The Relative Efficacy of Fiscal and Monetary Policy at the Zero Lower Bound: Where Are the Goalposts, Anyway?: The Honest Broker for the Week of January 5, 2013
Since 1950 and before 2007, the way to bet was that, whatever the current gap between U.S. real GDP and potential output was, the U.S. economy would close 2/5 of that gap over the course of the next year with roughly neutral policy. Unusually stimulative policies given the state of the economy would push it up; unusually contractionary policies given the state of the economy would push it down; but the way to bet was that the output gap in a year would be only 60% of its current value, in two years 35%, in three years 20%.
Then came 2008.
Real GDP fell 7.5% below potential output. But--in spite of policies that would have been classified as very stimulative indeed back in 2007--the economy did not then bounce back, closing 2/5 of the gap vis-a-vis potential in each year. Instead, over the past four years the gap has been closed at a pace of only 1/12 per year--and that gap-closing has been accomplished not by real GDP growing faster than the pre-2007 trend but rather by potential output growing more slowly post- than pre-2007.
And toward the end of 2012 two shifts took place in macroeconomic policy:
- It became clear that the federal government was about to undertake another contractionary shift in fiscal policy stance via the sequester.
- The Federal Reserve announced that it was going to undertake QE III--to purchase $85 billion of long-term bonds in an attempt to lower interest rate spreads and to continue buying $85 billion a month until... well, it was not exactly clear until when.
Would these policy shifts increase the pace of the recovery, or decrease it?
Believers that only fiscal policy matters at the zero lower bound thought that monetary policy was pushing on a string, that the adoption of QE III was a nothingburger, that the pace of recovery was unlikely to accelerate relative to baseline and, that there would be little effect of QE III on interest rates.
Believers in market monetarism thought that fiscal policy was nearly irrelevant, and that the adoption of QE III would substantially affect long-term interest rates and substantially spur the recovery relative to baseline
Believers in regime change thought that if markets were convinced that the Federal Reserve would pursue QE III until the output gap shrank and would not then reverse its asset purchases--that QE III was actually QE ∞--that expectations of the future price level would rise and those expectations would pull current nominal demand up, accelerating the recovery relative to baseline.
And left unspecified (or almost unspecified) by all was the question: what was the baseline? (a) Was the baseline still that the economy should recover 2/5 of the way to potential each year, and that less gap-closing than that was a disappointment? (b) Was the baseline that at the zero lower bound the equilibrium-restoring forces in the economy were broken, and that any gap-closing at all showed that an expansionary shift in policy stance had been effective? (c) Do we split that difference and take a 1/5 recovery per year to be the baseline?
So what is the outcome?
Believers in (3)--including at least part of my mind--were disappointed because it soon became clear that neither markets nor the Federal Reserve interpreted QE III as QE ∞. So we still think that monetary policy could be effective if it takes the form of a regime change, and we glance to the west at Abeonomics, wondering if it will succeed.
Believers in (1)--including at least part of my mind--were disappointed but not surprised by the failure of the economy to close more than 1/12 of the output gap over the past year, and by the fact that that gap-closing came not from faster growth than the pre-2007 pace of potential growth but rather because of slower growth of potential output as the Lesser Depression does permanent damage to the economy. But believers in (1) were surprised by the fact that Ben Bernanke's announcements that QE III was nearing its end provoked large and substantial shifts in asset prices. That should not have happened according to the only fiscal policy matters at the zero lower bound.
And believers in market monetarism? They appear to be declaring victory. And damned if I can see why.
Alex Tabarrok: The Austerity Flip-Flop: "On April 28, 2013 Paul Krugman clearly said that 2013 was a test of market monetarism:
But as Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.
Yesterday (Jan 4, 2014) however, Paul Krugman, said:
…I don’t take seriously the claims of market monetarists that the failure of growth to collapse in 2013 somehow showed that fiscal policy doesn’t matter.
There are two obfuscations here. First, it wasn’t the market monetarists who established the test it was Konczal and Krugman who laid down the glove so Krugman is saying he doesn’t take his own (April) claims seriously. Second, in April Krugman did appear to take his claims seriously, perhaps because:
…the results aren’t looking good for the monetarists: despite the Fed’s fairly dramatic changes in both policy and policy announcements, austerity seems to be taking its toll.
Now that the results are in, however, Paul claims that compared to southern Europe American austerity wasn’t so bad or it was really bad but small enough to be offset by “other stuff”:
US austerity, although a really bad thing, wasn’t nearly as intense as what happened in southern Europe; it was small enough that it could be, and I’d argue was, more or less offset by other stuff over the course of a single year.
But the ticker tape (April 27, 2013) suggests a much different emphasis (note also that here Paul names “other stuff’ and it is adding to the problem not subtracting):
There is some tendency among economic commentators to think that austerity policies in a deeply depressed economy are mainly a European thing… But the truth is that federal stimulus is years behind us, while state and local governments have cut back, so the overall story is one of fiscal contraction that’s smaller than in Europe, but not by that much….Bear in mind that in the years since the recession began we’ve seen a significant number of boomers reach retirement age, which would ordinarily have led to rising spending, not to mention the effects of rising health care costs. Bear in mind also that the private sector is still deleveraging, which means that government should be spending more to help sustain the economy. So this is actually a picture of very bad policy.
