue of government
debt. In this recession the main factor inhibiting the use of counter-cyclical fiscal policy has
been fears over the level of debt. This has important implications for long-term debt policy
outside of recessions.
Before the current recession, there was a broad consensus that fiscal policy should not be
involved in macroeconomic stabilization. The paper ends by considering how that consensus
needs to be modified in the light of recent events.

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73

1 See Dooley and Garber (2009). A more sophisticated, and plausible, explanation for search for yield is contained
in Beaudry and Lahiri (2009), which focuses on a lack of conventional investment opportunities. However, in their
story low interest rates are, if anything, a symptom rather than a cause, and monetary policy plays no role.

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Turn now to the USA, which after the downturn in 2001 had reduced interest rates substantially. The economy began to recover, but interest rates stayed low, initially because there
appeared to be plenty of domestic spare capacity and core inflation was low. US interest rates
(particularly at the long end) then remained low as a consequence of the global savings glut. In
technical terms the natural rate of interest (the rate of interest that gives us zero inflationary
pressure) fell in the USA and elsewhere because of global excess savings, implying that what
appeared to be an expansionary US monetary policy was, in fact, neutral. More simply, we
can say that most of these Far East savings went to buy up US dollar denominated assets,
raising their price and reducing their yield.
These persistently low US interest rates encouraged a search for yield in financial markets,
by which we mean a search for assets that would bring significant positive returns in an
environment when interest rates on relatively riskless assets were very low. The simplest way
of raising yield is to increase risk. In addition, low interest rates raised the demand for credit
among those who could only afford to take out loans if interest rates stayed low and the price
of their assets continued to rise. So sub-prime borrowers demanded credit and the markets
were keen to lend. Hence, so the argument goes, it was the macroeconomic environment that
created the excess risk-taking by the financial sector.
Two morals are often drawn from this narrative. The first is that the global imbalances
involved in Chinese surpluses and US current account deficits are potentially dangerous and
must be prevented from continuing or recurring. The second is that if US monetary policy had
raised US interest rates more quickly after 2001, the credit crunch could have been avoided.
Both conclusions rely on a crucial argument, which is that low nominal interest rates lead
to a search for yield that encourages excessive risk-taking. This idea is certainly not part
of standard economic theory, where preferences for risk are not normally endogenous to the
level of interest rates.1 But leaving this scepticism to one side, this key link in the narrative
surely suggests a rather more fundamental moral than the ones drawn, which is that it is low
interest rates (perhaps including a compressed yield curve) rather than imbalances per se that
are inherently dangerous.
This is important, because it is possible to think of a whole host of reasons why the
natural real rate of interest might fall for significant periods of time, none of which has
anything to do with global imbalances. A period of rapid technological change, for example,
might require low interest rates to stimulate demand for the additional supply. If policy is
successful at keeping inflation low, then low real rates will imply low nominal rates. In
these circumstances, should monetary policy avoid low interest rates in case this encourages
excessive risk-taking?
Such a view appears to place far too heavy a burden on monetary policy. Monetary policy,
as we now understand it, is about trying to mitigate the externalities generated by sticky
prices by getting as close as possible to an imaginary flexible price equilibrium. As we know
from other examples, if monetary policy also tries to mitigate distortions in that flexible price
equilibrium, then serious conflicts and problems can arise.
There is a far simpler lesson to be drawn from this macroeconomic narrative, which is that
we should do other things to stop excessive risk-taking. To take the behaviour of the financial
sector as given and immutable, and then to give interest-rate policy the task of preventing
excessive risk taking, puts far too great a burden on what interest-rate policy can do.

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Simon Wren-Lewis

2 Even the strongest advocates of this idea concede that other factors, such as globilization or just luck, may
have also played a role in reducing variances over this period.

