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“Everything about recent experience,” Paul Krugman said a year ago, “suggests that the world desperately needs fiscal expansion to boost demand and … that our sole reliance on central banks isn’t working.” As evidence, Krugman pointed to a positive relationship between government expenditure and economic growth over the years 2010 to 2013.
Krugman’s argument that central banks can’t boost deficient demand on their own, and that greater government spending must do the job, is empirically false. The positive relationship he charts between public spending and growth holds only for countries without their own central banks—like those in the Eurozone. As shown in the left-hand figure above, there is no such relationship for countries that operate an independent monetary policy. The logic, entirely conventional, is that central banks can (and do) act to offset the stimulative and contractionary influences of changes in fiscal policy.
Krugman has in the past responded by arguing that everything is different at the zero lower bound (ZLB) for monetary policy, pointing to his work on so-called liquidity traps. And indeed he has invoked the ZLB in support of fiscal expansion in the U.S., the UK, and Japan. So what about these three?
As the right-hand figure above shows, there is no relationship between government expenditure and growth even for countries at the ZLB. (In fact, it is slightly negative.) Of course, all three of these countries used monetary policy tools aggressively between 2010 and 2015—even while at the ZLB.
In short, Krugman’s Great Lesson of the Great Recession—that government spending trumps monetary policy—is wrong.