Monday, March 2, 2015

Paul Krugman Needs a T-Shirt

Paul Krugman is frustrated (my bold):
In my own case, I’d guess that about 80 percent of what I’ve had to say about macroeconomics since the crisis was prefigured in my 1998 liquidity trap paper, which was classic MIT style — a stylized little model backed by and applied to real-world events, with lots of data used simply. (Seriously, skim that piece and you’ll see why I sometimes seem so frustrated: People keep rolling out arguments I showed were wrong all those years ago, or trotting out arguments I made back then as something new and somehow a challenge to conventional wisdom.)
Here is a carton figure from an earlier post where I manage to depict Krugman's frustration. Look closely at his t-shirt, it says it all. To be clear, I agree with the key point of Krugman's 1998 paper: for monetary policy to have a meaningful effect on a depressed economy it has to commit to permanent monetary injections. And that is something the Fed failed to do over the past six years.

P.S. Here is the shirt Scott Sumner is wearing. You can purchase it.

The Origins of the Eurozone Monetary Policy Crisis

I made the case in my last post that the Eurozone crisis was largely a monetary policy crisis. That is, had the ECB lowered interest rates sooner and begun its QE program six years ago the fate of the Eurozone would be more certain. Instead it raised interest rates in 2008 and 2011, waited until this year to begin QE, and allowed inflation expectations to drift down. In short, had the ECB been more Fed-like the Eurozone crisis would have been far milder.

This begs the question as to why the ECB failed to act more Fed-like. Why did it effectively keep monetary policy so tight for so long?

To answer these questions it important to note that there were actually two stages to the Eurozone crisis. The first stage began in 2008 when the ECB raised interest rates just as the Eurzone economy began to weaken. This explicit tightening along with the subsequent failure of the ECB to offset the passive tightening of monetary policy through 2009 adversely affected all of the Eurozone. In this stage nominal spending--or aggregate demand--fell in both the core and periphery economies. Consequently, real economic activity also collapsed in both regions. This can be seen in the two figures below. The first figure shows nominal spending for the two regions while the second one reports real GDP growth and the change in the unemployment rate.1

The above two figures also point to the second stage of the Eurozone crisis which begins in 2010. The first figure shows that while aggregate demand continues to grow in the core regions (albeit below trend) after 2010, it actually falls in the periphery. Likewise, the second figure shows that for the 2010-2013 period real GDP growth rises and the unemployment rate falls for the core, while the opposite happens to the periphery. The core heals while the periphery bleeds during this stage.

What these figures suggest is that the first stage of the crisis was a Eurozone-wide monetary crisis, while the second stage was only a regional Eurozone monetary crisis. In other words, the first stage of the crisis was not that different than what happened in the United States during 2008-2009. And for the core economies as a whole the ECB was sort of Fed-like for them after 2010. It was, then, the periphery economies that suffered from the absence of Fed-like policy after 2010.

This notion is borne out by looking at Taylor rules fitted to these two regional economies. Following the work of Fernando Nechio, I created Taylor rules for these two regions and plotted them alongside the actual ECB policy interest rates:2

This figure shows that monetary policy was too tight in 2008-2009 for both regions, but afterwards it was too-tight only for the periphery. Hence, the second stage of crisis was a regional monetary policy crisis localized to the periphery.

The fact that second stage of the crisis was a regional one speaks to what I see is the real underlying reason for the monetary policy crisis: the Eurozone is an unequally yoked currency union. It has member states that have economies so vastly different that applying an one-size-fits-all monetary policy is bound to create problems.

The Taylor rules in the figure above vividly illustrate s this problem. It shows a persistent pattern of the ECB setting its interest rate target in a manner more consistent with the core economies. For example, when the Eurozone first formed in 1999 the core economies--particularly Germany--were struggling so the ECB lowered interest rates to accommodate them. Doing this, however, meant monetary policy was way too loose for the periphery as seen by the large gap between the red and dashed lines above. Monetary policy would continue to stay too loose for the periphery up through 2008. After the crisis, ECB policy has again been more consistent with the core economies, but this time it has meant monetary policy has been too tight for the periphery.

