By contrast, expansionary monetary policy at the zero lower bound requires that the Federal Reserve commit to continuing extraordinary action even after the crisis is passed--and that markets believe it.
Paul Krugman listens to Mike Woodford on monetary and fiscal policy at the lower bound, and reports:
Woodford on Monetary and Fiscal Policy: I’ve been asked... why I spent 2009 campaigning for fiscal expansion rather than monetary expansion. Well, at the Keynes conference this morning Mike Woodford gave an overview of policy options when you’re up against the zero lower bound that in some ways expressed better than I’ve managed to what I was thinking at the time.
First, Mike argued that monetary expansion once you’re at the ZLB mainly works, if it does, through affecting expectations. If people don’t perceive the expansion as representing a change in policy that will persist even after the economy has recovered, even big changes in the monetary base have hardly any effect.... Japan reversed much of the initial expansion in the monetary base, confirming the expectations of those who might have regarded that expansion as temporary – and Japan did this even though deflation continued! Note also that nominal GDP never moved at all despite the huge amount of money “printed”.
So why is a fiscal response any better? Mike argued:
- A fiscal response to a severe slump doesn’t require committing yourself to changes once the storm has passed; it “only requires unusual action while the situation remains grave.”
- Fiscal policy is “not wholly dependent on expectations changing for its effect (more robust to alternative models of expectations)”
That’s about what I was thinking in, say, January 2009. With the severe financial crisis still relatively recent, and many people still expecting a V-shaped recovery, it didn’t seem possible to persuade the Fed to commit to a permanent rise in the monetary base or a rise in the medium-run inflation target, nor did it seem possible to convince markets that there had been a long-run change in policy. The chances for persuading Congress to agree to a large temporary fiscal stimulus seemed much better.
But as it turned out, that didn’t happen either; we got an inadequate stimulus, and the failure of that stimulus to do more was then taken as proof that Keynesian policies don’t work – in part because the Obama administration insisted and continues to insist that the size of that stimulus was just right.
So what was the right answer? I guess I’d say that if powerful political forces block any effective response to a crisis, there is no effective response to that crisis.