In this paper we argue for a new approach to monetary and fiscal policy. During the Great Moderation, the inflation targeting regime worked well. Central banks used the interest rate to stabilize inflation, and—subject to inflation being controlled—stabilized the level of demand. Fiscal policy exerted discipline over the public-sector deficits, thereby—indirectly—managing the level of public debt. Such ‘fiscal housekeeping’ worked well, because the monetary authorities were stabilizing the economy. But once private-sector deleveraging led to the Great Recession, and interest rates hit their zero bound, the outcome could no longer be managed by monetary policy. Recovery depended on the ‘automatic stabilizers’: output and tax revenues have fallen, public debt has been created, and assets have been created which a deleveraging private sector wishes to hold. But the effect has been very gradual. Recovery would have been faster if fiscal policy had been responsible for the restoration of full employment, in an environment which tolerated the necessary rises in public debt. Conversely, policies of austerity, designed to reduce public debt, have slowed the recovery. Growth will not be resumed until the private sector begins to invest strongly again, creating the financial assets which the private sector wishes to hold, thereby enabling public debt to be retired. This has not yet happened because the private sector, correctly, does not believe that macroeconomic policy is capable of sustaining a strong recovery.

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