Fiscal and Monetary Policy in a Liquidity Trap Now and Then
Paul Krugman:
Why Believe In Keynesian Models?: [W]hat evidence makes me believe that Keynesian economics is broadly right, given the relative absence of experience with large fiscal stimulus programs?...
First, we’re talking about a model.... So you can ask about the ancillary predictions of that model as opposed to rival models. Anti-Keynesians assured us that budget deficits would send interest rates soaring; Keynesian analysis said they’d stay low as long as the economy remained far from full employment. Guess who was right?... Keynesianism isn’t just about sticky prices, but it does generally assume sticky prices — and there is overwhelming evidence, from a variety of sources, that prices are indeed sticky. Also: there’s plenty of evidence that monetary policy can move output and employment — and it’s very hard to devise a model in which that is true that doesn’t also say that fiscal policy can be effective, especially when you’re up against the zero lower bound.
Second, while we don’t have a lot of postwar experience with fiscal stimulus, we do have a lot of experience with anti-stimulus, that is, austerity — and that turns out to be reliably contractionary. Again, it’s hard to think of a model in which austerity is contractionary but stimulus isn’t expansionary.
Finally, there is evidence from fiscal expansions in the 1930s, which actually did lead to economic expansion too.
Mainly I’d stress the first point. We have a model... an implication of that model is that fiscal stimulus will work under conditions like those we face now. If interest rates had soared, if the rise in base money had led to rising GDP and/or soaring prices despite the zero lower bound, I would have sat down to reconsider what I thought I knew about macroeconomics. In fact, however, my preferred model has passed the test of events with flying colors, while the other guys’ models have been totally wrong.
Miguel Almunia, Augustin S. Bénétrix, Barry Eichengreen, Kevin H. O’Rourke, and Gisela Rua: 18 November 2009:
The effectiveness of fiscal and monetary stimulus: There is one important source of information on the effectiveness of monetary and fiscal stimulus in an environment of near-zero interest rates, dysfunctional banking systems and heightened risk aversion that has not been fully exploited: the 1930s.... [W]here fiscal policy was tried, it was effective.
The Keynesian argument for expansionary fiscal policy – whether right or wrong – was not known in this pre-Keynesian era. Hence there was relatively little variation in fiscal stance, with conservative policies being the default option. The aggressive use of discretionary monetary policy was also relatively unusual, as central banks were wedded to gold-standard ideology. But there were exceptions. Japan’s aggressive use of monetary policy under Takahashi was one, Italy’s large budget deficits under Mussolini another. And there were good – exogenous – reasons for this variation. Fiscal impulses were generally governed by forces other than immediate economic conditions; Italy’s war in present-day Ethiopia, Hitler’s rearmament, the approach of World War II. Who responded to the crisis with monetary stimulus depended heavily on prior monetary experience; counties that had suffered high inflation in the 1920s tended to be reluctant to abandon the gold standard in the 1930s.
Cross-country comparisons can thus help us untie the Gordian Knot and move the debate from the realm of ideology to that of evidence. Our project therefore focuses on assembling annual data on growth, budgets and central bank policy rates, mainly from League of Nations sources, for 27 countries covering the period 1925-39....
We use panel vector autoregressions (VARs) with conventional assumptions about the “ordering” of the variables (whether a variable affects the others contemporaneously or only with a lag). We consider alternative orderings, and also run panel VARs with defence expenditure entering the equations as an exogenous variable. We run panel instrumental variables regressions using defence spending as an instrument for fiscal policy and gold standard membership as an instrument for monetary policy. And we run alternative panel regressions looking at the impact of fiscal and monetary shocks, the latter calculated by running simple autoregressions and extracting the residuals.
The details of the results differ, but the overall conclusions do not. They show that where fiscal policy was tried, it was effective. Our estimates of its short-run effects are at the upper end of those estimated recently with modern data; the multiplier is as large as 2 in the first year, before declining significantly in subsequent years....
The results for monetary policy are less robust but point in the same direction. A positive shock to the central bank discount rate leads to a fall in GDP... [that] just misses statistical significance at conventional levels.... This result is notable, given the presumption, widespread in the literature, that monetary policy is ineffective in near-zero-interest-rate (liquidity trap) conditions. On the contrary, in the 1930s it appears that accommodating monetary policy helped, by transforming deflationary expectations (Temin and Wigmore 1990) and by helping to mend broken banking systems (Bernanke and James 1991). Given the prevalence of both problems circa 2008, we suspect that the results carry over...
