Monetary alchemy, fiscal science

Jeffrey Frankel, 29 January 2013



The year 2013 marks the 100th anniversary of two major institutional innovations in US economic policy:

  • The Constitutional Amendment enacting federal income tax (February 1913);
  • The law establishing the Federal Reserve (December 1913);

It took some time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy respectively. It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macroeconomy. John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression. Milton Friedman blamed the Depression on the Fed because it allowed the money supply to fall.

In subsequent debates:

  • Keynes was associated with support for activist or discretionary policy. The aim was a countercyclical response to economic fluctuations: expansion in recessions, discipline in booms;1
  • Friedman opposed activist or discretionary policy, believing that government institutions – whether monetary or fiscal – were unable to time their interventions effectively.

However, what the great economists were both opposed to was procyclical policy moves such as the misguided US tightening in 1937 at a time when the economy had not yet fully recovered.

Postwar lessons

After the second world war, the lessons of the 1930s (see Eichengreen et al. 2009) were incorporated into all macroeconomic textbooks and, to some extent, permeated the beliefs and actions of policymakers. But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by other major economic phenomena, such as the high-inflation 1970s. Many politicians in advanced countries are repeating the mistakes of 1937 today. This is happening despite conditions (see Almunia et al. 2010) qualitatively similar to those that determined Keynes’ policy recommendations in the 1930s (Eichengreen and O’Rourke 2010): high unemployment, low inflation, and rock-bottom interest rates.

The austerity-versus-stimulus debate (see Frankel 2012a, Corsetti 2012) has been thoroughly hashed out. On the one hand, proponents of austerity correctly point out that the long-term consequences of permanent expansionary macroeconomic policy – both fiscal and monetary – are unsustainable deficits, debts, and inflation. On the other hand, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt-to-GDP ratios that go up rather than down. With conditions of excess supply in goods and labour markets, as opposed to full capacity and full employment, demand expansion goes into output and employment. Procyclicalists (see Frankel 2012b) both in the US and Europe represent the worst of both worlds. They push in the direction of expansion during booms (such as that of 2003-07 ) and in the direction of contraction during recessions (such as that of 2008-2012), thereby exacerbating both upswings and downswings. Countercyclicalists have it right: working in the direction of fiscal and monetary discipline during booms and fiscal and monetary ease during recessions.

Less thoroughly aired recently is the question of whether, given recent conditions, monetary or fiscal expansion is the more effective instrument. This question was addressed clearly in 1937 by Sir John Hicks in a once-famous article entitled ‘Mr. Keynes and the Classics’ (Hicks 1937). The graphical model is known to many generations of undergraduate students in macroeconomics under the label ‘IS-LM’.

Which form of policy is more effective?

Under the circumstances that held in the 1930s and that hold again today – conditions not just of high unemployment and low inflation but also of near-zero interest rates – stimulus in the specific form of fiscal expansion is much more likely to be effective in the short term than stimulus in the form of monetary expansion. Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero. This situation, labeled by Keynes as a liquidity trap, is today called the ‘Zero Lower Bound’. In addition, firms are less likely to react to easy money by investing in new factories and equipment if they cannot sell the goods they are producing in the factories they already have. The hoary but still evocative metaphor is ‘pushing on a string’ (that is, it is easier to stop an expansion than to end a severe contraction). Meanwhile, fiscal expansion is rendered relatively more effective, in that it doesn’t push up those rock-bottom interest rates and thereby crowd out private-sector demand.

Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries. It is worth trying all sorts of things2: quantitative easing, forward guidance, nominal targets. But the effects of each are highly uncertain. That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position. But many economists have forgotten much of what they knew and politicians may not have even heard the proposition.

Introductory economics textbooks have long talked about the Keynesian multiplier effect: the recipients of federal spending – or of consumer spending stimulated by tax cuts or transfers – respond to the increase in their incomes by spending more as well, as do the recipients of that spending, and so on. Again, the multiplier is much more relevant under current conditions than in more normal situations where the expansion goes partly into inflation and interest rates, and thus crowds out private spending. By the time of the 2008-09 global recession, even those who believed that fiscal stimulus works had marked down their estimates of the fiscal multiplier (intimidated, perhaps, by newer theories of policy ineffectiveness). The subsequent continuing severity of recessions in the UK and other countries pursuing contractionary fiscal policies, apparently to the surprise of the politicians enacting them, suggested that multipliers are not just positive, but greater than one, as the old wisdom had it. The IMF Research Department (Blanchard and Leigh 2013) has reacted to this recent evidence and bravely confessed that official forecasts, including even its own, had been operating with underestimates of multiplier magnitudes.

New-wave estimates of fiscal multipliers

A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others. Baum, Poplawski-Ribeiro and Weber (2012) allow the estimate to change when crossing a threshold measure of the output gap. Batini, Callegari and Melina (2012) allow regime-switching across recessions versus booms. Others that similarly distinguish between multipliers in periods of excess capacity versus normal times (see Ramey 2012) include Auerbach and Gorodnichenko (2012a, 2012b), Baum and Koester (2011), and Fazzari, Morley and Panovska (2012). Most of this research finds high multipliers – above 1.0 – under conditions of excess capacity and low interest rates, though few have the courage to mention that this is what one would have expected from the elementary textbooks of 50 years ago. Related studies confirm other conditions that matter for the size of the fiscal multiplier in precisely the way the traditional textbooks say, for example (see Ilzetzki, Mendoza and Vegh 2011) that they are lower in small open economies because of the crowding out of net exports.