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There is an important sense in which this macroeconomic narrative about the causes of the
credit crunch is diversionary. Because it treats the behaviour of the financial sector as given,
and attempts to analyze how macroeconomic policy might have avoided the credit crunch, it
diverts attention away from the need to increase financial regulation. It is a useful tactic for
those who have an interest in trying to preserve as much as possible of the financial industry
status quo. (See Booth (2009) for a clear example.) As Eichengreen (2009) has emphasized,
one of the lessons academics need to draw from their collective failure to foresee the credit
crunch is to recognize the power and influence of these financial interests.
There is an alternative macroeconomic story that links monetary policy with excessive risk
taking, which is as plausible as those discussed above but which receives much less attention.
It is based around what has been described as the great moderation. The hypothesis is that a
monetary policy regime based on independent central banks implementing explicit or implicit
inflation targets helped reduce2 the variance of both output and inflation in the 15 years before
the current recession. (The credit crunch itself does not disprove this idea because, as we note
below, the hypothesis never did apply in the face of a large negative shock.) This, in turn,
may have encouraged financial markets, and house buyers, to believe that this tranquility
would continue forever. Should we therefore conclude that monetary policy had been too
successful, because it produced a period of stability that encouraged excessive risk taking?
That would be ludicrous, and the more obvious lesson is that we should deal with excessive
risk taking directly. Perhaps the reason we hear less about this story linking macroeconomic
policy with the credit crunch is that it fails to divert attention from the need to increase
financial regulation.
In this debate over the origins of the financial crisis, it is often argued that lack of financial
regulation cannot be the true cause, because the financial sector had been lightly regulated
for many years before the credit crunch, and so it cannot explain why the credit crunch did
not happen earlier. This ignores the important role of more recent financial innovation, such
as collateralized debt obligations (CDOs), which meant that no one knew how exposed any
financial institution was to sub-prime US housing debt. However there is a deeper problem
with this argument, which is best explained by analogy. Imagine a fault with a car, which only
becomes apparent when the car is driven above 50 mph. The best response when the fault is
detected is to get the fault fixed, rather than never to drive above 50.
If we accept the need for greater financial regulation as the primary defence against a future
credit crunch, we also need to accept that it may occasionally fail, and in that case monetary
policy may need to respond. Regulation may not be able to prevent all asset price bubbles,
and so, occasionally, monetary policy can lean against the wind in an attempt to prick these
bubbles before they can do too much harm. Yet we should also note that if financial regulation
fails, there are arguably better instruments available to prick asset price bubbles than nominal
interest rates, and these include market specific taxes. (This point is also made in the paper
by Dale et al., 2010, in this issue.)
Consider the housing market. Bubbles can arise because housing is considered as an
investment good, and a period of steadily and sometimes rapidly rising prices can foster the
belief that capital gains on this asset will always be positive and generally large. We may be
able to prevent these beliefs from creating a bubble by macro prudential regulation, such as
specifying maximum loan-to-value ratios, for example, where this maximum might vary over

Macroeconomic policy in light of the credit crunch

75

time.3 But failing this, there is a variety of fiscal variables which can influence the realization
of capital gains from owning houses. These taxes are either specific to the housing market,
or can be made to be so. It is, therefore, much more efficient to try and mitigate a housing
bubble by varying these specific taxes, than by changing interest rates which impact on the
whole economy. This is an example of a more general argument made below, which is that
where taxes operate on the same margin as a distorted price, it is efficient to use that tax to
offset the distortion.4

If the argument above is correct, the credit crunch does not represent a failed macroeconomic
policy, but a large negative macroeconomic shock generated by a failure of financial regulation. Large negative shocks require low or negative real interest rates, at a time when inflation
is likely to be falling. We can hit a zero-bound constraint or liquidity trap, and monetary
policy loses its corrective power. In fact, interest rates begin to add to the problem, because
with nominal rates stuck at zero, lower demand that reduces inflation increases real interest
rates. This is the negative feedback of deflation that everyone fears.
In this situation, the monetary authorities can print money. How effective this is depends
on whether we take a monetarist or a Wicksellian point of view. Put crudely, monetarists
focus on monetary aggregates and tend to believe that if more money is created, it will find
some way of stimulating demand. Wicksellians see interest rates as the way that monetary
policy operates, and if quantitative easing just involves exchanging money for another (nonmoney) safe asset that has a near-zero yield, then this will have virtually no impact on the
economy (although it will not do any harm). For Wicksellians, therefore, the lower bound
of zero for short-term interest rates is a serious problem, which quantitative easing does not
remove.
However, the zero-bound problem can, in theory, be mitigated to a significant extent, if the
monetary authority can credibly announce that monetary policy will be more expansionary
than normal after the zero-bound constraint has lifted. In other words, the monetary authority
commits to keeping interest rates at zero for longer than it would normally do given conditions
at the time. If the public believes this commitment, this can help now for two reasons. First,
intertemporal consumers spend in proportion to their discounted lifetime income, and this
rises when either current or future interest rates fall. Lower future short-term rates should also
reduce current long-term interest rates. Second, in a New Keynesian Phillips curve current
inflation depends on the discounted sum of future output gaps, and so lower future interest
rates will raise future output and therefore current expected inflation. By raising current
expected inflation we reduce todays real interest rate, which mitigates the risk of deflation.
3 Whether these prudential controls should be seen as additional monetary policy instruments to be set alongside
interest rates by a Monetary Policy Committee (MPC) or its equivalent, or set by the body charged with financial
regulation more generally, is an important debate.
4 For similar reasons, attempts in this case to embed leaning against the wind by including house prices in the
inflation measure that central banks target seem misguided. My own view is that the appropriate price index should
depend directly on why inflation damages welfare (Kirsanova et al., 2006), and in this context the case for including
asset prices alongside goods prices has not been made.

