The dominance of Keynesian economics in the post Second World War period is largely credited to the widely-held belief that it was expansionary fiscal policy that was effective in countering the Great Depression of the 1930s. The case for Keynesian stimulus is straightforward, following directly from the National Income identity (Y = C + I + G + Net Exports) and the investment-income multiplier. An expansion of government consumption and investment merely substitutes for the contraction in private demand to restore the economy to trend growth and full employment through the multiplier process. When domestic demand destruction is combined with external demand shock, and monetary policy is also ineffective, theoretically there is no alternative to fiscal expansion to restore growth over the short-term. It is relevant to note that Keynes made no distinction between government consumption and government investment as far as impact is concerned.
Fiscal policy, however, soon became a political minefield, easy to navigate while in expansionary mode, but difficult to exit following the recovery. Fortified by the Philips curve that postulated a trade-off between inflation and growth, and difficulties in estimating potential growth, governments kept pushing the fiscal envelope to increase growth even when fiscal stimulus was not necessary, and even when it was contra-indicated. Fiscal policy therefore had an inherent inflationary bias that tended to crowd out private demand. This ultimately culminated in the ‘stagflation’ of the seventies, with the widely acclaimed Phillips curve breaking down.
Milton Friedman sounded what appeared at that time to be the death knell of Keynesian economics by placing monetary policy at the heart of macro-economic stabilisation. He identified inflation as basically a monetary phenomenon. While strict monetarism was never followed, Paul Volcker’s dogged and aggressive monetary tightening finally tamed hyper-inflation. Inflation rates have been well anchored ever since in advanced economies. Over time, monetary policy tools were streamlined and became more rule-bound, with several central banks following variants of the ‘Taylor Rule’.
The dominance of monetary policy was assisted, on the one hand, by the decline in the role of the public sector in the economy, and the deepening and sophistication of financial markets through which monetary policy is transmitted. It therefore emerged as a powerful, and arguably more easily manageable, alternative tool to stabilise the economy. Discretionary fiscal policy fell into disrepute, although fiscal policy continued to play a role through ‘automatic stabilisers’, such as unemployment benefits, that kicked