Needless to say, the effects of fiscal policy are subject to substantial uncertainty. One never knows, for example, when rising debt levels might suddenly alarm global investors who then abruptly start demanding higher interest rates, as happened to countries on the European periphery in 2010 (for this reason, the US would be well advised to lock in a long-term path towards debt sustainability, even while undertaking a little short-term stimulus). In the case of stimulus in the form of tax cuts, one never knows how much of the boost to disposable income will be saved by households rather than spent. We are also uncertain as to the magnitude of negative effects of high tax rates, via incentives, on long-term growth. And it is true that monetary policy is much better understood than it was in the past.

Monetary alchemy and fiscal science

Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter. One might even dramatise the contrast by speaking of ‘monetary alchemy and fiscal science’.

A much-admired paper by Eric Leeper (2010) had it the other way around: he characterised monetary policy as science and fiscal policy as alchemy. It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to the best that modern society has to offer. It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state of economic knowledge and largely motivated by politicians’ desire to be re-elected. These political realities may be what Leeper had in mind.

Alchemists were not stupid or selfish. Nor were they not listened to. Rather, alchemy fell far short of modern chemistry. The term alchemy could be applied to pre-Keynesians like US Treasury Secretary Andrew Mellon, whose Depression prescription was that President Herbert Hoover should “liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate ... it will purge the rottenness out of the system”. It could also be applied to the UK ‘Treasury view’ circa 1929, defined by Churchill as the Treasury believing that “when Government borrow[s] in the money market it becomes a new competitor with industry and engrosses to itself resources which would otherwise have been employed by private enterprise, and in the process raises the rent of money to all who have need of it". But in light of all that was learned in the 1930s, it would be misleading to characterise the current state of fiscal policy knowledge as ‘alchemy’.


Almunia, Miguel, Agustín Bénétrix, Barry Eichengreen, Kevin O’Rourke, and Gisela Rua (2010), "From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons", Economic Policy 25,62, 219-265.

Auerbach, Alan and Yuriy Gorodnichenko (2012a), "Measuring the Output Responses to Fiscal Policy," American Economic Journal: Economic Policy, 4(2), 1-27, May.

Auerbach, Alan and Yuriy Gorodnichenko (2012b), "Fiscal Multipliers in Recession and Expansion," NBER Chapters, in Alberto Alesina and Francesco Giavazzi (eds.) Fiscal Policy after the Financial Crisis, Chicago, University of Chicago Press.

Batini, Nicoletta, Giovanni Callegari and Giovanni Melina (2012), "Successful Austerity in the United States, Europe and Japan", IMF Working Papers 12/190, International Monetary Fund.

Baum, Anja and Gerritt Koester (2011), “The Impact of Fiscal Policy on Economic Activity Over the Business Cycle - Evidence from a Threshold VAR Analysis” Deutsche Bundesbank, Research Centre series, Discussion Paper Series 1: Economic Studies, 3.

Baum, Anja, Marcos Poplawski-Ribeiro and Anke Weber (2012), "Fiscal Multipliers and the State of the Economy," IMF Working Paper 12/286, International Monetary Fund, December.

Blanchard, Olivier and Daniel Leigh (2013), “Growth Forecast Errors and Fiscal Multipliers”, IMF Working Paper 13/1, January, forthcoming in The American Economic Review, May.

Corsetti, Giancarlo (2012), “Has austerity gone too far?”,, 2 April.

Eichengreen, Barry and Kevin H O’Rourke (2010), “A tale of two depressions: What do the new data tell us?”,, 8 March.

Eichengreen, Barry Kevin H O’Rourke, Miguel Almunia, Agustín S Bénétrix, and Gisela Rua (2009), “The effectiveness of fiscal and monetary stimulus in depressions”,, 18 November.

Fazzari, Steven, James Morley, and Irina Panovksa (2012), “State-Dependent Effects of Fiscal Policy”, UNSW Australian School of Business Research Paper, 2012-27, April.

Frankel, Jeffrey (2012a), “The First World’s Fiscal Follies”, Project Syndicate, 19 July.

Frankel, Jeffrey (2012b), “The Procyclicalists: Fiscal austerity vs. stimulus”,, 7 August.

Friedman, Milton and Anna Schwartz (1963), A Monetary History of the United States, 1867–1960, Princeton University Press.

Hicks, John (1937), “Mr. Keynes and the Classics: A Suggested Reinterpretation”, Econometrica, 147-59.

Ethan Ilzetzki, Enrique Mendoza & Carlos Vegh, 2011. "How Big (Small?) are Fiscal Multipliers?", IMF Working Papers 11/52, (International Monetary Fund.) Forthcoming, Journal of Monetary Economics.

Leeper, Eric (2010), “Monetary Science, Fiscal Alchemy,” NBER Working Paper 16510.

Ramey, Valerie A (2012), “Government Spending and Private Activity”, first presented at the 2011 NBER conference ‘Fiscal Policy after the Financial Crisis’ in Milan, December.

Romer, Christina and David Romer (2013), “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter,” University of California, Berkeley, January.

Spilimbergo, Antonio, Steven Symansky, and Martin Schindler, “Fiscal Multipliers,” Staff Position Note 2009/11, International Monetary Fund.

1 It is a myth that he favoured big government more generally. Indeed, he said “the boom is the time for austerity”

2 For an alternative perspective, see Romer and Romer (2013) for a discussion of ‘why monetary policy doesn’t matter’.

Topics: Global crisis, Macroeconomic policy
Tags: Federal Reserve, fiscal policy, Great Depression, Keynes, monetary policy

Jeffrey Frankel

Professor of Economics, Harvard Kennedy School

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