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III. The necessity of scal action following large negative

shocks

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Simon Wren-Lewis

IV. The right sort of scal policy

There is a popular misconception (that may even be shared by the occasional economics professor) that Ricardian Equivalence implies that fiscal policy will not be effective at changing
demand. This extends the scope of the Ricardian idea too far. Even if Ricardian Equivalence
held exactly, it only implies that the intertemporal income-transfer effect of a tax change
has no impact on consumption. Temporary changes in government spending will still have a
direct effect on demand. The impact of the change in consumers current or future disposable
income will be smoothed, leading to only a small decrease in current consumption. So the net
effect on short-run demand is positive, with little crowding-out through lower consumption.
Ricardian Equivalence will imply that there is virtually no additional multiplier from temporary government spending increases, but it does not imply that this type of fiscal policy is
ineffective.
In addition, there are many reasons why Ricardian Equivalence does not hold. Perhaps the
most important empirically is the existence of credit-constrained consumers (i.e. consumers
who are not able to borrow as much as they would wish). These consumers could have a
marginal propensity to consume from a tax cut of as much as one. An important implication
is that different types of tax or transfer change may have quite different effects in stimulating
demand, depending on where the extra money goes. A reduction in the higher rate of income
5 This reluctance might change if, following the recession, economies enter a long period of stagnation, similar
to Japans lost decade. This might occur if consumers require a long period of high savings to rebuild net wealth. In
these circumstances we might desire negative real interest rates that are less than zero minus the inflation target for
some considerable period, in which case the inflation target inhibits recovery.

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As this policy creates excess inflation during the recovery it is costly, but this cost is much
smaller than the costs of deflation (Eggertsson and Woodford, 2003, 2004).
One serious problem with this policy is that it is time inconsistent. When the recession is
over, it is now optimal to return to a zero output gap and the inflation target. But this involves
reneging on the policy commitment to keep interest rates low once the zero-bound constraint
has lifted. (Although a prolonged period of low interest rates was optimal during the recession,
once the recession is over it becomes optimal to raise interest rates.) So the policy will not
work if the policy-maker does not have a reputation for sticking to a time-inconsistent policy.
Even if a central bank has a reputation for avoiding time inconsistency temptations, it might
be concerned about announcing a policy that could create excess inflation, because that policy
may be misinterpreted. In particular, it could be viewed instead as the monetary policy-maker
bowing to pressure from fiscal authorities who want to reduce the burden of high government
debt. This is the last thing a central banker wants to appear to do. (For further discussion on
this issue, see Kirsanova et al. (2009).)
Ambiguities in interpretation of policy could be reduced if an explicit or implicit inflation
target was replaced by a price-level target. As Eggertsson and Woodford show, this serves as
a good proxy for the optimal policy, for, as deflation bites, the necessity of excess inflation in
the future to meet the target increases. However, no monetary authority or government seems
prepared at the moment to modify inflation targets in this way.5 As a result, monetary policy
becomes impotent when we hit the zero bound, and we are left with fiscal policy to mitigate
the recession.

Macroeconomic policy in light of the credit crunch

77

6 This

point seems to have been understood by the UK government, which temporarily cut VAT at the end of
2008, but not by many of the commentators at the time.
7 See at http://www.cbo.gov/ftpdocs/100xx/doc10008/03-02-Macro_Effects_of_ARRA.pdf
8 This proposal is quite different from the idea, discussed below, that a Fiscal Council should monitor the longterm sustainability of government debt. Although the two innovations could be combined, there are strong arguments
against doing this (see Kirsanova et al., 2007).

