Prior to the recent crash of financial markets, there was a widespread belief that monetary policy was all that was needed to stabilize the economy. By following some version of a Taylor rule (i.e. linking the target federal funds rate to inflation and output), the economy can be kept on a relatively smooth, high growth path. It was all very technocratic.
However, one important thing we learned recently is that central banks are not all powerful. They cannot prevent all large downturns in the economy and they cannot, on their own, always provide the help that is needed to stabilize the economy. How did we come to have so much faith in monetary policy? Why did we assume that monetary policy alone would be enough to stabilize the economy always and everywhere, that fiscal policy was no longer needed as a stabilization tool?
The fall in the volatility of output beginning in 1984 and the corresponding fall in inflation to low and stable levels is known as the Great Moderation (the variance of output fell to one half its pre-1984 value during this time period). Though this is debated in the literature, monetary economists for the most part attributed the Great Moderation in large part to the skill of central bankers (at following the rules the monetary economists said were optimal). There was a big change in the monetary policy operating procedure right around the time the Great Moderation began, and many monetary economists believe this change is what caused the enhanced stability of output.
Greenspan - prior to the crisis - was heralded far and wide for his skill at managing the economy and preventing cyclical swings. If this was just self-congratulation among economists with no effects beyond making themselves feel smart and important, there would be no reason to to be concerned. But this belief that policymakers could fine tune the economy and that the era of big breakdowns was over had important consequences because it diverted the attention of policymakers away from an important issue, the possibility of system-wide collapse.
In recent decades, policymakers at the Fed and academics studying monetary policy became increasingly concerned with the finer points of economic stabilization. For example, should the coefficient on the output term in the Taylor rule be .5 as Taylor advocates, or some other value, e.g. .92 as others have favored? Is it possible to squeeze a little bit more stability out of the system by refining the rule in some way, for example adding terms or changing the definition of variables (e.g. should we use core inflation, trimmed inflation actual inflation, inflation today, expected future inflation, inflation based upon the CPI, inflation based upon the PCE, inflation based upon the GDP deflator, etc.)?
The main concern of policymakers during this time period was finding ways to tweak the policy rule to achieve even more stability. But in doing so, they forgot to ask an important question, what should we do to prevent big meltdowns, and what should we do if they occur? Policymakers' belief in their own skills and in the institution of capitalism (which was, in theory, a self-regulating and self-correcting system), made policymakers ignore the possibility of a systemic breakdown. It just couldn't happen in a modern economy with all of its internal checks and balances, its modern information producing technology, and its skilled policymakers overseeing the entire system. Policymakers were so worried about refining the Taylor rule, so devoted to fine-tuning the system, that they forgot to ask what might cause the system to break down entirely, and what we should do if that happened.
As for fiscal policy, it fell off the map altogether. Fiscal policy is wrought with political battles, e.g. should it be spending or tax cuts, who should benefit from these programs, etc., and this makes fiscal policy difficult if not impossible to apply in "normal" breakdowns. So it was convenient to leave these worries to monetary policymakers. If central banks can get the job done, and the belief was that they could, why bother to have these political fights that are likely to end in a stalemate anyway?
So when the system did break down, both monetary and fiscal policymakers were caught unprepared, and it showed. Monetary policymakers in particular looked like a deer caught in headlights when the crisis first hit. There were no plans on the shelf advising policymakers how to deal with this problem, nobody had much thought about what to do and they were entirely unprepared when it happened. Question such as how to structure auctions for toxic assets that should have been considered and resolved before the crisis ever hit had to be solved under the pressure of the moment, and the solutions took up valuable time and weren't always correct. Policy, at least at first, appeared to be an ad hoc, trial and error procedure, not something well grounded in theory and experience.
Will we learn? Will we be better prepared to implement fiscal policy next time? Will we be better prepared with monetary policy actions to solve liquidity and solvency problems when this happens again (and it will, assuming it won't is part of the problem)? With planning, can we bail out the financial system in a way that does not reward the bad actors who caused the problem, can we provide more protection for taxpayers who must foot the bill for the bailout? I think we can do much, much better than we did this time, but we have to plan in advance, we cannot assume that big breakdowns are a thing of the past and then try to solve problems on the fly when that assumption is proven wrong.
We've been here before. After the Phillips curve was first discovered in the late 1950s, economists believed that the stabilization problem was largely over, it was simply a mater of picking the inflation-unemployment combination you wanted. However, the subsequent evolution of the economy -- the 1970s in particular -- showed that that this confidence was misplaced, economists hadn't solved the stabilization problem after all.
But it didn't take long for us to forget our overconfidence and the costs it imposes, and by the 1980s we were well on our way to assuming yet again that we had the stabilization problem under control, that the economy would never again be subject to large cyclical swings, and certainly not to a systemic breakdown.
I would like to believe that we've learned our lesson, that we will never again assume we have the stabilization and systemic breakdown problems fixed forever and be caught unprepared when the next big shock hits, but I'm not very confident that we have permanently learned our lesson. I don't know if it's the desire to prove ourselves to the world that causes us to overestimate our own abilities, if we simply forget with time, if it's a new generation of economists wanting to prove that they have moved the profession forward, or what, but our history of forgetting the past, and then believing in ourselves and our abilities even when such beliefs are not justified by our longer history seems to be a cyclic phenomena that we haven't yet learned to overcome.