Despite massive fiscal measures in many countries to stabilize and revive aggregate economic activity from the depressed levels that prevailed in these economies, hard-hit by the global recession, the global economy is still struggling to reach a path of robust growth. Stabilization efforts have not been uniformly successful, with the consequence that differences among countries, especially within the euro area, have tended to widen as these economies have been subjected to increasing stress due to a sovereign debt crisis that is chipping away at the fundamentals necessary for recovery and growth.
After the 1970s, both macroeconomists and policy-makers became convinced that the key policy factor driving inflation, and more generally the short-run dynamics of the macroeconomy, is the inherent time-inconsistency of economic policy-making, and that this is an issue that cried out for resolution so as to anchor expectations. The 1980s then saw institutional solutions marked by a wider separation between fiscal and monetary policy-making. Monetary policy was delegated to independent central banks and, especially in the 1990s, inflation targeting gained ground among central banks, particularly in the more advanced economies, as the key monetary policy strategy for maintaining price stability, ie low and stable inflation. Monetary policy assumed a key role in short-run stabilization policy, whereas fiscal policy focused more on structural issues related to longer-run growth. The resulting policy regime and the associated policy responsibilities were only occasionally questioned, and the arrival of the era of Great Moderation rendered the regime seemingly self-confirming.
With the benefit of hindsight, we see that one of the key assumptions underlying the delegation of monetary policy to an independent central bank seems to have been that, whatever happens, fiscal policy would ensure the sustainability of public finances, so that monetary policy could focus on inflation control. In modern parlance, from the perspective of price-level determination, the policy regime was intended to be one of monetary dominance. In macroeconomics, the period of the Great Moderation was one of active interaction between monetary macroeconomics and actual monetary policy-making. However, many in macroeconomics who were seeking to come to grips with inflation and its determinants were comfortable with abstracting away from fiscal policy and implicitly assuming that the fiscal adjustments needed to enable monetary policy to control inflation would always be forthcoming. On the other hand, although the issue of the sustainability of public finances was raised in public debates, the effects of the interaction of fiscal policy measures and public debt dynamics on aggregate outcomes were systematically studied by a mere handful of macroeconomists prior to the most recent crisis. Their voices were mostly drowned out by the scoffers of killjoys who would remove the punch bowl while the party was in full swing.
The most recent crisis changed the scene. Fiscal policy is now back at the forefront of macroeconomics. In particular, fiscal policy is again on the agenda for price level determination as well as stabilization. In this context, recent studies have produced a set of new and promising results on the effects of fiscal-monetary policy interaction on price level determination as well as on the effects of interaction between stabilization policy and public-sector financial sustainability. This literature has introduced, in particular, the notion of a country's fiscal limit to argue that the macroeconomic outcome of a fiscal-monetary policy regime at or near the fiscal limit can be quite different from that which obtains far away from the limit. Moreover, concerns about the sustainability of public finances may overburden stabilization efforts, such that the latter lose some of their more conventional properties, ie properties with which we are comfortable at a lower level of government indebtedness. For example, near the fiscal limit, the output-contracting effects of a temporary monetary tightening are relatively strong, whereas inflation recedes only momentarily before beginning a sustained medium-term rise. Although the fiscal-limit concept is well defined theoretically – maximum government debt that the government can finance via future tax increases – currently we are short of ideas of how to map its theoretical content into observables – empirically measurable quantities. However, one may argue that the idea of a fiscal limit is useful in the following sense: it forces us to consider all aspects of a country's fiscal-monetary policy regime and offers us a broad view as to whether there is a sustainability problem in government finances that needs the attention of policy-makers and which could prevent the regime from producing optimal macroeconomic outcomes. The fiscal limit is more than a number; it is perceptive way of looking at fiscal-monetary policy regimes.