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tax, for example, is likely to have little income effect, because most recipients are likely to be
saving and will not be credit constrained. An increase in unemployment benefit, on the other
hand, may have a much larger impact on the consumption of those concerned, and therefore
on aggregate demand.
Tax changes will also have relative price effects as well as income effects. Perhaps the most
important example is changes in sales taxes (VAT), if these are passed straight on to consumers.
By influencing expectation about consumer prices, they create potentially powerful incentive
effects. The impact of monetary policy on consumption works by changing the real interest rate
consumers face. This real interest rate can also be changed by changing expected consumer
price inflation. So temporary VAT changes are as close to monetary policy as fiscal policy can
get.6 Pre-announcing increases in VAT may also be a very effective method of stimulating
demand for countries that feel they cannot increase the level of public debt. (For a numerical
discussion of the impact of different fiscal measures, see Wren-Lewis (2000) for the UK, and
CBO estimates for the USA.7 )
Another popular misconception is that the once popular MundellFleming model proved
that fiscal policy was ineffective in a small open economy. The result is true for that model,
but only because it assumes a fixed money supply. In a recession, as we are seeing today,
there is no good reason to keep the money supply fixed. It is the case more generally that a
permanent, country-specific increase in government consumption, to the extent that it is not
offset by anticipated future increases in taxes, will be crowded out through an appreciation in
the nominal exchange rate. This is because higher government spending will have little impact
on the supply of domestic goods, so in the medium term any increase in the demand for these
goods will be crowded out. In a small open economy this crowding out takes place through the
real exchange rate rather than the real interest rate. Finally, uncovered interest parity brings
this medium-term appreciation into the short term. But if the change in government spending
is temporary, there need be no medium-term appreciation. If interest rates stay unchanged
(because they are at a lower bound, for example), then this extra spending will not be crowded
out.
So fiscal policy can be an effective tool at stimulating demand, but some fiscal instruments are better than others. One of the difficulties in enacting stimulus packages is that
these differences are not well understood by the public, and so the mix of any fiscal package can become a familiar battle between the political Right (tax cuts are good) and Left
(public spending is good). The picture is further confused by the fact that there remain some
economists (particularly in Chicago) who deny the power of any fiscal expansion to influence
demand.
Wren-Lewis (2003) proposed giving independent central banks the power to change temporarily, within predefined limits, a small number of tax instruments.8 The argument was
that certain distortionary shocks could be better dealt with using such instruments rather than
interest rates. For the UK, I also had in mind the potential future constraint of monetary union,
but the possibility of hitting a zero lower bound for interest rates provides a similar justification. However, another advantage I saw in the proposal was to disentangle macroeconomic

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Simon Wren-Lewis

stabilization arguments from political debates between Left and Right. Recent experience
suggests that this disentangling remains to be done.

V. Limits on debt

9 An upper bound on tax receipts is implied by the Laffer curve, but there is no equivalent constraint on how
much government spending can be cut.
10 Allowing for different generations also means that intergenerational equity considerations may influence
optimal debt levels: see the paper by Barrell and Weale (2010, in this issue).

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The most obvious and most important limit on the size of any governments debt is the risk of
default, or alternatively that a government may avoid default by allowing inflation rapidly to
deflate the value of that debt. There are severe costs for a government and a country in doing
this, but these costs have to be set against the costs involved in raising taxes or cutting public
services to at least stabilize a high level of government debt. Although the cost of paying
interest on debt rises at least linearly with the size of the debt stock, there is probably a fixed
element in the cost of default (i.e. the punishment imposed on a government that defaults
will not rise with the amount by which it defaults), so the chances of default increase with
the level of debt.
The key limit is not when a government will probably default, but when the possibility that
it will default becomes significant enough for lenders to require a risk premium to offset this
chance. Recent developments in the Euro area suggest that for some countries this position
has already been reached (although how rational such fears are is debatable; see De Grauwe,
2009). Similar risk premia have not yet emerged for the larger OECD economies, but that
does not mean that they will never do so. Unfortunately, we do not have robust models that
can tell us when risk premia might emerge, in part because this depends on political as much
as economic factors.9 (See the paper by Buiter (2010, in this issue) for further discussion on
this.) Once they do emerge, the risk premia themselves increase the cost of financing debt,
making default more likely, and as a result governments may want to stay well clear of this
territory.
Even if we did know the level of government debt at which markets would start requiring
risk premia, there are two reasons why governments might not be comfortable getting even
close to this level. The first reason is prudential: a further negative shock may raise debt
before a government can react, or market sentiment could easily change in a negative way.
The second is that high levels of debt may crowd out investment in capital, leading to a level
of capital and output which is sub-optimal in terms of social welfare. In the most common
intertemporal macroeconomic model, this crowding out does not occur, because agents care
about their children as much as themselves and therefore they act as if they live forever. In
these circumstances, and provided other rather unrealistic conditions hold, government debt is
not regarded as net wealth by agents. This implies Ricardian Equivalence, but it also implies
government debt will not crowd out private capital. In models without bequests (Overlapping
Generation, or OLG, models), people save primarily to finance their retirement. This saving
can be in the form of government stock or productive capital. If the supply of government
debt rises, the amount of savings available to finance capital investment will fall, and we get
crowding out. Unless society starts out with too much capital (dynamic inefficiency), then
less output will imply lower levels of consumption, reducing social welfare.10

Macroeconomic policy in light of the credit crunch

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VI. How quickly should debt come down?

