How then to respond to valid concerns about fiscal sustainability, excessive credit creation and the eventual return to normality in a world where policy credibility is essential? The right approach is policies that commit to normalizing conditions but only when certain thresholds are crossed. The Federal Reserve might commit to maintain the current Fed funds rate until some threshold with respect to unemployment or expected inflation is crossed. Commitments to fund infrastructure over many years might include a financing mechanism such as a gasoline tax that would be triggered when some level of employment or output growth has been achieved. Tax reform could phase in new rates in pace with the rising economic performance.Like I said back in April 2011, my idea of how I wished the ARRA (the "stimulus bill" at the beginning of the Obama administration) had been different would have been for it to be "state contingent" because it was clear by then that the downturn was deeper and longer-lasting than policymakers understood when they designed the policy. As I noted here, Peter Orzag has also been arguing the same point. Of course Orzag and Summers would have been in a position to do something about it had this occurred to them in 2009.
Contingent commitments have the virtue of providing clarity to households and businesses as to how policy will play out, and in areas where legislation is necessary, eliminating political uncertainty. They allow policymakers to project a simultaneous commitment to near-term expansion and medium-term prudence — exactly what we require right now.
In this earlier post, I argued state-contingent policies could potentially address some of John Taylor's objections to fiscal policy. Chicago Fed President Charles Evans has been advocating state-contingent monetary policy.