I have been reflecting upon the ebbs and flows of the economy over my lifetime and the various policy tools used to modulate those changes. While a furious debate still rages about Keynesian economics and there are clashes concerning Greenspan's legacy, it seems that a few points are inescapable and may give us a good guide book for policy in the future.
There is general consensus that we would all like a world with low or no inflation and high real GDP growth. Of course, the problem is that as the economy picks up momentum, bottlenecks emerge and prices rise producing inflation. Over time, due to these bottlenecks and "inflationary expectations" prices tend to rise simply because they have been rising in the recent past - indexing contributes to this. I can vividly remember the late 1970s when employees were insulted when they got a 10% raise because they weren't keeping up with inflation.
Most of the time it seems that Federal Reserve interest rate policy is sufficient to prevent explosive inflation and to stimulate the economy when it is slowing down. Indeed, in the early 1980s, Paul Volcker's high interest rate policy brought inflation under control - even though the federal government was running enormous deficits at the time. In a similar manner, a lowering of interest rates can generally stimulate the economy and produce an increase in real GDP with a lag time.
The fine tuning of this mechanism is sometimes described as the Taylor Rule which posits an an ideal federal funds rate based on inflation and "slack" in the economy measured by comparing actual and potential output. Other economists have proposed variations on the formula (the Mankiw version is the one I am most familiar with) but the general approach is clear. When inflation and capacity utilization are high, interest rates should be high. When inflation and capacity utilization are low, interest rates should be low.
It is interesting that, so far, we haven't confronted the issue of fiscal policy at all. It appears that interest rate policy can reduce inflation even if the government is running a big deficit - that certainly seems to be the lesson of the Reagan years. This may have led some politicians to conclude that "deficits don't matter" and that kind of thinking can have some pernicious effects. The government shouldn't spend money wastefully - whether it is running a deficit or running a surplus - and a cavalier attitude toward deficits certainly opens the door to wasteful spending. But that is a problem of government efficiency - not necessarily a problem of inflation or macroeconomic policy.
Anyhow, the problem with interest rate policy is that, although interest rates can theoretically be raised to infinite levels, there is a limit to how far they can be lowered - zero is pretty much the bottom. And in a severe recession with deflation or very low inflation, the Taylor Rule (and its variations) implies a negative interest rate. Another way of stating this is that, under certain circumstances, the Taylor Rule suggests that a zero interest rate is too high and will slow down the economy further and create additional deflation. Of course, this is the exact opposite of what most of us would want to see happen at the bottom of a recession and so we have a problem.
It would seem that under the unusual circumstances when the Taylor Rule suggests an interest rate below zero, fiscal policy has a legitimate role to play and that countercyclical deficit spending may be necessary. To be sure that the spending does not simply "crowd out" private sector investment, the government debt necessary to support the spending should be monetized by expansion of the Federal Reserve's balance sheet. In simple terms, the Federal Government should simply print more money and spend it.
Once the Taylor Rule suggests that a zero rate is appropriate, then the deficit spending may be less necessary and macroeconomic policy can return to its primary reliance upon interest rate policy of the Federal Reserve. The Federal Reserve's decision about when and whether to reduce its balance sheet by selling the bonds it acquired should depend upon inflation and not upon any concern that the government must "pay back' the money it borrowed.
There is no symmetrical need to run a surplus at times of high inflation because there is no limit to how high interest rates can be raised and therefore the government's fiscal policy over a long period of time will have a "deficit bias." This will tend to lead to wasteful spending and other measures must be adopted to guard against this.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.