Can Econometrics Distinguish between the Effects of Monetary and Fiscal Policy During the Crisis?

People are taking victory laps over monetary policy, saying it's now clear that either fiscal policy doesn't work or, even if it does, it will be offset by monetary policy? Or they are making the claim that those who said monetary policy is ineffective at the zero bound have been shown to be wrong? I'm sorry, but it's too soon to do this. I knew this was going to happen, it always does, and tried to warn about it in August 2009:

...Much of the uncertainty in economics derives from our inability to do laboratory experiments, and that includes uncertainty about which model best describes the macroeconmy. 

When the present crisis is finally over, those who advocated fiscal policy, those who advocated monetary policy, and those who advocated no policy at all will all say "I told you so" based upon their reading of the evidence.

Some New Keynesians will cite fiscal policy as the important policy response, and the timing of the policy relative to the recovery will likely support that argument. Other New Keynesians along with Monetarists (e.g. Lucas and others who believe monetary policy can help, but fiscal policy is ineffective) will insist it was monetary policy that saved us. The timing of the monetary policy response will support their position as well.

Still others, those such as Prescott who believe in Real Business Cycle models, will say the economy recovered despite policy, and would have recovered all that much faster if government hadn't gotten in the way. Without a baseline to refer to showing what would have happened without policy, it would be hard to refute this argument.

Once this is all over, there will be ways to tease this out of the data, e.g. the pattern of the response of key macroeconomic variables may be most consistent with one of the policies, but there will still be considerable uncertainty due to the high correlation in the timing of the monetary and fiscal policy responses (cross-country studies could help too since the policy response varied by country, but other differences across countries that are difficult to control for making these estimates uncertain as well).

Ideally, we would go to the lab and run the economy with the same initial conditions, say, 1,000 times with no policy intervention at all to establish the average non-intervention response (and its variance), i.e. the baseline, an important missing piece of information when all you have is non-experimental data. Then, we would run the economy again with a monetary policy response to the crisis 1,000 times (or do several experiments with different monetary policy responses to see which is best), and yet again 1,000 more times with fiscal policy (or, as with monetary policy, perhaps several fiscal polices involving different levels of spending and taxes), then compare the results to see how well each policy attenuates the cycle. (I would also want to run the economy with several combinations of the two polices in case there are important interaction effects the experiments with individual treatments might miss.)

That would probably give us a pretty good idea about which policy works best. However, without the ability to do experiments, the best we can do is to build a model of the economy based upon historical data, and then use the model to simulate the experiments above. That is, estimate the model based upon actual data, then run it with various combinations of monetary and fiscal policy and see how the outcome varies with differences in policy. Unfortunately, the answers you get are only as good as the model used to get them, and considerable uncertainty remains over which macroeconomic model is best (which is why we have Real Business Cycle, New Keynesian, and Monetarist type macroeconomic models along with all their various sub forms, though more recently questions have arisen over whether any of the existing theoretical structures are satisfactory). ...

The evidence about which, if any policies worked best simply isn't there yet, and claims that, say, monetary policy was effective while fiscal policy did nothing simply cannot be supported with the solid econometric results. It's particularly amusing to see people saying that QEII raised employment in January when we know good and well that there are substantial lags in the policy process and it would be very unusual for monetary policy to work that fast. It would be just as easy to point to the recent tax cuts that Congress (surprisingly) put into place and give those credit for recent employment gains. Similarly, the timing works quite well for the argument that the employment gains we've seen recently -- meager as they are -- come from the spending on infrastructure and other projects in the ARRA. If you impose the standard lags for fiscal policy and take good account of when the spending came online, it's just as easy to give fiscal policy credit as it is monetary policy. Or, if you'd like, a case can be made that QEI is responsible for recent upticks in activity. Finally any policies such as QEII and the recent tax cuts that are put into place in the neighborhood of a trough of a recession are going to look effective even if they do nothing. The economy is headed upward anyway, and it's hard to say how the trajectory is affected by policy.

So it is no harder, and perhaps even easier, to make the claim that fiscal policy did it all and monetary policy did nothing. Again, we don't have the evidence yet and won't for some time -- so people can claim whatever and it's hard to agree or disagree based upon solid evidence. We need the full series through the recovery and all the data revisions in place to do this right, and even then the separate effects of monetary and fiscal policy will be difficult to identify for the reasons discussed above. Those who are claiming victory are simply reading the data in a way that supports what they've predicted in the past -- there's no way to decisively make the case based upon the evidence at hand. Conclusions that say otherwise more upon ego than evidence. As I've said recently, I do this too -- my ego leads me to read the data in a way that supports what I've said would happen in the past -- but if I'm honest I have to admit that there's no way to make an evidence based case one way or the other yet, and there may never be a decisive way to sort out the effects of monetary and fiscal stimulus. Both monetary and fiscal policy tended to occur together during the crisis, and the last round occurred near the trough confounding the analysis even more.

One final note. Many people have been pointing to results from simulations showing that monetary policy had some effect on employment and output, though not a huge effect, as a means to support their prior predictions about monetary and fiscal policy. But as noted above, these simulations are based upon models that failed to predict the crisis and that do not have the connections between the real and financial sectors that are needed to properly model the monetary transmission mechanism. Why people would put a lot of weight on the results from models that do not capture that monetary transmission mechanism is puzzling. Until we have models of the crisis that have these connections, such evidence should be regarded with skepticism.