In previous sections we argued that fiscal expansion was necessary in response to a large
negative shock which led monetary policy to hit a zero bound. We should not worry about the
large increase in government debt that this creates, as long as that debt did not start requiring a
significant risk premia to be sold. For much the same reason, attempting to bring government
debt down again in a way that endangered macroeconomic recovery would be an unfortunate
mistake.
Suppose, however, that an economic recovery is proceeding well, such that monetary
policy-makers can contemplate raising interest rates from their lower bound. We noted in the
previous section that there were good reasons why government should then start to reduce
debt levels.11 But how quickly should debt be reduced, and how far should this reduction go?

11 Here

and in the rest of this section, I use debt levels as a shorthand for the debt-to-GDP ratio.

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I believe we can draw two conclusions from this discussion. First, default and risk premia
do provide limits to the amount of debt a government can safely issue, but we have very little
idea what those limits might be. Second, if debt comes close to those limits following a sharp
recessionand the previous sections suggested good reasons why it should be allowed to do
sothen governments will want to start moving away from those limits as long as reducing
debt does not endanger or forestall a macroeconomic recovery. In the next section we look
at how quickly debt should be reduced once the economy starts recovering. However, before
doing so it is important to reiterate a key point about the relationship between fiscal expansion
and debt.
While providing a macroeconomic fiscal stimulus often goes together with rising debt, it
is not inevitable that it should do so. In the previous section we noted how, in a Ricardian
world, temporary increases in government spending financed by higher taxes rather than
debt would still raise demand. We also noted how anticipated changes in sales taxes could
stimulate demand by changing real interest rates. There may be many other fiscal tricks that
can persuade consumers or firms to bring forward their expenditure. Transfers that moved
money from unconstrained savers to credit-constrained borrowers (such as the unemployed)
would also boost demand. These points may come to the fore if economies enter a period of
stagnation after the recession, perhaps because consumers are trying to rebuild net wealth in
an environment of greater risk aversion. If monetary authorities stick to unchanged inflation
targets, then real interest rates may not be able to fall low enough to prevent this stagnation,
and output gaps may remain large. If governments also feel that they have reached an upper
bound on levels of debt, then fiscal policies that expand demand without raising debt may be
the only tool we have left to avoid a lost decade for the world economy as a whole.
So limits to debt do not necessarily imply a limit to fiscal expansion. The main problem with
fiscal measures to expand the economy which do not raise debt is political. Higher government
spending, even if it is temporary, raises taxes and temporarily increases the size of the state,
which is unpopular on the right of the political spectrum. Fiscal transfers that move money
from unconstrained savers to those who are credit constrained also tend to involve transfers
from the rich to the poor. Although useful from the point of view of stimulating effective
demand, they may not be politically acceptable.

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Simon Wren-Lewis

Minimize i=0  Ti2 /(1 + r )i = T02 + T12 /(1 + r ) + T22 /(1 + r )2 +

subject to Dt = (1 + r )Dt1 Tt each period t 0, where r is the real interest rate. We
normalize the impact of distortionary taxes on welfare to one for simplicity.
Writing this as a Lagrangian

 

L 0 = T02 20 (T0 (1 + r )D1 + D0 ) + T12 21 (T1 (1 + r )D0 + D1 ) (1 + r ) +
then each period the first-order conditions will be
Tt t = 0
t + t+1 = 0
for all t. We can see immediately that the Lagrange multiplier is constant, so taxes will be
constant in every period, which if debt is not to explode implies a constant level of debt. So
taxes in each period are enough simply to finance the interest payments on the inherited level
of debt, and the optimal policy involves keeping debt at this inherited level, whatever this
inherited level might be. (For example, accommodation implies taxes have to rise to rD1 .
The discounted welfare cost of this is r(1+r)(D1 )2 . Compare this to the cost of eliminating
debt immediately, (D1 )2 , which is clearly larger for all feasible values of real interest rates.)
The implication of this analysis is stark. If we were unconcerned about intergenerational
issues, crowding out of capital, and risk premia, then we should not attempt to bring debt
levels down following a recession. More generally, debt targets (such as those adopted by the
UK government before the credit crunch) do not make sense in this framework: government
debt is a buffer which we should allow to be blown this way and that according to the economic
wind. (This benchmark result also explains why governments might not worry about what

