Something extraordinary has happened to macroeconomic policymaking. Partly owing to the impact of Covid-19, the old orthodoxy has morphed into a new one—but without anyone acknowledging the implications of the shift, or indeed that there were any problems with previous convention.

In a recent interview, for example, former Bank of England (BOE) Deputy Governor Paul Tucker said that 'monetary policy should now take a back seat to fiscal policy.' Other central bankers, finance ministry mandarins, and OECD and International Monetary Fund officials are saying much the same.

What our financial paladins never or only rarely acknowledge is how wrong they were in the past. The Financial Times came closest with its recent limping admission that the spending cuts it advocated in 2010 'may have had a bigger negative impact than expected.' That is about the nearest thing to a mea culpa as we can expect from this citadel of the financial establishment, and it does not come close to capturing the magnitude of the rupture with the theory of macroeconomic policy that prevailed only a few years ago.

Before the 2008-09 crash, many believed that macroeconomic stabilisation was entirely a matter for monetary policymakers, and should be carried out by independent central banks targeting a mandated inflation rate by means of interest-rate policy. This followed from the orthodox belief that economies were cyclically stable, provided that inflation was controlled. Fiscal policy should be passive, or even contractionary if spending cuts would boost market confidence.

The belief in the superiority of monetary policy survived even the savage 2008-09 downturn. Quantitative easing (QE), or 'unconventional monetary policy,' as it was called, would replace orthodox interest-rate policy when the nominal benchmark rate hit its 'zero bound.' Central banks worked out all manner of fanciful 'transmission mechanisms' by which the extra cash they placed in bond sellers’ hands would flow into the real economy, ignoring the possibility that most of it would instead be used to replenish depleted bank reserves or swap financial assets. Meanwhile, governments would play their part by cutting their own spending.

Although the combination of monetary expansion and fiscal contraction failed to bring about the expected recovery, belief in monetary therapy was still strong when the Covid-19 pandemic struck in 2020. This prevented governments from thinking seriously about channelling the hundreds of billions of new QE money to those parts of the real economy that remained open for business, rather than giving millions of people months of paid leave.

In fact, the outstanding feature of Western governments’ responses to the pandemic was their untargeted character. Policymakers preferred mass lockdowns and furloughs to any attempt to keep people working by deploying technically feasible mass testing, tracking, and tracing systems, as many East Asian countries did.

Now the penny has dropped. In the absence of stimulus, the post-Covid-19 European and US economies are expected to have shrunk in 2020 at the highest rate since World War II, with a concomitant rise in unemployment. Now, furlough schemes will end, and central banks say that they are running out of ammunition—meaning their ability to keep bondholders confident about being repaid.

In these conditions, fiscal policy is the only game in town. We urgently need a new macroeconomic framework, covering the aims of active fiscal policy, the rules for conducting it, and its coordination with monetary policy.

Given that we are suffering from both a demand and a supply shock, recovery policy will also have to address issues of supply. In other words, the Keynesian demand-side remedy of paying people to dig holes and fill them in again is inadequate. Although any direct boost to demand will also indirectly boost supply by increasing national income, a serious lag in the supply response risks causing inflation. For this reason, if for no other, investment in new capacity should be an important part of any fiscal stimulus.

This imperative will, in turn, direct policymakers’ attention to the nature of the supply that the economies of the future will require. In view of the long-term challenges of automation and climate change, any post-pandemic recovery policy should aim to secure the economy’s sustainability, not just its cyclical stability.

The case for fiscal policy is not only that it is a more powerful (because more targeted) macroeconomic stabiliser than monetary policy, but also that government is the only entity apart from the financial system capable of allocating capital. If we are not willing to allow investment in technology and infrastructure to be shaped by a purely financial logic, then the need for what Mariana Mazzucato calls a 'mission-oriented' public investment strategy that includes taxation policy becomes inescapable.

The second big discussion we need to have concerns the relationship between fiscal and monetary policy. In the United Kingdom, the expansion of QE since March 2020 has exactly tracked the increase in the budget deficit. Can the perception of BOE independence and the credibility of its inflation target survive when the central bank has been acting as an agent of the Treasury for the past year?

If the government is to be the active macroeconomic player, we need to work out how or whether the central bank should revert to its traditional role of checking fiscal excesses. But the fiscal rules themselves should be rewritten to allow for both more active counter-cyclical policy and a much larger government role in allocating capital than has recently been fashionable.

The pandemic presents an opportunity for an open public discussion of these matters. One hopes that this debate will replace the system of insider nods and winks and subterranean understandings that have shaped our economic fortunes—or misfortunes—for too long.

—Project Syndicate