Even more amusingly, arch-Keynesian Paul Krugman now says we are approaching the long run! In a post titled What A Good Year Won’t Prove he says:
If 2014 is a year of relatively good growth, you know that many people will take that as somehow refuting Keynesianism — hey, didn’t you guys predict that the economy would never recover without fiscal stimulus?
No, we didn’t [the linked post, is from 2009, AT]
In the long run, we will have a spontaneous economic recovery, even if all current policy initiatives fail….
Now, to be fair, I happen to agree with Krugman that one test is not decisive. The economy is very complex and we don’t have controlled macro-experiments so lots of things are going on at the same time. But as one wise commentator put it:
…using hedged language doesn’t insulate you from consequences if things don’t turn out the way you were clearly suggesting they would, nor does the true point that sometimes the right model makes a wrong prediction. If your model led you to believe that inflation austerity was a “great danger” in 2009 2013 the fact that this danger never came to pass should substantially reduce your belief in that model – and should substantially reduce your credibility if you refuse to revise your beliefs.
Scott Sumner: Another disappointing reaction to The Great Market Monetarist Experiment: "In a recent post I discussed how Keynesians like Mike Konczal began the year claiming that we were going to have a test of market monetarism, and specifically the doctrine of "monetary offset."
[As recently as 2007, monetary offset (roughly zero fiscal multiplier) was standard new Keynesian doctrine, and yet by 2010 some bloggers were calling the concept "the Sumner critique." The fact that it had become so unpopular that they had to name it after a lowly Bentley professor speaks volumes about the recent decline of macroeconomics.]
Back in April 2013, Paul Krugman agreed with Konczal:
Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.
And the results aren't looking good for the monetarists: despite the Fed's fairly dramatic changes in both policy and policy announcements, austerity seems to be taking its toll.
Now the results are in and they show that market monetarism easily passed the test, as growth in 2013 is exceeding the pace of 2012. We know how Mike Konczal reacted, but what about Krugman? Today we got an answer:
One way to look at the US economy in 2013 is that it was, in effect, trying to begin a strong recovery, but was held back by terrible federal fiscal policy. Housing was making a comeback, state and local austerity was, if not going into reverse, at least not getting more intense, household spending was starting to revive as debt levels came down. But the feds were raising the payroll tax, slashing spending via the sequester, and more.
Incidentally, these other factors are why I don't take seriously the claims of market monetarists that the failure of growth to collapse in 2013 somehow showed that fiscal policy doesn't matter. US austerity, although a really bad thing, wasn't nearly as intense as what happened in southern Europe; it was small enough that it could be, and I'd argue was, more or less offset by other stuff over the course of a single year.
Where do I begin? Yes, growth did not "collapse" as the Keynesian model predicted. It increased. So say so! There was a dramatic reduction in the cyclically adjusted budget deficit, by any measure. I'm tempted to point out that a reduction in the cyclically-adjusted budget deficit (including the exact same 2% boost in the payroll tax) is what the Keynesians claim caused the severe 1937-38 depression. And yet growth accelerated in 2013. Or I could point out that the fiscal austerity in the US was just as intense as in the eurozone, whereas the unemployment rate in the US has fallen sharply since 2010, while the rate in the eurozone has risen sharply. The key difference was monetary policy, which was much tighter in the eurozone.
But none of this really matters, does it? Paul Krugman was the one that said 2013 was a test of market monetarism. He's the one who said it was a test of whether monetary policy could offset the drag of fiscal stimulus. And now the results are in. And what is Krugman's response? I can't quite tell, but it almost seems to me that he's denying that any test took place. Suppose real GDP had fallen at 1% instead of rising at 2.5%? Would he still be saying that no test took place in 2013? Would he say market monetarism didn't fail the test because "other things weren't equal?" Or would he say that a test did occur and market monetarism failed? I'll leave that question to my readers. But if you are interested, I have another post that cites Krugman criticizing other economists who failed to admit they were wrong.
My reading of 2013 is that (a) QE III--even though it wasn't QE ∞--was more powerful than I had thought it would be in boosting the economy, as evidenced by the tracks we see from QE III interest rates, and that combined with the fact that fiscal austerity actually turned out to be less than I expected a year ago kept us on the inadequate-and-extremely-slow-recovery track. Thus (1) is wrong in its belief that monetary policy is pushing on a string at the zero lower bound, (2) is wrong in its belief that fiscal policy is unimportant, and the jury on (3) is still out and is sitting in Japan.
And I do not understand why Tabarrok and Sumner are declaring victory for point-of-view (2)--although reading phrases like "arch-Keynesian Paul Krugman now says we are approaching the long run!" and "none of this really matters, does it? Paul Krugman was the one that said 2013 was a test of market monetarism. He's the one who said it was a test..." makes me think that much of what is going on here is not marking-our-beliefs-to-market but rather the tragedy of Krugman derangement syndrome at work...