Depression Economics begins with a discussion of the overconfidence
economists had in their ability to stabilize the economy during the period known
as The Great Moderation. Overconfidence in our abilities is a mistake economists
seem to be prone to making, and the book recalls the 1960s when, after the
discovery of the Phillips curve, "economists were holding conferences with
titles like 'Is the Business Cycle Obsolete?'" The volatile 1970s took care of
that attitude, and should have cured us of the tendency to be overconfident for
good, but it didn't. With the decline in the volatility in output and the taming
of inflation after 1984 - the period known as The Great Moderation - we found
Robert Lucas proclaiming in 2003 that the "central problem of
depression-prevention has been solved for all practical purposes.

Some of that confidence has, of course, eroded away as the current problems
the economy have unfolded and policy appears powerless to do anything about it.
It feels like watching a slow motion train wreck and being unable to do anything
about it. But the question I want to ask is whether overconfidence in policy is
responsible for our current predicament. I think the answer is yes, in part, but
I believe it is actually underconfidence in policy that has been the
bigger problem.

The Great Moderation saw the rise of the central banker as a central figure
in managing the economy and preventing business cycle fluctuations. Many, many
papers have been written asking what caused the Great Moderation, was it better
monetary policy, better technology, financial market innovation, globalization,
good luck, or some other reason? It's a safe bet that some paper somewhere
looked at just about any cause that is reasonably imaginable. And a great number
of those papers came to the same conclusion: It was monetary policy, particularly inflation targeting (through Taylor rule type interest rate management) that brought about the lower inflation and a more stable economy since 1984. We had entered a new era, or so we thought as we patted ourselves on the back.

I can remember talking with colleagues about the fact that we had done this once before, we had become overconfident in our ability to manage fluctuations in the 1960s, and that we should be careful not to do it again. But it was hard not to believe that policy was responsible for the Great Moderation if you are a monetary economist. Monetary economists wanted to believe that their work, their research efforts, had paid such wonderful dividends to the economy. And they did believe, though there was always that nagging voice that wondered if we really had this nailed down as well as we seemed to think.

But in the process of elevating monetary policy to its lofty status, in being overconfident in its ability to get us out of any economic difficulty we might encounter, we ignored another key stabilization tool, fiscal policy. There was plenty of discussion about fiscal policy during the years that make up the Great Moderation, but it was largely about growth policy, not stabilization. The main question was how taxes could be adjusted to maximize economic growth. The use of fiscal policy to offset economic fluctuations was hardly discussed, and certainly not promoted, and in any case it couldn't compete with monetary policy for celebrity status.

During this period, there were many arguments about why fiscal policy wouldn't work, and one main objection was that the legislative process was broken and this made it too hard and too lengthy a process to do what is needed. But there were a whole host of other arguments as well, and all of these objections made policymakers believe fiscal policy was hardly worth trying. Besides, who needed it, we had monetary policy and that would be more than enough.

That lack of confidence in fiscal policy as a stabilization tool has been costly, especially in the face of big downturns such as we are experiencing now. Maybe monetary policy can manage the normal, routine type fluctuations in the economy, I believe it can, but when big shocks hit the economy monetary policy alone isn't enough. We need more.

But the overconfidence in monetary policy and the lack of confidence in fiscal policy has not allowed us to do more, at least not to the extent needed, and it seems to me the lack of confidence itself - the belief that fiscal policy won't work - is the biggest impediment. For example, serious discussions about implementing infrastructure spending to prop up the economy began a year ago, but "it won't work", "it takes too long", "let's wait to see if monetary policy works first", and other such objections have delayed its implementation. It wasn't until it became clear that nothing else was going to work that fiscal policy has come to the forefront, and even then there hasn't been nearly enough
urgency to get a fiscal policy plan in place - we're still waiting. There are hopeful signs that things may change with the new administration, but even then it's not at all clear that there is enough belief in fiscal policy to bring about the policy that is needed.

Legislators have to understand that they cannot simply rely upon the Fed to fix the economy and avoid any tough decisions about the use of deficit spending to help the economy when times are bad (and to figure out how to pay for that spending when times are good). If legislators understand and believe that early and decisive fiscal policy action is a crucial part of the policy mix needed to avoid large down turns, and especially if their constituents begin to understand this, perhaps timeliness of fiscal policy will be less will be less of an issue. Legislators have certainly shown that they can implement some types of policies - tax rebates - very quickly when they are sufficiently motivated to do so, and when they have the president's support.

Economists have a role to play here. We have put monetary policy on too high of a pedestal, and we have unfairly shunted fiscal policy into secondary status when it deserves a more prominent role. If I have a complaint about Depression Economics, it's that it does not do enough to offset this perception. Economists need to help restore confidence in fiscal policy, and they need to be more realistic about monetary policy. The updated version of Depression Economics takes a step in this direction, the last chapter in particular, but much, much more is needed. I trust, however, that Paul Krugman will continue to use his powerful public forum to help both policymakers and the public understand the essential role that fiscal policy plays in avoiding severe economic downturns.