Here's Paul Krugman suggesting that the ECB has been in a liquidity trap for years:
And yes, Europe is very much in a trap. Inflation is falling because the economy is weak, and the economy is being weakened in part by falling inflation. That's the Japan syndrome. It leads eventually to actual deflation, but to the extent that there's a red line (or more accurately, an event horizon), it's crossed when monetary policy starts being limited by the zero lower bound, which happened years ago.
On one level this makes no sense, as the ECB has been almost continually raising and lowering interest rates ever since it began in 1999. Indeed the ECB has cut rates many times in the past few years, and raised them several times in 2011.
I'd guess that Krugman is thinking of something else, the fact that risk free market interest rates in the eurozone are quite low, and hence the ECB might not be able to conduct a highly expansionary monetary policy even if it wanted to. I don't agree, but that's a defensible argument.
But that argument does not mean that fiscal austerity in the eurozone has reduced output. The reason is very subtle, so I'll start with a nautical metaphor. Let's assume a ship is going west, and something goes wrong with the steering wheel. It cannot be turned in a counterclockwise direction, and hence the captain cannot turn toward the southwest. But the wheel can move clockwise, and hence the captain can turn toward the northwest. Now assume that in 2011 the captain turns the wheel toward the northwest, and then occasionally nudges the boat this way or that. In that case the inability of the wheel to move in the counterclockwise fashion would not restrict the captain from going in the direction he chose, and hence would not be constraining the ships direction. Any wind that buffeted the ship would not throw it off course, as the captain would simply adjust the steering.
The ECB starting raising rates in 2011, from 1.0% to 1.5%. Those rates are still quite low, and it's possible that a rate cut to zero in 2011 would not have helped all that much. But that doesn't matter. The ECB was steering the ship, and hence the new Keynesian model applies. The fiscal multiplier was zero, as the ECB would have simply offset the impact of more fiscal stimulus with tighter monetary policy. It's revealed preference 101.
[Technically my metaphor requires a weird steering wheel that determines absolute direction, not direction relative to current course. But you get the idea.]
Nautical metaphors are an excellent way to learn monetary economics. Here are 7 more:
1. The Fed should steer the nominal economy between the Scylla of high inflation and the Charybdis of high unemployment (or better yet between 4% and 6% NGDP growth.)
2. Because of policy lags, many people believe steering the economy is like piloting a huge tanker. It responds slowly to a shift in the rudder. In fact, policy lags are much shorter than many people assume.
3. Monetary offset prevents fiscal stimulus from having an expansionary effect. If I am steering a ship and my daughter starts to push on the steering wheel, I push back with equal force. This keeps the boat on that path that I choose. My daughter (fiscal policy) doesn't get to choose the path for NGDP.
4. Fiscal and monetary policy are not equivalent ways of impacting nominal spending. Fiscal stimulus is costly, analogous to revving up an engine with more costly fuel being added (future distortionary tax increases.) Monetary policy is costless. Therefore it makes more sense to think of monetary policy as a setting of the steering wheel. It doesn't cost more to set the steering wheel at one setting compared to another. It's not "more" it's "different." Setting a NGDP target at 5% doesn't require any more costly fuel than 4%, for two reasons. You probably would not have to do any more open market purchases, as a higher NGDP target raises base velocity. And even if you did OMPs are essentially costless.
5. Nick Rose likes to point out that if you want higher nominal interest rates and higher NGDP growth, you have to cut interest rates in the short run. This would be like a ship with a steering wheel that had to be turned right to move the ship left.
6. The central bank should target the forecast, but very few actually do so. They should set policy so that expected NGDP growth equals target NGDP growth. Failing to do so is equivalent to a captain setting the steering wheel at a position where he expects to end up in Boston, even though the ship's destination is New York. So adjust the steering Captain Ben! You should expect to arrive at the place that you wish to arrive. BTW, an NGDP futures compass might help the captain.
7. The liquidity trap is a tough one. Interest rate targeting could be compared to a steering mechanism that works fine except when you need it most; it locks up in rough weather. Alternative mechanisms include QE, which would be like side jets that help steer the ship, or forward guidance. Forward guidance would be like shooting a long cable to the spot you want to arrive at, and then using a winch to reel in the ship.
OK, the last one is a bit far fetched. But hey, I grew up in Wisconsin and never saw salt water until I was 20 years old (at 3am while driving in Tampico, Mexico.) So I'm a bit rusty with some of the nautical terms.