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To answer this question we need to outline a key result that has been established by research
over the last decade.
Suppose we ignore the possibility of default, and we assume that the economy is made up
of infinitely lived agents so that debt does not crowd out private capital. The economy is
then hit by a negative demand shock, which may be offset by an expansionary fiscal and/or
monetary policy. The net effect is to raise the stock of government debt. After the shock is
over, we can think of two choices. The first is to accommodate the rise in debt: raise taxes (or
cut spending) by just enough to finance interest payments on the higher stock of debt. This
results in a permanent distortion (taxes are permanently higher), but the discounted value of
this distortion is finite. The second choice is to raise taxes (or cut spending) by much more,
to bring debt back to its original level. We can call this debt targeting. This has much higher
costs in the short term, but these costs are temporary.
In this baseline model, the optimal choice in these circumstances is to accommodate rather
than target i.e. to let debt be permanently higher (see Schmitt-Grohe and Uribe (2004) and
Benigno and Woodford (2003)). Although this result may seem surprising, it is a simple
variant of Barros argument for tax smoothing. If the costs of a distortion rise with the level
of that distortion, then it is best to smooth those costs, even if that means the costs are never
eliminated.
To demonstrate this at its simplest, suppose we ignore government spending, and assume
debt is entirely financed by taxes. Assume the optimal level of taxes is zero, and their cost is
quadratic. The optimal level of debt is also clearly zero, but let us assume that we inherit a
positive debt D1 >0. Optimal policy involves choosing debt and taxes to minimize discounted
costs, i.e.

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12 This result needs to be qualified in various respects. Discretionary policy will aim to return debt to its efficient
level, which in Leith and Wren-Lewis (2007a) equals the initial level by construction. The speed of adjustment may
also be influenced by the maturity structure of debt and any zero-bound constraint, if interest rates are used as an
instrument to reduce debt.

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the optimal level of debt is, even when debt targets are imposed, because the least damage is
done by having a target equal to the inherited debt stock.)
How robust is this result? In this example, the only way to reduce debt was by raising taxes.
The first-order conditions were identical for all time periods including the first, so the policy
is also time consistent. In practice a good deal of government debt is fixed in nominal terms.
In these circumstances, we could reduce the debt burden by unexpectedly raising inflation.
Inflation itself is costly, so even if the government rather than an independent central bank
controlled inflation, there are limits to the amount of surprise inflation a government would
plan for. But a key point is that, come the next period, it would be optimal to reduce debt
still further by this means, so policy becomes time inconsistent. Agents assuming rational
expectations will anticipate this continuing incentive to raise inflation, and so the optimal
policy will (given these expectations) become the time consistent, discretionary solution.
The same point would arise even if all debt was real, because the monetary authority can
temporarily reduce real interest rates when prices are sticky. This has a similar effect in
reducing the debt burden, but because it influences inflation, any attempt to reduce debt this
way will also be time inconsistent if inflation is determined in a forward-looking manner.
In these circumstances, as Leith and Wren-Lewis (2007a) show, the time-consistent policy
has to involve debt returning to its initial, pre-shock leveli.e. it has to be a debt-targeting
policy rather than a debt-accommodation policy. If it was not, then there would always exist
a first-period incentive to move debt slightly towards its initial level, and so the policy would
be time inconsistent.
Could we then conclude that the reason why fiscal policy-makers would target rather than
accommodate debt is that they are forced to follow a discretionary (time consistent) policy?
After all, few would argue that fiscal policy-makers had strong reputations for commitment.
There are two reasons for doubting this argument. First, as Leith and Wren-Lewis (2007a)
also show, the time-consistent policy involves debt returning to its initial level far more rapidly
than policy-makers attempt to achieve in practice.12
Second, we normally associate strong incentives to deviate from the optimal, timeinconsistent path with impatience. In the standard monetary policy example, there are
short-term gains in exploiting the time inconsistency (i.e. revising policy), but the costs
of subsequently being forced to be time consistent are more long term. The more myopic or
impatient the policy-maker, the greater their incentive to deviate from the time-inconsistent
plan. It also seems reasonable to believe that fiscal policy-makers may on occasion be more
subject to excessive impatience than central banks. However impatience in the case of debt
does not appear to imply a greater likelihood of deviating from a time-inconsistent policy
plan. The benefits of exploiting the time inconsistency are long term: the increase in debt after
the shock is slightly lower, implying lower permanent debt-service costs. The costs of being
forced to follow a time-consistent policy are short term: taxes have to rise or government
spending has to fall quickly. An impatient fiscal policy-maker has every incentive to commit
to the accommodation path. (In fact, if the policy-maker was using an objective function
where the discount factor was higher than the discount factor used by the private sector,
then this policy-maker would want to deviate from the random walk result in the opposite
direction, allowing debt to gradually explode, as Kirsanova et al. (2007) illustrate.)

