Are negative interest rates really the solution?
Miles Kimball believes that the zero lower bound (ZLB) constitutes a significant economic problem (he is not alone, of course). His viewpoint is expressed clearly in the title of his post: America's Huge Mistake on Monetary Policy: How Negative Interest Rates Could Have Stopped the Recession in its Tracks.
That's quite the bold claim. But what is the reasoning behind it? Yes, I can see how a price floor can distort allocations and make things worse than they otherwise might have been if prices were flexible. But would interest rate flexibility really have prevented the recession?
Suppose I wanted to teach this idea in my intermediate macro class, using conventional tools. How would I do it? (Maybe it can't be done, but if not, then someone present me with an alternative.) I think I might start with the following standard diagram depicting the aggregate supply and demand for loanable funds (the foundation of the so-called IS curve):
Suppose the economy starts at point A. (I am assuming a closed economy, so aggregate saving equals aggregate investment.) The real interest rate is positive.
Next, suppose that there is a collapse in investment demand. For the purpose of the present argument, the reason for this collapse is immaterial. It might just be psychology. Or it might be the consequence of a rationally pessimistic downward revision over the expected future after-tax return to capital spending. In either case, the economy moves to a point like B, assuming that the interest rate is flexible.
But, suppose that the Fed is credibly committed to a 2% inflation target. Moreover, suppose that the nominal interest rate cannot fall below zero (the ZLB). Then, when the nominal interest rate hits the ZLB, the real rate of interest is -2%.
If this was a small open economy, the gap between desired saving and desired investment at -2% would result in positive trade balance (as domestic savers would divert their saving to more attractive foreign investments, over the dismal domestic investment opportunities). But in a closed economy, saving must equal investment and so, as the story goes, domestic GDP must decline to equilibrate the market for loanable funds. As domestic income falls (and as people become unemployed), desired domestic savings decline (the Desired Saving function moves from the Full Employment position, to the Under Employment position, in the diagram above).
Now, if this is a fair characterization of the situation as Miles sees it (and it may not be--I am sure he will let us know), then I would say sure, I can see how the ZLB can muck things up a bit. The economy is at point C, but it wants to be at point B (conditional on the pessimistic outlook).
But while point B might constitute an improvement over point C, it does not mean an end to the recession. Domestic capital spending is still depressed, and ultimately, the productive capacity of the economy will diminish. I'm not sure I see how a negative interest rate is supposed to prevent a recession, or get the economy out of a recession, if the fundamental problem is the depressed economic outlook to begin with.
If anyone out there has another way of looking at the problem, please send it along.
***
Update: Here is a reply from Gerhard Illing:
That's quite the bold claim. But what is the reasoning behind it? Yes, I can see how a price floor can distort allocations and make things worse than they otherwise might have been if prices were flexible. But would interest rate flexibility really have prevented the recession?
Suppose I wanted to teach this idea in my intermediate macro class, using conventional tools. How would I do it? (Maybe it can't be done, but if not, then someone present me with an alternative.) I think I might start with the following standard diagram depicting the aggregate supply and demand for loanable funds (the foundation of the so-called IS curve):
Suppose the economy starts at point A. (I am assuming a closed economy, so aggregate saving equals aggregate investment.) The real interest rate is positive.
Next, suppose that there is a collapse in investment demand. For the purpose of the present argument, the reason for this collapse is immaterial. It might just be psychology. Or it might be the consequence of a rationally pessimistic downward revision over the expected future after-tax return to capital spending. In either case, the economy moves to a point like B, assuming that the interest rate is flexible.
But, suppose that the Fed is credibly committed to a 2% inflation target. Moreover, suppose that the nominal interest rate cannot fall below zero (the ZLB). Then, when the nominal interest rate hits the ZLB, the real rate of interest is -2%.
If this was a small open economy, the gap between desired saving and desired investment at -2% would result in positive trade balance (as domestic savers would divert their saving to more attractive foreign investments, over the dismal domestic investment opportunities). But in a closed economy, saving must equal investment and so, as the story goes, domestic GDP must decline to equilibrate the market for loanable funds. As domestic income falls (and as people become unemployed), desired domestic savings decline (the Desired Saving function moves from the Full Employment position, to the Under Employment position, in the diagram above).
Now, if this is a fair characterization of the situation as Miles sees it (and it may not be--I am sure he will let us know), then I would say sure, I can see how the ZLB can muck things up a bit. The economy is at point C, but it wants to be at point B (conditional on the pessimistic outlook).
But while point B might constitute an improvement over point C, it does not mean an end to the recession. Domestic capital spending is still depressed, and ultimately, the productive capacity of the economy will diminish. I'm not sure I see how a negative interest rate is supposed to prevent a recession, or get the economy out of a recession, if the fundamental problem is the depressed economic outlook to begin with.
If anyone out there has another way of looking at the problem, please send it along.
***
Update: Here is a reply from Gerhard Illing:
Hello David,
I am not sure if that is what you are asking for, but at least within the standard NKM framework (with negative time preference shocks) it is fairly straightforward to illustrate that eliminating the ZLB would allow monetary policy to perfectly stabilize the economy at the natural rate. I just finished a sort of “textbook” version (allowing for an explicit analytical solution) of that framework.
In terms of your graph (with the nominal interest rate as adjustment tool to time preference shocks under sticky prices) it looks as follows:
Presumably you are not happy with the NKM framework as a realistic description of current issues - but within that logic, these arguments follow naturally, in particular if you are on the “secular stagnation” trip.
And here is a further elaboration, provided by Gerhard:
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