Think about what this means for the periphery. Countries like Greece, Ireland, and Spain were on average growing in nominal terms anywhere from about 8 to 15 percent between 1999 and 2004. The ECB policy rate during this time averaged near 2 percent. This large spread between the nominal growth of periphery and the low financing costs screamed leverage. It is no surprise there was a buildup of debt, soaring asset prices, and large current account deficits for these economies. Conversely, with persistently tight monetary policy since 2008 it is no wonder the periphery has been in a depression.

The importance of the ECB's monetary policy can be seen if we take the actual difference between the ECB policy rate and the Taylor Rule rate for each country--a measure of the stance of monetary policy--and see how it changed over the 2010-2013 period and then plot these values against the real GDP growth we get the following figure: 

There is a very strong relationship here that indicates how well Eurozone economies fared over the second stage of the crisis depended on the stance of monetary policy. Even if we throw Greece out we still get a good fit:

All of this points to the Eurozone monetary crisis being the product of a poorly designed currency union. It is, in other words, far from being an optimal currency area. From this perspective, the monetary policy crisis in Europe can be thought as a structural crisis that is not going to go away anytime soon. Even a more robust monetary policy by the ECB--say a nominal GDP level target--that kept the periphery from going into a depression might still not solve the structural problem. It might solve the periphery's problems while causing overheating and buildup of imbalances in the core economies. It seems to me, then, ECB monetary policy will continue to create problems for the Eurozone moving forward.

So look forward to more Eurozone crises. Or a breakup.3

1Fernando Nechio of the San Franciso Fed,  I define the core as Austria, Belgium, Finland, France, Germany, and the Netherlands while the periphery as Greece, Ireland, Italy, Spain, and Portugal.
2 Like Fernando Nechio, I use the 1999 Taylor Rule. Here I use the harmonized core inflation and the IMF's output gap in the Taylor Rules.
3Alternatively, the periphery economies could reform their economies to be more like the core, but that does not seem likely. Nor does it seem likely that the shock absorbers needed in the Eurozone--increased labor and capital mobility and meaningful fiscal transfers--will be ever be forthcoming. Too much history.

Thursday, February 26, 2015

The Eurozone Counterfactual

Imagine the ECB had not raised its interest rate target in 2008 and 2011, but had lowered it. Also imagine the ECB began its open-ended QE program back in 2009. Would there now be a brighter future for the Eurozone? If the answer is yes, then the Eurozone economic debacle is at its core a monetary policy crisis.

There are compelling reasons to believe the answer to this counterfactual question is, in fact, yes. A comparison of total money spending growth in the United States and Eurozone is one of them. Unlike the ECB, the Fed did cut its target policy interest rate quickly and implement QE programs. Though these programs were flawed, the Fed was able to promote a stable growth path for total money spending because of them. And it did so despite a tightening of U.S. fiscal policy beginning in 2010. This suggest the ECB could have done the same for the Eurozone economy. Instead, it did not and the growth of Eurozone nominal GDP growth faltered.

Another reason to believe this counterfactual is to note that the aggressive monetary easing outlined above would have addressed, at least partially, a key problem in the Eurozone: the real appreciation of the periphery. Monetary easing would have done this by causing inflation to rise more in those parts of the Eurozone that were closer to full employment. These regions happened to be the core, particularly Germany. The price level, in other words, would have increased more in Germany than in the troubled periphery of the Eurozone. Good and services from the periphery would have become relatively cheaper.  This was one way to a real depreciation of the periphery. Instead, monetary easing was not tried and so a real depreciation occurred through painful deflation in the periphery.  

Now some observers will object and say the Eurozone crisis was actually a debt crisis. It was the consequence of irresponsible government spending policies that finally came home to roost. For some countries like Greece this was true, but for others it was not the case. Spain, for example, was actually running primary surpluses for several years leading up to the crisis. It was the crisis that worsened its debt position, not the other way around. This can be seen in the figure below. It shows Spain's debt-to-GDP ratio was falling until the crisis erupted. The flat-lining of nominal GDP growth closely matches the surge in Spain's debt-to-GDP ration. This is no coincidence.

This pattern holds up more generally across the Eurozone as seen in the next figure.

These figures point to the Eurozone crisis not being a debt crisis, but a monetary one.

Others will contend the Eurozone crisis is actually an austerity crisis. They point to a positive relationship between government spending and real GDP growth in the Eurozone. For example, the figure below replicates for 33 European countries a scatterplot produced by Paul Krugman that shows this relationship.1  This figure reveals a strong relationship between these two series with a R-squared of 63%.

