- Amir Sufi is correct, it is all in the book! If you look at footnote four for chapter 4, you will find four studies that "influenced the thinking" of the authors. The studies show that the real problem is the ZLB. Debt, itself, is not the problem. This is because for every debtor there is a creditor who could provide offsetting spending if the interest rates adjusted down to their natural rate level. This adjustment process is impeded when the natural interest rate is negative since nominal interest rates cannot go below zero percent. This point is raised in a 2012 IMF study that the authors also cite. Here is an excerpt from that study:
"A shock to the borrowing capacity of debtors with a high marginal propensity to consume that forces them to reduce their debt could then lead to a decline in aggregate activity... Here, a sufficiently large fall in the interest rate could induce creditor households to spend more, thus offsetting the decline in spending by the debtors. But, as these models show, the presence of the zero lower bound on nominal interest rates or other price rigidities can prevent these creditor households from picking up the slack."
Note, that the ZLB problem is just another way of saying there is excess demand for money assets. During this crisis, the excess money demand has been mostly for institutional money assets. Back to Amir Sufi:
- Nice classy reply from a University of Chicago economist. But seriously, he is right that many believe the ZLB problem is surmountable if monetary policy were done right. However, the institutional realities the Fed now face makes the ZLB a real constraint as I have noted here and here. So what are the ways the ZLB problem could have been solved? Here is my reply:
- From the above linked post, here is how the negative interest rate approach works:
"There are two key parts to Miles Kimball's solution. The first part is to make electronic money or deposits the sole unit of account. Everything else would be priced in terms of electronic dollars, including paper dollars. The second part is that the fixed exchange rate that now exists between deposits and paper dollars would become variable. This crawling peg between deposits and paper currency would be based on the state of the economy. When the economy was in a slump and the central bank needed to set negative interest rates to restore full employment, the peg would adjust so that paper currency would lose value relative to electronic money. This would prevent folks from rushing to paper currency as interest rates turned negative. Once the economy started improving, the crawling peg would start adjusting toward parity. More details on his proposal can be found here.There is much to like about his proposal. It is effectively how a free-banking, profit maximizing system would solve the ZLB, as shown by JP Koning. Holding risk constant, it would move all interest rates down and maintain spreads so that financial intermediation would not be disrupted. It would also eliminate the illusion that liquid short-term debt contracts are risk-free. Most importantly, it would allow short-tern nominal interest rates to better track their natural interest rate level.
The figure below shows how how Miles Kimball's solution would provide an escape route from the ZLB problem. It shows a situation where there is a negative output gap and a negative short-turn nominal natural interest rate. Miles would have the Fed would lower its policy interest rate down to the natural interest level at time t. The output gap would start to close and consequently, the natural interest rate would start to rise. The Fed would follow suit and start raising its policy interest rate in line with the natural rate. Eventually, the economy would return to full employment and the nominal interest rates would settle at their long-run values (which typically are positive). The escape from the ZLB would be complete."
- And here is the Nominal GDP targeting approach to solving the ZLB problem:
"His approach is to "shock and awe" the economy with a regime change to monetary policy that would catalyze a sharp recovery. This recovery would pull the natural interest rate back into positive territory and eliminate the ZLB problem. Scott would implement his "shock and awe" program by having the Fed announce a NGDPLT (or total dollar spending target) and credibly committing to do whatever it takes to make it happen.This amounts to the Fed committing to a permanent expansion of the monetary base, if needed. That is, a NGDPLT creates the expectation that if the market itself does not self correct through a higher velocity of base money, then the Fed will raise the amount of monetary base as needed to hit higher level of NGDP. If credible, this becomes a self-fulfilling expectation with the market itself doing most of the heavy lifting. In other words, the regime change would spark a major portfolio rebalancing away away from highly liquid, low-yielding assets towards less liquid, higher yielding assets. The portfolio rebalancing would raise asset prices, lower risk premiums, increase financial intermediation, spur more investment spending, and ultimately catalyze a robust recovery in aggregate demand. It would be similar in spirit to what monetary policy portion of Abenomics is now doing in Japan.The figure below shows how Scott's solution would provide an escape route from the ZLB. Like before, the figure shows a negative output gap and short-run nominal natural interest rate that is negative. At time t, Scott would have the Fed introduce NGDPLT. The output gap would begin shrinking and put upward pressure on the natural interest rate. Eventually the natural interest rate would broach zero and the Fed would have to start raising its policy rate in line with it. Finally the economy would return to full employment and the natural interest rate to its long-run positive value. The escape from the ZLB would be complete."
- This latter "shock and awe" approach is similar in spirit to what countries stuck at the ZLB in the 1930s did by going off the gold standard. And to some extent it is what Japan is doing with Abenomics.
- This point is underscored by the performance of Australia:
As seen onmacromarketmusings.blogspot.com
What Caused The Great Recession? Household Deleveraging or ZLB?
byDavid Beckworth2,241 Views