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2016-01-12 06:23:53
Economists evolving understanding of the zero-rate liquidity trap
Dec 31st 2015, 10:32 by R.A. | LONDON
MY COLUMN this week sets out three possible scenarios for the American economy
in 2016, in the aftermath of the Fed's first rate hike in more than nine years.
Each scenario corresponds to an understanding of why it is that near-zero
interest rates are so difficult to leave behind; economies eventually managed
the trick in the decades after the Depression, but those that have sunk to the
zero lower bound in recent years have been unable to escape it for long.
What strikes me as interesting, and what motivated the column, is that our
understanding of the pull of near-zero rates has evolved since late 2008, and
continues to evolve, in a very ominous direction.
Back in late 2008 and early 2009, when rates around the rich world fell below
1%, the framework most economists reached for was what you might call the
traditional Hicks-Krugman story of the liquidity trap. John Hicks's analysis of
the work of John Maynard Keynes first set out the concept of a liquidity trap
in 1937. Paul Krugman borrowed and updated that framework in 1998 in an
analysis of the Japanese economy. This story is one in which a really nasty
economic shock knocks an economy into a bad equilibrium; rates fall to zero, at
which point monetary policy loses its punch. Real rates can't go low enough to
stimulate the economy, which remains stuck with a shortfall in demand. To get
out, the government either needs to borrow heavily and spend to boost demand,
or the central bank needs to promise to tolerate high inflation once, at some
point in the distant future, the economy returns to health: to "credibly
promise to be irresponsible", in Mr Krugman's phrase. Higher exected inflation
reduces the real interest rate in the present, providing the needed stimulative
jolt. In his paper, Mr Krugman mused that a target of 4% inflation for fifteen
years might be the sort of thing needed to get Japan out of its trap assuming
Japanese households would find such a target credible.
An alternative view emerged over the course of the recession and recovery,
which one might call the Friedman-Schwartz-Bernanke story. In the Monetary
History of the United States, Milton Friedman and Anna Schwartz argued that
monetary policy had not been helpless in the 1930s, and that in fact the blame
for the depth and length of the Depression should be set at the feet of the
Federal Reserve, which tolerated a dramatic drop in the money supply. Ben
Bernanke's Fed adopted a version of this framework, which continues to shape
policy today: that a liquidity trap is only a trap for an insufficiently
aggressive central bank. Use enough unconventional monetary policy, and the
trap can be overcome. And so the Fed never attempted to gin up any sort of
regime change, or to dramatically increase the market's expectations for future
inflation. Instead, it used QE and promises to keep rates low for as long as
necessary to support demand. And the Fed now seems confident that, having
generated a robust-enough recovery, it is safe to move away from zero, as
nonchalantly as if one were raising rates from 4% to 4.25%.
That view is almost certainly wrong. Other rich-world central banks with other
robust-enough recoveries have tried and failed to sidle away from zero; it
doesn't work. Markets don't think it will work this time; futures markets
project a path for the federal funds rate about half as steep as the (already
gentle) path that the Fed suggests it will follow.
At the same time, the traditional liquidity trap story also looks inadequate.
America has enjoyed a relatively robust recovery, at least over the last year
or two, despite big government budget cuts and inflation rates, both actual and
expected, barely above zero. And meanwhile other economies around the world,
which performed reasonably well during the dark period from 2008-2010, are
finding themselves drawn toward the zero lower bound.
And so a new narrative is gaining adherents (among them Mr Krugman himself):
the Hansen-Summers "secular stagnation" story of low rates forever. The story,
I write in my column goes like this:
[T]he problem is a global glut of savings relative to attractive investment
options. This glut of capital has steadily and relentlessly pushed real
interest rates around the world towards zero.
The savings-investment mismatch has several causes. Dampened expectations for
long-run growth, thanks to everything from ageing to reductions in capital
spending enabled by new technology, are squeezing investment. At the same time
soaring inequality, which concentrates income in the hands of people who tend
to save, along with a hunger for safe assets in a world of massive and volatile
capital flows, boosts saving. The result is a shortfall in global demand that
sucks ever more of the world economy into the zero-rate trap.
The long downward trend in global real interest rates pre-dates the Great
Recession. In the early 2000s the Fed was already struggling to manage a
low-rate, low-inflation environment. The glut of global savings in search of
safe assets with a reasonable rate of return fueled the American housing
bubble. The financial crisis ushered rich-world rates to the zero lower bound,
but the fall to zero was probably inevitable. What's more, it is only a matter
of time until the rest of the world gets stuck as well:
Economies with the biggest piles of savings relative to investment such as
China and the euro area export their excess capital abroad, and as a
consequence run large current-account surpluses. Those surpluses drain demand
from healthier economies, as consumers spending is redirected abroad. Low
rates reduce central banks capacity to offset this drag, and the long-run
nature of the problem means that promises to let inflation run wild in the
future are less credible than ever.
This story, which looks increasingly convincing, implies that as the Fed
attempts to raise rates the dollar will rise in value and inflation will remain
low. The American economy will sputter and stall, forcing a quick reversal in
rates though it might keep growing for a time if the government and households
tap the money flowing their way and borrow to fuel consumption (or real estate
investment).
If this narrative is the right one, an aggressive-enough central bank can
ameliorate the zero-rate problem but cannot solve it. A higher inflation rate
would allow an economy to maintain positive nominal interest rates in a world
in which the global real rate stays rooted near zero. Modestly ambitious
monetary policy that depreciates the currency will boost an economy, but mostly
by capturing demand from other countries. Economies that have had enough can
adopt capital controls to keep the tide of savings out and regain
monetary-policy independence. None of that is especially satisfying. But a
proper, sustainable long-run solution would require a fix to the global
savings-investment imbalance. That, in turn, might mean dramatic reforms around
the world, much higher rates of immigration to rich countries with shrinking
workforces, and heavy borrowing by safe-asset issuing governments.
The secular stagnation picture is a grim one. It might be wrong; maybe
America's economy will keep on trucking even as the Fed lifts rates. If America
finds itself dragged slowly back to zero, the outlook for the global economy
over the next decade or so is an uncertain and worrying one.