Escaping the Great Recession

We develop a model in which policy makers' reputation for Fiscal Virtue evolves over time. Fiscal Virtue is generally desirable because it leads to a stable macroeconomic environment, but when entering the zero lower bound, policy makers face a trade-off between preserving their reputation and escaping a large recession. Given that policy makers' behavior is constrained at the zero lower bound, beliefs about the exit strategy are substantially more important than policies implemented during the crisis. Announcing a period of austerity is detrimental in the short run, but it preserves macroeconomic stability in the long run. A large recession can be avoided by abandoning Fiscal Virtue, but this results into a sharp increase in macroeconomic instability. Contradictory announcements by the fiscal and monetary authorities can lead to high inflation and large output losses. Finally, while high uncertainty is an inherent implication of entering the zero lower bound, deflation is not, because agents are likely to be uncertain about the way policy makers will deal with the large stock of debt arising from a severe recession.