The zero lower bound in our minds
PRIOR to the crisis, there was a general (if tenuous) accord among macroeconomists of many different stripes, that the Federal Reserve could and would act to stabilise the economy when necessary. Then, in December of 2008, the Fed hit the zero lower bound, when it dropped its target for the federal funds rate to between 0% and 0.25%, where it has sat ever since. At the time, the unemployment rate was 7.3%. It eventually peaked at 10% about a year later, and it has come down, very slowly and fitfully, to just 8.5% since then. For fully three years, America has been a zero lower bound world.During that time, economists have been working very hard to figure out the implications of the zero lower bound are for macroeconomic policy and unemployment. Are we stuck, or what? At a session this morning, I saw a few presentations on the topic. There was a general agreement among them on the nature of the zero lower bound problem and the liquidity trap. There are two different kinds of people in the economy: savers and borrowers. The borrowers borrowed heavily until the shock of the crisis changed the nature of their borrowing constraint and forced them to rapidly deleverage. Without an increase in demand elsewhere, the high rates of saving of the borrowers will plunge the economy into a deep recession. Normally, the real rate of interest should adjust downward until the savers cut their desired saving enough to offset the increase in desired saving of the borrowers; that is, they spend more to make up for the others furiously trying to pay off their bills. But in some cases, the extent of the deleveraging by borrowers may be great enough to drive the market-clearing real interest rate into negative territory. Since the Fed can't cut rates below zero, savers don't spend enough, there is excess saving, and the economy is stuck with high unemployment.What then? Paul Krugman, who presented a paper in the session with Gauti Eggertsson, noted that fiscal policy was likely to prove effective in such a situation. The government could borrow from those wishing to save more and provide the economy with needed additional demand. At the zero lower bound, government spending doesn't generate crowding out of other investment activities via higher interest rates, so policy is even more effective than usual. And so on. There are other potential solutions, as well; one presenter noted that "unconventional fiscal policy" could replicate an ideal monetary policy through a combination of tax changes—a consumption tax scheduled to rise over time alongside a tax on labour that would decline over time.But Stanford economist Robert Hall really nailed the crux of the question, so far as I was concerned. At the AEA meetings a year ago in Denver, I listened to Mr Hall speak a few times on this issue and point out that with the market-clearing interest rate below zero the economy was stuck with high unemployment. At the time, I wondered why, if that were true, that the answer wasn't simply a higher rate of inflation, which could combine with a zero nominal interest rate to move the real interest rate below zero.This time around, Mr Hall addressed the point head on. He noted that in a liquidity trap, the real rate of interest was simply equal to the negative inflation rate. In other words, if the Fed's nominal rate is at 0% and the inflation rate is 2%, then the real rate of interest is -2%. If a -3% real interest rate is necessary to clear the economy, then all that's needed is a higher rate of inflation—3% rather than 2%. Mr Hall noted that this was an important point because potentially the Fed could have an enormously helpful impact on the economy simply by raising inflation just a little. And here's where things got topsy-turvy. Mr Hall argued that:
- A little more inflation would have a hugely beneficial impact on labour markets,
- And a reasonable central bank would therefore generate more inflation,
- And the Federal Reserve as currently constituted is, in his estimation, very reasonable; therefore
- The Federal Reserve must not be able to influence the inflation rate.
Now, perhaps there was a political economy subtext to this argument; if so, I missed it. Rather, he seemed to be saying (as others, like Peter Diamond, have intimated) that at the zero lower bound it is simply beyond the Fed's capacity to raise inflation expectations. Now admittedly I haven't done a rigorous analysis, but it seems clear to me that the Fed has been successful at using unconventional policies to reverse falling inflation expectations. Why is Mr Hall—why are so many economists—willing to conclude that the Fed is helpless rather than just excessively cautious? I don't get it; it seems to me that very smart economists have all but concluded that the Fed's unwillingness to allow inflation to rise is the primary cause of sustained, high unemployment. And yet...this is not the message resounding through macro sessions. Instead, there are interesting but perhaps irrelevant attempts to model the funny dynamics of a macro challenge that actually boils down to the political economy constraints (or intellectual constraints) facing the central bank. Let's focus our attention on that, for heaven's sake.