From zero to one, then back to zero
Economists’ evolving understanding of the zero-rate liquidity trap
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 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 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 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.