Paul Krugman notes that the prolonged housing slump seems to suggest that a relatively modest fiscal boost could push us to a higher employment equilibrium:
Suppose that Obama announces that we face a clear and present danger from Ruritania, and that to meet that threat we need immediate investment in roads and rail (to move troops, of course). The economy surges on the emergency spending — and newly employed men and women at last get to move out of their relatives’ basements. Home construction surges. Then Obama apologizes, says that his advisers have learned that there is no such country as Ruritania, and cancels the program. But we still have the new roads and rail links; plus, the surge in housing demand is now self-sustaining, and the economy remains strong.
And of course we could do this even without the pretend invasion. But there is (as ever) a monetary angle. As Karl Smith puts it before increased demand leads to increased supply of homes, it needs to lead to higher rents. Among other things, you can’t build a home instantaneously. That has implications for the proposed anti-Ruritanian fiscal boost. In particular, if the Federal Reserve is happy with the current inflation rate that means it’s going to need to tighten money during the “higher rents” phase and short-circuit the fiscal boost. Which is just to say that any time fiscal policy works, it’s going to work in part by increasing the price level which means it will only work if it’s tolerated by the central bank.
How exactly this goes together depends in part on your model of what’s happening at the Federal Reserve. One way of looking at it is that if the Fed were willing to accept a higher inflation rate, they’d be doing QE3 right now. So the fact that they’re not doing QE3 shows that they would tighten money to offset any boost from fiscal policy. Hence, even though fiscal policy could work, it wouldn’t. Another view, however, is that the Fed isn’t doing QE3 primarily because of political worries around QE3 itself. If the US Congress and President Obama were to initiate a fiscal stimulus that they claim responsibility for, the Fed would be happy to stand pat and let the price level rise, issuing a statement about the continued existence of excess capacity and well-anchored expectations. This is a scenario considered by Scott Sumner:
This suggests the Fed’s previous actions have given her a “loose” reputation. She’s willing to be easy, but not that easy. Of course you and I know that monetary policy has been very tight. But what matters in questions of virtue are perceptions. And there are few areas of life more permeated by Victorian morality that monetary policy.
If this is the problem, then fiscal stimulus might just work. The Fed cares about the perceived stance of policy. It wants more NGDP, but isn’t willing to put out.
All things considered, this highlights the extent to which non-transparency and lack of accountability at the Fed has itself become a problem. A medium-sized fiscal boost might solve all our problems by sparking a self-sustained recovery, or it might be a total waste of money and which it is depends on one’s view of the murky internal politics of the central bank.