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The combined first-order condition now becomes

(Dt D ) Tt + Tt+1 = 0.
Now if Dt > D , optimal taxes will gradually fall over time, and debt will asymptote towards
the desired level. But if a later shock raises the level of debt, then reoptimization will imply
gradually reducing debt from this new, higher level, rather than an attempt to return to the
previous (pre-shock) path for debt.
So as long as debt was not attracting a significant risk premium, its reduction should be
slow, and is likely to be erratic as further shocks hit the economy. For this reason, it would be a
mistake to adopt D as an explicit debt target, even if we knew what D was. Macroeconomic
targets are useful when there is a chance that the target might be hit within the lifetime of a
government or government agency, and when failure to meet that target represents a policy
failure. The inflation target given to the MPC probably meets both these conditions, but
neither condition holds for D above. Instead, it may make sense for D to be reached over a
period of decades rather than years, and there may be good macroeconomic reasons why the
approach path to D may be bumpy.
As a result, a more robust summary of optimal debt policy is that it should involve a
tendency for debt to decline over time. This rate of decline should be higher when debt is
high, but it will still be slow, and it should accommodate macroeconomic shocks. For similar
reasons, it is rather unlikely that D will ever be reached (as D may well be negative), so
there is unlikely to come a time when debt should stop showing a tendency to decline. The
argument based on the liquidity trap for debt to show a tendency to decline over most periods
does not depend on any asymmetry in the shocks hitting the economy, but instead on an
asymmetry in the fiscal response to shocks generated by the zero lower bound for interest
rates.
Unfortunately, it is well known that the trend across OECD countries over the last few
decades has been for debt-to-GDP ratios to rise, rather than fall in the manner suggested
above: so called deficit bias. The imposition of fiscal rules, either by governments on
themselves or through a super-national body such as the European Union, may mitigate this
trend but, as the recent example of the UK shows, this is far from guaranteed. Kirsanova
et al. (2007) argue that rules should be supplemented by national Fiscal Councils, which
would be set up by governments both to make long-term fiscal projections and to advise on
optimal levels of government borrowing each year.13 The Fiscal Council would do its best to
13 Some countries have already adopted a form of Fiscal Council, and a proposal similar to that in Kirsanova
et al. (2007) was adopted by the UK Conservative Party in 2008.

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In deriving the result that debt should be accommodated, we ignored risk premia and
possible crowding out of capital. As we have already argued, both of these considerations
imply that high levels of debt should not be accommodated. But this does not mean that we
should ignore the logic of the accommodation result, which implies that even if debt levels
need to be reduced, this reduction should be slow, and should be sensitive to macroeconomic
shocks hitting the economy. We can show this very crudely by adding a quadratic term to
social costs in the form of deviations of debt from a target (D ). Here D could be the level of
debt (or assets) at which fiscal policy would have all the necessary freedom to act in a severe
recession, or the level of debt that delivers an optimal capital stock in an OLG framework.
The policy problem then becomes
 

Minimize i=0  Ti2 (1 + r )i + (Di D )2 /(1 + r )i .

Macroeconomic policy in light of the credit crunch

83

calculate the optimal path for debt in a rather less crude manner than suggested above, but
more importantly it could be the judge as to when it was sensible to allow debt to rise, or fall
more rapidly, and help avoid governments succumbing to political pressures leading to deficit
bias. A Fiscal Council would encourage governments to be explicit and objective about their
future fiscal plans, which would in turn clarify the impact of more short-term fiscal measures,
for reasons discussed in Leeper (2009).

VII. Modifying the consensus assignment

14 We assume here that fiscal policy remains passive in the sense used by Leeper (1991), so that some of the
problems of the kind analysed in Chung et al. (2007) do not arise.

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The consensus assignment charges monetary policy with the task of controlling inflation
by managing demand, while aggregate fiscal actions focus on controlling government debt
(Kirsanova et al., 2009). However the zero-bound constraint for interest rates places an
important caveat on that consensusthe assignment does not apply when economies are
hit by large negative shocks. As was argued above, counter-cyclical fiscal policy is both
appropriate and, if well chosen, also effective, when interest rates are stuck near zero during
a severe recession.
How important is this modification of the consensus assignment? Should we confine fiscal
stabilization policy to the hopefully rare occasions when large negative shocks occur? Can
fiscal counter-cyclical policy be tucked away in one corner of the armoury, only to be used
in these special circumstances? The combination of uncertainty with the well-known lags in
the operation of fiscal policy suggest not. Implementation lags mean that it makes sense to
anticipate the possibility of hitting a zero bound by announcing an expansionary fiscal policy
before that bound is reached. But as severe recessions cannot be predicted with certainty, this
inevitably means using an expansionary fiscal policy during some economic downturns that
do not turn into severe recessions.
Imagine, for example, a downturn in activity that leads nominal interest rates to fall from 4
per cent to 1 per cent. Suppose there are two possibilities for what might happen next period,
in the absence of fiscal action. The economy might recover, allowing interest rates to return
to 4 per cent, or the downturn might turn into a recession. In the recession, monetary policymakers might want to set interest rates at 1 per cent, but of course they cannot because we
have hit the zero bound. Fiscal action is possible, and for the sake of exposition assume it will
raise demand by the same amount as a 1 per cent cut in interest rates, but with one periods
additional lag. In the case where the economy continues to decline, it would make sense to
announce expansionary fiscal action when interest rates were at 1 per cent, so it can support
demand during the recession. We (just) avoid the zero-bound constraint. Of course, we do
not know which outcome will occur when interest rates are at 1 per cent, so there is a good
chance that this fiscal expansion will be inappropriate. In this case, interest rates will rise to 5
per cent rather than 4 per cent, and we will bear the costs of an inappropriate fiscal monetary
mix. However, these costs are likely to be small compared to the costs of hitting the zero
bound (see Eggertsson and Woodford, 2003, 2004), so it is a risk worth taking.14
This combination of uncertainty and implementation lags means that, ex post, we will be
using fiscal stabilization policy more often than we would like. However, as proposed, fiscal