However, if one pulls out non-Eurozone countries (red squares) this relationship disappears while it gets even stronger for the Eurozone countries (blue diamonds) with the R-squared going to 72%. This can be seen below:

This scatterplot suggests, then, that some omitted variable unique to the Eurozone over this time was affecting both regional economies and their level of government spending. The obvious candidate is the tight monetary policy of the Eurozone.

One, however, could reasonably object that the above scatterplot does a poor job reflecting austerity since it only looks at government spending. Austerity could also work through tax changes and more generally, through changes in the government budget balance. To account for this possibility and to control for the effects of the business cycle on fiscal policy, I plot below the 'structural budget balance' as a percent of potential GDP against real GDP growth for the 2010-2013. This measure comes from the IMF's Fiscal Monitor and includes all levels of government.

We see in this figure a positive and fairly strong relationship between the stance of fiscal policy and real GDP growth for the IMF group of advanced economies. However, like before, if we pull out non-Eurozone countries (red squares) this relationship largely disappears while it gets even stronger for the Eurozone countries (blue diamonds) as seen in the higher R-squared. 

So once again, the evidence points to something unique to the Eurozone that affects both the economy and  fiscal policy. The Eurozone's tight monetary policy over this period fits the billing. 

It is reasonable to conclude, then, that had the ECB had not raised its interest rate target in 2008 and 2011, but lowered it and had it started its open-ended QE program back in 2009 there would now be a much brighter future for the Eurozone. Instead, we now face the prospect of a Grexit for which the ECB has only itself to blame.

.1There is a slight difference between this figure and Krugman's. Here I use the entire 2010-2013 period as one data point for each of the 33 countries. Krugman actually uses each year from 2010-2013 for 33 countries as data points. I chose the former approach since it creates a cleaner scatterplot and actually improves the fit (i.e. higher R-squared).   

Friday, January 9, 2015

Don't Worry, Be Happy: Falling Treasury Yields Edition

Long-term treasury interest rates are falling again with the 10-year treasury briefly dipping below 2% this week. Some observers see this decline in yields as an omen for the U.S. economy:
The United States economy is accelerating... Yet a huge bond market with a strong track record for predicting economic problems is flashing a warning sign right now.The prices of Treasury bonds are rallying fiercely. The slide in oil prices has elevated concerns about growth in the global economy, and investors, as they do in times of stress and uncertainty, are seeking out the safety of government bonds. 
The rally in global government debt is pushing their yields, which move in the opposite direction from their price, to astonishing lows... “Make no mistake, these low levels of rates are challenging the notion that we are going to see robust and constant growth,” said George Goncalves, a bond market analyst with Nomura. In other words, the bond market is raising the specter that a period of economic growth that may have already felt lackluster to many Americans could be on the verge of losing steam. 
So is this dire view of the falling interest warranted? I am not convinced that it is, but before I explain why it is worth noting that even monetary authorities are bewildered by it. According to the Wall Street Journal's Jon Hilsenrath (AKA the "Fed Wire"), Fed officials are not sure how to interpret what is going on with yields: 
Falling long-term interest rates pose a quandary for Federal Reserve officials... If falling yields are a reflection of diminishing inflation prospects, as is typically the case, it ought to prompt the Fed to hold off on raising short-term interest rates in the months ahead. If, on the other hand, lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner or more aggressively than planned. 
The Fed’s next policy meeting is three weeks away. It is clear officials will spend a considerable time debating the correct response to a perplexing lurch down in long-term rates.
The worried market observers and the perplexed Fed officials should take a deep breath. The Adrian, Crump, and Moench (2013) method of decomposing treasury yields paints a far more benign story, one that signals the U.S. recovery is on a solid footing.

To see why, we first need to recall that long-term interest rates can be broken down as follows:
(1) long-term interest rate = average short-term interest rate expected over same horizon + term premium
The term premium is the added compensation investors require for the risk of holding long-term treasuries over short-term ones. For example, if investors are worried that the Eurozone crisis is about to flare up again and desire to hold more U.S. treasuries, they will demand less compensation to hold the long-term securities. This will drive down the term premium. The term premium is also the component of the long-term interest rate the Fed was trying to manipulate with its large-scale asset purchases. 

