VoxEU Column Global crisis Macroeconomic policy

Jackson Hole, the crisis and policy responses: A new orthodoxy

The crisis is deepening in Europe, and recession is spreading globally. This column argues that macroeconomic policies have failed to overcome the dual problems of flagging aggregate demand and high and spiralling public debt. It urges policymakers to abandon failed orthodoxies and irrelevant treaties and consider new, alternative solutions.

Demand, output, manufacturing activity and exports are weakening in many parts of the industrialised world. Quantitative easing policies have generally run their course, as interest rates are at the zero bound or thereabouts. In the Eurozone it is questionable whether the ‘one-size-fits-all’ policy interest rate approach is helpful or meaningful, or whether it can be sustained. In those countries suffering the worst collapse in GDP, authorities are applying draconian ‘fiscal austerity’ policies. This approach is not only dragging economies lower, but it is adding to budget deficits and public debt and increasing interest rates periodically. All sorts of rescue, firewall and bailout policies have been applied and proposed, but the principal source of the problem – the new government bond financing of on-going budget deficits – has not been addressed by policymakers. Separate debt fires in neighbouring countries could join up at any time. The stakes are very high.

Policymakers need to abandon failed orthodoxies and irrelevant treaties and consider new, alternative short- and long-term policy strategies. To be able to do this, policymakers need to review their beliefs and conceptual analysis. The risk is that many policy advisers are trapped in the paradigms appropriate to the past era of high inflation and have not sufficiently adjusted to the new era of high public debt.

Printing money and inflation

Many advisers, some central bankers included, are of particular concern in this regard. For instance, Charles Plosser (2012) argued in May – presumably in an attempt to shore up the case for central bank independence – that there are good reasons for separating the functions and responsibilities of central banks and fiscal authorities. He asserts that:

‘History teaches us that unless governments are constrained institutionally and constitutionally, they often resort to the printing press to avoid making tough fiscal decisions. But history also teaches us that this can create high inflation and, in the extreme, hyperinflation’

This assertion is not supported by detailed IMF research (Benes and Kumhof 2012). Referring to the German hyperinflation in the 1920s, the IMF authors conclude:

‘This episode can therefore clearly not be blamed on excessive money printing by a government-run central bank, but rather by a combination of excessive reparations claims and a massive money creation by private speculators, aided and abetted by a private central bank’. (Emphasis added).

Referring to the claim that the government monopoly of money issuance would be highly inflationary, the IMF authors conclude:

‘There is nothing in our theoretical framework to support this claim…. And there is very little in monetary history of ancient societies and Western nations to support it either’

Rather than the separation of functions and responsibilities advocated by Plosser, I argue the alternative position in a recent CEPR Policy Insight (Wood 2012). In my view, much closer coordination of monetary and fiscal policy holds the key to achieving economic stimulus without increasing public debt further.

I put forward the case for ‘monetisation of budget deficits’. This policy option is not evil, and it is not really radical in the context of today’s economic circumstances: deficient aggregate demand and high public debt. Indeed, deficit monetisation has been referred to for possible consideration by John Maynard Keynes, Abba Lerner, Milton Friedman, Ben Bernanke, Max Corden, Richard Wood, Willem Buiter and Ebrahim Rahbari, Martin Wolf, and Anatole Kalestsky.

Under this plan, new money creation would be used not for further quantitative easing (to the benefit of unproductive bank reserves) but, rather, to finance ongoing budget deficits and to provide fiscal stimulus (benefiting consumers, public infrastructure and the low-income disadvantaged) without increasing public debt. Under this approach, sharp austerity policies could be relaxed, and public debt would stop rising. This would go a long way to avoiding a major financial crisis and to restoring confidence in governments and the economy. The policy could be applied whether periphery governments stayed in the Eurozone or left it.

My Policy Insight explains why new money creation does not add to public debt. I also identify a number of reasons why deficit monetisation would not be inflationary, and suggest a legislative cap if governments want to remove any doubt in this regard. Moreover, the proposed approach would allow for the application of both differentiated monetary and differentiated fiscal policies in the absence of a full-fledged monetary and fiscal union. This could take pressure off German taxpayers and the German government, and provide improved economic outcomes in periphery countries.
The article illustrates, diagrammatically, the effects of three different policy options: 1) a new government bond financed fiscal stimulus, 2) the combination of a new government bond financed fiscal stimulus and quantitative easing and 3) deficit monetisation. The article explains why option 2) does not yield the same economic results as option 3).

International competitiveness

The article also addresses the ‘international competitiveness’ problem, which is constraining the growth of some periphery countries. This problem is currently being addressed by sharp austerity and market forces. The current approach relies heavily on fiscal austerity to drive up unemployment in order to drive down wages. This policy further lowers aggregate demand expansion. It is very slow moving, particularly so because of entrenched rigidities, and has contributed to the toppling of governments. It also saps the motivation and willingness to undertake new structural reforms.
My Policy Insight proposes that an alternative set of policies could achieve a quicker and less painful adjustment of wages and prices.


Periphery countries in particular are currently facing colossal difficulties, largely as the consequence of policy failures and oversights since the global economic crisis started. Fighting debt fires with even more debt does not address the source of the blaze.

Japan, the US, and the UK are also experiencing inadequate domestic demand and rising debt levels. Because these countries have their own national currencies they are in less jeopardy, as they can always print new currency to repay debts, but policymakers can do much better going forward than in recent years. This requires creative discussion, bold actions, and greater efficiency in the joint application of monetary and fiscal policy.

Because interest rate policy options are now constrained, and because of the need to achieve synergistic efficiencies by stronger coordination of monetary and fiscal policy to lift economic activity, ministries of finance and governments seem well placed to assume a lead role in policy development.


Benes, J and M Kumhof (2012), “The Chicago Plan Revisited”, IMF Working Paper, 12/202, April.

Plosser, C (2012), “When a monetary solution is a road to perdition”, Financial Times, Comment, 17 May.

Wood, R (2012), “The economic crisis: How to stimulate economies without increasing public debt”, Policy Insight No. 62 , 31 August.

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