[T]he liquidity trap is real; conventional monetary policy, it turns out, can’t deal with really large negative shocks to demand. We can argue endlessly about whether unconventional monetary policy could do the trick, if only the Fed did it on a truly huge scale..
So what have these monetary policy differences yielded? The chart below answers the question in terms of real GDP growth through the first half of 2013:
The outcome seems very clear: when really tried, monetary policy can be very effective at the ZLB. Now fiscal policy is at work too, but for this period the main policy change in Japan has been monetary policy. And according to the IMF Fiscal Monitor, the tightening of fiscal policy over 2013 has been sharper in the United States than in the Eurozone. Yichang Wang illustrates this latter point nicely in this figure. So that leaves the variation in real GDP growth being closely tied to the variation in monetary policy. Chalk one up for the efficacy of monetary policy at the ZLB.
[M]easuring austerity is tricky. You can’t just use budget surpluses or deficits, because these are affected by the state of the economy. You can — and I often have — use “cyclically adjusted” budget balances, which are supposed to take account of this effect. This is better; however, these numbers depend on estimates of potential output, which themselves seem to be affected by business cycle developments. So the best measure, arguably, would look directly at policy changes. And it turns out that the IMF Fiscal Monitor provides us with those estimates, as a share of potential GDP…
So what is the implication of this figure? First, it shows that independent of business cycle influences fiscal policy has been tightening since 2010. It has gone from an overall deficit of 8.5% in 2010 to an expected one of about 4.6% in 2013. Stated differently, the above reduction in the general budget deficit is not the government endogenously adjusting its balance sheet in response to improvements in the private sector’s balance sheet. Rather, it is the consequence of explicit policy choices to sharply tighten fiscal policy.
So what explains this development? How is it that fiscal policy tightening in conjunction with the Eurozone shocks, the China slowdown shocks, and other negative shocks has not slowed down aggregate demand growth? The answer is that Fed policy has effectively offset the effect of the fiscal austerity and the other shocks. This is another great quasi-natural experiment that demonstrates the effectiveness of monetary policy even with interest rates close to zero percent. Chalk another one up for the efficacy of monetary policy at the ZLB.
This cross-country, quasi-natural experiment of the efficacy of monetary policy at the ZLB should give any monetary skeptic pause. Christina Romer notes that in the case of the U.S. economy this recovery was almost entirely the consequence of easing monetary conditions. Fiscal policy played little role.
These three quasi-natural experiments indicate that there is much monetary policy can do at the ZLB. If so, the key issue is why central banks did not do more over the past three years to shore up the recovery.
This piece is cross-posted from Macro and Other Market Musings with permission.