The other component, the average short-term interest rate, is a nominal interest rate and via the Fisher relationship can be further decomposed into a real interest rate and an expected inflation:
(2) long-term interest rate = (average expected real short-term interest rate over same horizon + average expected inflation over same horizon) +  term premium
This average expected real short-term interest rate is often called the real risk-free interest rate since it is free of investor's risk considerations, the Fed's tinkering with risk premiums, and the expected path of inflation. This interest rate measure, consequently, tracks the fundamentals of the economy and is equivalent to the average expected path of the 'natural interest rate'. 

By looking at these components we can make sense of what is driving the fall in yields. We can also look to the real risk-free interest to see what it implies about the health of the U.S. economy. The Adrian, Crump, and Moench (2013) decomposition of the 10-year treasury yield into these components is below:

What we see is that changes in inflation expectations and the term premium are both behind the decline in the 10-year treasury interest rate. This suggest that there may be concerns about future inflation--though this might also be reflect the temporary drop in inflation from declining oil prices--and that there has been a rush into treasuries because of the worries about the Eurozone and China.

But there is more. After being negative for several years, the real risk-free interest rate has been steadily climbing and is now positive. This only happens when the economic outlook improves as seen in the figure below. It shows a close relationship between the real risk-free interest rate and the business cycle:

So the upward trend of the real risk-free rate implies we are in the midst of a solid recovery in the United States. This interpretation is supported by the spate of positive economic news shows. Yes, the economic problems in Europe and China could eventually harm the U. S. economy.  But for now the U.S. economy seems to be in the clear. 

So be careful when interpreting long-term treasury yields. They might be signalling a robust recovery even if they are falling.

Sunday, January 4, 2015

Solving the ZLB Problem without Eliminating Cash

Should the Federal Reserve should eliminate cash as a way to avoid the zero lower bound (ZLB) problem? Ken Rogoff says yes in a recent paper. John Cochrane, on the other hand, is not ready to give up cash and is convinced that even if we did it would not solve the ZLB problem. Who is right?

Before answering these questions, let us recall the nature of the ZLB problem. It occurs when the market-clearing level of nominal short-term interest rates turn negative while actual short-term interest rates get stuck at 0%. This happens because individuals would rather hold paper currency at 0% than invest their money at a negative interest rate. The ZLB, in short, is a price floor that prevents interest rates from clearing the output market. And like any price floor, the ZLB creates a glut. In this case, it is an economy wide-glut better known as a recession.

So why not get rid of cash, as suggested by Ken Rogoff? John Cochrane gives several reasons why getting rid of cash may not be such a good idea. First, doing so would hurt the people who depend the most on cash: the poor who do not have access to or do not trust the formal banking system, the foreigners who need hard currency (e.g. Zimbabwe), and those wanting anonymity in their transactions. I share these concerns. Are harming these groups really worth beating the infrequent ZLB?

You might take an utilitarian approach and say yes, but even then it would be wrong. For one does not need to eliminate cash to solve the ZLB problem. As Miles Kimball has argued for the past few years, all that is needed is to make electronic (deposit) money the sole unit of account and turn the current fixed exchange rate between cash and deposits into a crawling peg based on the state of the economy. When the economy falls into a slump and the central bank needs to set a negative interest rate target to restore full employment, the peg would adjust so that paper currency would lose value relative to electronic money such that folks would not rush to it as interest rates go negative. This would effectively impose the same penalty on cash and deposits and kick start the monetary hot potato. Once the economy started improving, the crawling peg would start adjusting toward parity.

