There are three variations of this question that I have come across in recent posts and comments.
1) If monetary policy had targeted nominal GDP, it could have been successful whatever fiscal policy had been.
2) Even within the context of inflation targeting, Quantitative Easing (QE) allows monetary policy to overcome the problem of the zero lower bound (ZLB) for nominal interest rates. So inadequate demand can be put down to not enough QE.
3) Less austerity would have led to higher inflation, which given the recent behaviour of monetary policy makers would have led to higher interest rates, leading demand back to where it now is.
On (1), I have said that the possibility of moving to a different monetary target has a lot to commend it, and that this should be discussed much more actively in the UK right now. However I do not think targeting nominal GDP means that the monetary authorities can achieve that target at all points in time. The main way I think it overcomes the zero lower bound (ZLB) for nominal interest rates is by promising to create higher inflation in the future, which is itself a cost. The more austerity reduces current demand, the more inflation we will have in the future to counteract it.
Argument (2) in effect says that the ZLB does not matter: monetary policy just switches from one instrument to another. I think this is seriously wrong. Although recent studies suggest QE has some effect, everyone I talk to who is involved with monetary policy thinks the uncertainties and limitations of QE are of an order above those of conventional policy. If I had to choose between QE and fiscal policy as a way of regulating demand, I would choose fiscal policy.
Argument (3) suggests that if we had not had austerity, inflation would have been higher, and monetary policymakers would have raised interest rates. There are two uncertainties here. First, we cannot be sure that if there had been less austerity, inflation would have been significantly higher. In the UK there is a very simple reason for this – part of the additional austerity was to raise VAT. But more generally, what we may be seeing today is that inflation is much less sensitive to the output gap when inflation is low.
Second, we cannot be sure how monetary policy makers would have reacted. As I have argued before, sensible monetary policy targets both inflation and the output gap, so when the latter is large and negative, you should be very tolerant of moderate and temporary excess inflation. You certainly do not appear to ignore the output gap. Unfortunately that is exactly what monetary policy makers did do in the Eurozone in 2011, and I really hope this decision is now regretted by the ECB. In the UK they nearly did the same, and I have discussed this episode at length. So I know what monetary policy should have done if we had had less austerity (not raise interest rates), but I do not know what they would have done.
So I agree that, if demand was stronger because we had had less austerity and more fiscal stimulus, inflation might have been higher, and interest rates might have increased as a result. However not only am I uncertain about this, but the monetary policy response would have been a policy choice. In this situation, should I say that austerity does not matter? Should I instead blame the monetary authorities for something they might have done, had austerity not happened? This seems a bit odd to me.
I’m also a bit concerned that all three arguments hark back to a place too many were at before (and even during) the recession, which was to believe macroeconomic stabilisation was only about monetary policy. Now my own writing and research has been quite supportive of what I call the conventional assignment, under the right conditions. But those conditions do not apply at the ZLB, and they obviously do not apply to members of a currency union. There are also other circumstances where fiscal policy could in principle assist monetary policy in its stabilisation role. This tendency to discount the short term macroeconomic effects of fiscal policy is part of the reason we are in our current situation.