Bullard's "Death of a Theory" Paper

Jim Bullard has posted his "Death of a Theory" paper here. This is essentially a call for a return to pre-financial-crisis views of the relative efficacy of fiscal policy and monetary policy for stabilization. Before the financial crisis, even New Keynesians were primarily focused on monetary policy. Mike Woodford's "Interest and Prices," for example, is almost exclusively a handbook on monetary policy. The views of New Keynesians on fiscal policy seemed to have been more or less consistent with those of Milton Friedman. Fiscal policy matters, but fiscal policy is about the long run. The process of making fiscal policy decisions is awkward and time-consuming, and we know little enough about how the economy works that stabilization using fiscal policy is inappropriate.

Things have changed since the financial crisis, however. Governments have been putting fiscal policy to use for stabilization purposes, and New Keynesians have jumped on the bandwagon. Bullard's paper argues, in light of the evidence and the economics literature, that the pre-financial crisis view is entirely appropriate, i.e. fiscal policy should focus on the long run and leave the short run to the central bank. Bullard says:

In short, existing political processes are, generally speaking, far too cumbersome and contentious to enact effective and timely short-term actions in response to market events. They are ill-equipped to deliver the types of subtle tax and spending interventions that may actually be effective according to a careful reading of the available macroeconomic literature on the topic.

Here's part of what the content of the paper is about:

I will describe and comment on two strands of the macroeconomic literature in this area, one highly formalized and the other intuitive but rhetorically potent. The …first is the heavily studied fi…scal multiplier idea in the context of New Keynesian DSGE macroeconomics. The second is less studied and not formally articulated very often. It is that a substantial increase in de…ficit-financed government purchases sends a signal to the private sector that a high growth regime is possible— and likely— going forward. This could infl‡uence private sector expectations and lead to a virtuous equilibrium in which actual output and employment are high. Rhetorically, this seems to be what many advocates have in mind, even if this is not what happens inside most of the macroeconomic models used to analyze this issue.

This is interesting, as it highlights an aspect of policy recommendations coming from hardcore Keynesians - Krugman for example - that do not make clear what the underlying source of inefficiency in the economy is. From a Keynesian point of view, the inefficiency could be sticky wages and prices, on the one hand, or a coordination failure, on the other. What the policy response should be depends on the inefficiency, though not every Keynesian understands this. As Bullard states, the type of coordination failure that some Keynesians appear to have in mind - self-fulfilling beliefs about the future driven by fiscal policy - has not really been formally studied.