Now this is where John Cochrane's second objection comes into play. He worries that even if the Federal Reserve did lower short-term interest rates to a significantly negative value (say -5%) it still would probably not work because individuals would cleverly find other assets that would earn a 0% nominal return. Here is Cochrane:
[Q]uiz question for your economic classes: Suppose we have substantially negative interest rates -- -5% or -10%, say, and lasting a while. But there is no currency. How else can you ensure yourself a zero riskless nominal return?    
Here are the ones I can think of:    
(1) Prepay taxes. The IRS allows you to pay as much as you want now, against future taxes.  
(2) Gift cards. At a negative 10% rate, I can invest in about $10,000 of Peets' coffee cards alone. There is now apparently a hot secondary market in gift cards, so large values and resale could take off.  
(3) Likewise, stored value cards, subway cards, stamps. Subway cards are anonymous so you could resell them.  
(4) Prepay bills. Send $10,000 to the gas company, electric company, phone company.  
(5) Prepay rent or mortgage payments.  
(6) Businesses: prepay suppliers and leases. Prepay wages, or at least pre-fund benefits that workers must stay employed to earn.  
Cochrane should be more optimistic here. For all of these options only move the negative interest rate problem from one party to another. Here, the issuers of the 0% yielding assets have inherited the negative interest rate problem. They have effectively borrowed money at 0% and must decide if they want to deposit the funds at -5% in their banks or invest in something with a higher yield like riskier financial assets or capital expenditures. Obviously, the former option is not sustainable so they will opt for the latter one. But the latter option implies more risk taking and spending--the old monetary "hot potato" at work! So even in these cases the negative interest rate is still doing its intended job. Bill Woolsey makes this point in his response to Cochrane:
I am going to start with Cochrane's second example.  People could supposedly get a riskless zero nominal rate of return by purchasing gift cards... Under usual circumstances, when a retailer sells a card it is getting a loan... a zero interest loan. And so, now the retailer has the money. What do they do with it? If the interest rate on money is sufficiently negative, then the retailer will find borrowing money at a zero interest rate and then paying to hold it  unattractive. Of course, perhaps the retailer can invest by purchasing assets that have a positive yield. Or maybe they will accumulate inventory to be prepared for the greater sales when the cards are spent. It doesn't matter. As long as the retailer doesn't hold the money, the lower (below zero) nominal interest rate has done its job. 
And what does Walmart do with the money it receives?  If it holds it, that is a problem. But that is what the below zero interest rate on money aims to deter. If Walmart purchases other assets or purchases inventories of goods, constructs new buildings, or whatever, the problem is solved. 
Consider Cochrane's fourth example--pre-paying utilities... [I]f the utility companies allowed people to [prepay and] have credit balances on their accounts and didn't charge any fee, the question remains, what does the utility do with the money? All the negative yield on money is supposed to do is reduce the amount people want to hold. If the utility spends the money on other financial assets or spends it to construct a new plant, the negative yield on money has done its job. 
Cochrane also says that people could prepay their mortgages or their rent... what are the monetary consequences?   Paying down bank mortgages tends to contract the quantity of money.  However, any single bank receiving such repayments will accumulate reserves.   And the interest rate on that form of money is negative as well... Banks are motivated to purchase other assets due to these negative yields on reserves.
Scott Sumner and JP  Koning make similar arguments. The good news here is the John Cochrane can take solace in knowing the ZLB can be tackled without eliminating cash via Miles Kimball's approach and it can be effective in restoring full employment. Negative nominal interest rates will still get the monetary hot potato going.   

Along these lines, it is worth noting that another way of looking at the ZLB problem is that it creates excess money demand. That is, the ZLB prevents the desired money holdings of individuals from lining up with the supply of money. This is a big deal because, as Nick Rowe likes to reminds us, money is the only asset on every market. Disrupt the supply of or demand for this one asset and you will disrupt every market. In the case of excess money demand you get a recession. This 'monetary disequilibrium' view of the ZLB implies, therefore, that the real reason we may sometimes need negative nominal interest rates is to restore monetary equilibrium.

Miles and Scott's Excellent Adventure

Wednesday, December 31, 2014

Farewell Secular Stagnation

Marc Andreessen recently looked at the arguments for and against secular stagnation. He cited my Washington Post article when examining the case against secular stagnation. One of the points I make in it is that the proponents of secular stagnation incorrectly invoke the long decline of real interest rates as prima facie evidence for their view. Where they go wrong is that they look at real interest rates without accounting for the long decline in the risk premium. Once the risk premium is stripped out of their real interest measure there is no downward trend in real interest rates. Rather, you get a stationary risk-neutral real interest rate measure that averages close to 2%. This can be seen in the figures below, drawn from my follow-up article with Ramesh Ponnuru:

Interestingly, this risk-neutral measure closely tracks the business cycle and suggests it was the severity of the Great Recession and not secular stagnation that explains the low interest rates over the past six years:

Given this business cycle-driven relationship, the recent spate of good economic news points to rising interest rates in 2015. In fact, the daily measure of the risk-neutral nominal 1-year and 10-year interest rates from Adrian, Crump, and Moench (2013) show just that. See the figure below and note that 2014 has seen a trend change in the path of neutral interest rates. If this continues--and the improved economic news suggests it will--then the Fed will have to raising its interest rate in 2015.