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15 I

am grateful to Chris Allsopp for suggesting this idea.

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action would only be contemplated during downturns where there was a significant risk of the
zero bound being hit. Why not go further, and always combine fiscal with monetary countercyclical policy? In other words, why not overturn the consensus assignment altogether?
The textbook reasons for following the consensus assignment are many and various. Some,
such as Ricardian Equivalence or ineffectiveness based on MundellFleming, have already
been questioned above. However, we also noted above the problem of deficit bias, and there
is a justifiable suspicion that allowing counter-cyclical fiscal policy would increase that bias
because governments would be too ready to expand fiscal policy in a downturn, but would
avoid fiscal contraction during a boom. In addition, the existence of implementation lags for
fiscal policy make it a less flexible instrument than monetary policy. Both factors may be
behind why most macroeconomists are in favour of letting the automatic stabilizers operate,
but are against (outside the zero-bound constraint) discretionary fiscal action. Both factors
could be diminished by institutional reforms of the kind discussed briefly above.
Suppose that institutional changes did help reduce concerns over deficit bias and implementation lags. Would we then want to use fiscal policy alongside monetary policy to control
the business cycle? Eser et al., 2009, suggest not. They show that when monetary policy
is and always will be unconstrained (e.g. outside of a zero-bound constraint, or outside of
a monetary union), it is optimal to rely entirely on monetary policy as a means of dealing
with business-cycle shocks. Monetary policy is more effective than fiscal policy because it
operates through labour supply as well as the demand for goods, and because changes in taxes
or spending lead to misallocation costs. In other words, the optimal stabilization policy is
monetary policy, and providing monetary policy remains unconstrained, fiscal policy should
eschew counter-cyclical action.
This conclusion holds for what we might term standard, economy-wide macroeconomic
shocks, and for fiscal policy used as a demand-management tool. However, changes in tax
rates also influence relative prices. This ability of fiscal policy to change relative prices could
in theory play a complementary role to monetary policy for two reasons. The first is that
price stickiness can lead to distortionary changes in key relative prices. For example, nominal
inertia in prices and wages will mean that technology shocks will not lead to the correct
changes in real wages, even if monetary policy replicates the natural real rate of interest. This
distortion can be corrected by movements in income and sales taxes (Leith and Wren-Lewis,
2007b). The second is that shocks themselves may be distortionary, and if a tax operates on
the same margin, it can be varied to offset that distortion. Sales taxes and cost-push shocks
are an obvious example (Benigno and Woodford, 2003).
In the current context, a negative demand shock caused by an increase in the degree of
credit rationing might be another example, operating through quantities rather than relative
prices.15 If the increase in credit rationing is an overreaction by banks reflecting excessive risk
aversion, then this creates a distortion irrespective of the impact on demand. As tax cuts are,
in effect, lending by the government, they could be seen as undoing the distortion created by
the banking system. If tax cuts could be targeted precisely at those suffering credit constraints
(unfortunately not a very realistic possibility) then this fiscal action might be preferable to
monetary policy as a response to this shock.
To sum up, the consensus assignment needs qualifying in two important ways. First, it is
prudent to use fiscal policy in a counter-cyclical manner when there is a significant possibility
that interest rates might hit the zero bound. (It should certainly be used once the lower bound

Macroeconomic policy in light of the credit crunch

85

has been hit.) Second, there may be many cases in which it is useful to use changes in specific
taxes when they operate on the same margin as distortionary shocks, or when they can change
relative prices that are away from efficient levels because of nominal inertia.

VIII. Conclusion

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A macroeconomic policy regime based on monetary policy trying to hit a flexible inflation
target is fundamentally sound, and should not be discarded as a result of recent events.
However the credit crunch shows that this policy needs to be supported in two ways. First,
we need much more effective regulation and control over financial markets. Without this
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seriously distorted by an aversion to asset price rises, and at worst the current crisis will
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gradually and erratically) in normal times seems appropriate.

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