Paul Krugman says he used to cosnider himself a "free market Keynesian" but doesn't anymore after watching the failure in practice of unconventional monetary policy or discretionary fiscal policy to stabilize the macroeconomy.
I also find this disheartening, but I don't really understand where it leaves us. Krugman says "the political economy of policy turns out to make an effective fiscal response to depression very difficult." I agree. And he says "the Fed hasn’t ever been willing, or felt that it had sufficient political room, to do that experiment." I also agree. So then he concludes:
At the very least it means that we need “macroprudential” policies — regulations and taxes designed to limit the risk of crisis — even during good years, because we now know that we can’t count on an effective cleanup when crisis strikes. And I don’t just mean banking regulation; as the authors of the linked paper say, the logic of this argument calls for policies that discourage leverage in general, capital controls to limit foreign borrowing, and more.
Those sound like good ideas to me. But "sharply limit borrowing during good economics times" doesn't strike me as any less politically challenging than "use fiscal and monetary policy to lift the economy during bad times." Seriously robust macroprudential policy is really difficult to pull off. Think about it. You've got one group of people who want to make more loans. You've got a second group of people who want to borrow more money. Then you need regulators who are going to interpose themselves into the middle of it, even though blocking the transaction doesn't serve the short-term interests of anyone at all.
That's not impossible. But it's hard. Paternalistic measures like cigarette taxes at least generate revenue for the government. Blocking business arrangements on the grounds of long-term risk is very much worth trying, but we shouldn't kid ourselves that it's likely to hold up over the long term.
By contrast, the political impediments to more robust fiscal and monetary policy are a little bit mysterious. Stimulative policy when the economy is depressed creates some losers along with the winners, but it's by definition not a zero sum game and functioning political institutions ought to provide a way to implement them. The fact that electorally vulnerable Democrats were too timid about fiscal policy and the Obama administration was too sluggish and complacent about its Fed nominations is tragic. But I'm not sure it should inspire a revolution in how we think about economics and it certainly shouldn't give us cause to underestimate the political challenges of prudential regulation.