I bring all of this up as a way to motivate a prediction for 2015: secular stagnation will fade from the national conversation for the U.S. economy. Instead, the conversation will focus even more on how to handle the advent of an increasingly digitized, automated economy where productivity growth is rapid and neutral interest rates are rising. Secular stagnation, in other words, is about to experience the same fate it had when it was first pushed in the 1930s. Here is what Ramesh Ponnuru and I wrote about that experience:
"The business cycle was par excellence the problem of the nineteenth century. But the main problem of our times, and particularly in the United States, is the problem of full employment. . . . Not until the problem of the full employment of our productive resources from the long-run, secular standpoint was upon us, were we compelled to give serious consideration to those factors and forces in our economy which tend to make business recoveries weak and anaemic and which tend to prolong and deepen the course of depressions. This is the essence of secular stagnation— sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment.” 
Thus wrote Alvin Hansen, a professor of economics at Harvard, in 1938. Slow population growth and the deceleration of technological progress, he argued, was leading to slow capital formation and weak economic growth. A program of public expenditures, though it had its dangers, was probably required to avoid this fate. 
Hansen’s article was of course spectacularly wrong as a guide to the next few decades. Instead of suffering through stagnation we entered an extended, broad-based, and massive economic boom. In hindsight we can see that his analysis, while thoughtful and intelligent, was unduly influenced by the depression he was living through, and can see as well that the depression was the result of specific policy mistakes rather than inexorable trends. Recent research by Alexander J. Field shows that the 1930s were actually a time of exceptionally high productivity growth. 
Hansen’s worry, some of his specific arguments, and his phrase “secular stagnation” are all making a comeback in our own day. Lawrence Summers, like Hansen an economics professor at Harvard, has sounded an alarm about the ability of industrial countries to achieve adequate economic growth. A new e-book, Secular Stagnation, includes chapters by Summers and other leading economists discussing the question. 
The fact that Hansen was wrong does not prove that contemporary stagnationists are. In this case, though, history is repeating itself rather exactly. We do not pretend to know what the future path of economic growth in the United States will be. But the case for stagnation is weak—and, as in the 1930s, it is getting undue credence because of a long slump caused by policy mistakes.
Farewell secular stagnation. Hello the second machine age.

Monday, December 29, 2014

Tinkering On the Margins

Paul Krugman disagrees with a point I made in my last post. Specifically, he takes issue with my claim that a monetary regime change is needed for both monetary policy and fiscal policy to effective at the zero lower bound (ZLB). To make my case, I gave as an illustration a scenario where the U.S. Treasury Department does a helicopter drop that is offset by the Fed tightening once the helicopter drop starts to raise inflation. I also said a helicopter drop in the Eurozone would face a similar fate from the ECB. Krugman thinks this is wrong: 
What Beckworth seems to be saying is that the Fed and the ECB are at their inflation target, and would therefore tighten policy if the economy were to expand and inflation to rise. But they aren’t at their inflation targets! The Fed has been below target for a number of quarters; the ECB is way below target. 
Krguman's argument, then, is that fiscal policy could raise aggregate demand up to the point where it raises inflation to its target. So why not have a helicopter drop? Surely it would do some good, says Krugman.

Okay, let say for the sake of argument Krugman is correct about the Fed not being able to hit its inflation target. If so, this still only amounts to fiscal policy tinkering on the margins. The Fed's preferred inflation measures, the PCE deflator and core PCE deflator, have both averaged about 1.4% since 2009. So we are talking about 60 basis points of wiggle room for fiscal policy to work. Do we really think that within this narrow window fiscal policy could have generated enough aggregate demand growth to close the output gap? 

To help us see that this is just tinkering on the margins, let us revisit the point Krugman and I agreed on in our previous posts: a monetary regime change is needed to make monetary policy effective at the ZLB. One example of such a monetary regime change would be a price level target that returns the PCE to its pre-crisis trend path. To return the PCE to its targeted path would require a temporary burst of higher-than-normal inflation. The expectation of and realization of this inflation burst would be the catalyst that spurred robust aggregate demand growth. 

Now let us pretend the Fed actually implemented a price level target back in 2010 when it began QE2. Specifically, imagine the Fed had made QE2 conditional on the PCE returning to its 2002-2008 trend path. The figure below shows this scenario with three different paths back to the price level target. Note that each path represents differing rates--5%, 4%, and 3%--of 'catch-up' inflation and for each path there is a significant amount of time--16 months, 26 months, and 49 plus months--involved to catch up to trend.

What this illustrates is that to get the kind of robust aggregate demand growth needed to close the output gap back in 2010, there needed to be a sustained (but ultimately temporary) period of higher-than-normal inflation. Doing more fiscal policy to squeeze out the last 60 basis points of the Fed's 2% inflation target would not cut it. Again, it would be tinkering on the margins. If fiscal policy really wanted to close a large output gap at the ZLB it too needs the support of monetary regime change.

Now in the Eurozone it is true that the ECB is further from its inflation target so that would give fiscal policy more wiggle room. But there is also a larger output gap in the Eurozone. So I think the tinkering on the margins critique applies there too. The Eurozone also need a monetary regime change to make fiscal policy really pack a punch.

But there is more. I think a reasonable case can be made that inflation is actually in the range where the Fed wants it to be. If so, then even the wiggle room is gone. Krugman anticipated this response from me:
The Fed has been below target for a number of quarters; the ECB is way below target. And don’t say that the failure to raise inflation rates shows that they must be happy with where they are. The whole point of our previous discussion has been that monetary policy is ineffective under zero-interest conditions unless you are willing to change regimes! 
Yes, in general, we need a monetary regime for monetary policy to be effective at the ZLB. However, there is compelling evidence the Fed has been doing QE to keep inflation in a range where it is comfortable. In fact, a number of observers have come to the conclusion that the Fed does not have a 2% inflation target but a 2% inflation ceiling. They note that a 2% target would be an average, and the Fed should be willing to allow inflation go above 2% as often as it is below. But that is not the case as noted below: 
[I]t turns out that the Fed’s 2 percent target for core inflation is not a target, it’s an upper bound. 
That’s not supposed to be how it works. If you really think that around 2 percent inflation is right... you’re supposed to view 1 percent inflation as being just as bad as 3 percent; in a situation in which inflation is below the target rate, you’re supposed to see a rise in that rate as a good thing. And correspondingly, if you’re where we are now, with below target core inflation and high unemployment, all lights should be flashing green for expansion. 
Instead, however, it’s clear that below-target inflation is considered no big deal, but that the Fed is extremely averse to seeing inflation rise above target, even temporarily.
That comes from none other than Paul Krugman. If this understanding is correct, then the Fed actually is targeting a range of inflation and is not undershooting its target. I previously presented evidence that this range falls between 1% and 2%. Let me briefly review it.

First, the timing of the Fed's QE programs suggests that the FOMC initiates them when core inflation is under 2% and has been falling for at least six months. It also indicates the FOMC tends to end QE programs when core inflation is above 1% and has been rising for at least six months. This can be seen in the figure below:

Second, the central tendency ranges of inflation forecasts provided by members of the FOMC consistently show 2% as an upper bound. Below are projections for 1-year and 2-years out:

It is remarkable that FOMC members are predicting inflation no higher than 2% two years out. Since the FOMC has meaningful influence on inflation this far out, this forecast reflects FOMC members' beliefs about current and expected Fed policy. They see the Fed doing just enough to keep core PCE inflation under 2%.

Fed Chair Janet Yellen admitted as much in her last post-FOMC press conference:
But it’s important to point out that the Committee is not anticipating an overshoot of its 2 percent inflation objective (p.13)
In short, inflation is below 2% in the United States because the Fed is happy with it being there. Fiscal policy is not going to change that and even if it could it would amount to tinkering on the margin.

A stronger case can be made that inflation is below the ECB's target. However, it is not clear how much it is below target since the ECB's definition of price stability is inflation under 2%. So maybe there is some wiggle room for fiscal policy, but nothing close to what is needed to close the output gap.