I’m not convinced that mild deflation is anything to worry about. It didn’t seem to hold back the U.S. economy during the post Civil War, pre-Fed era. But suppose you were worried about it. What could be done to reverse it? The standard answer is for the central bank to cut interest rates. But what if the central bank has already cut interest rates down to 0%, and deflation persists?
Dinosaur Keynesians have long said that under these circumstances, monetary policy is helpless. Expanding the money supply is like “pushing on a string.” But the best modern macroeconomists see through this error. Ben Bernanke lists quite a few ways to make monetary policy more expansionary when the nominal rate hits 0%:
To repeat, I’m not convinced mild deflation is a problem worth solving. But thinking about Bernanke’s speech made me realize that there is a simpler to make monetary policy more expansionary when the nominal rate equals 0%. And that is to cut rates again. If the rate of monetary growth is too low when the interest rate is zero, pick the negative interest rate that gives you the rate of monetary growth you want.
Under normal circumstances, of course, negative nominal rates are a recipe for hyperinflation. But when inflation is -1%, the real interest rate on a -.1% rate loan is +.9%. Borrowing to invest under these conditions is not a no-brainer. You can pay back less than you borrowed, and still be poorer afterwards.
How about borrowing to hold? You borrow $100 at -.1% interest, and repay $99.90 in a year, earning $.10 free and clear. That would indeed be a no-brainer if there were no transactions costs. But there always are. The upshot, then, is that mildly negative rates – just negative enough to exceed the transactions costs of a decent number of borrowers – would have a large but finite expansionary effect. If you were still worried about hyperinflation, you could treat the negative interest rate as a “sale price” that expires after a couple of days, or after x billions of extra dollars have been borrowed.
Rockwell called Bernanke a “crank” for engaging in this kind of thinking. And if I were advocating a negative interest rate right here, right now, a crank is what I would be.
But I’m not advocating anything. I’m just pointing out that the “liquidity trap” is even less worth worrying about than modern macroeconomists realize. It might seem like monetary policy runs into a wall when interest rates reach 0%. But this “wall” is made out of paper, not brick. You may not want to visit the negative interest rates on the other side, but getting there is easy.
READER COMMENTS
Mark Bahner
Jun 12 2005 at 7:47pm
And what about lowering the required reserve ratio?
pj
Jun 13 2005 at 5:56am
I don’t see the problem; the Fed can print as much money as it likes, and cause as much inflation as it likes. If it can’t loan money at 0% because it’s already bought all outstanding bonds and satisfied all loan demand (unlikely – currently debts outstanding are two orders of magnitude greater than currency in circulation), then it can start buying real property – gold, land, etc.
spencer
Jun 13 2005 at 7:46am
The problem may be that the best example of mild deflation or a liquidity trap may not be the US in 1880-90s. Rather it is Japan over the past 15 years.
Moreover, the Japanesee have tried many of the things you are proposing.
The Fed looked at the Japanese example and concluded the best way to compat it was the policy they implemented of taking short rates to 1%, far below what a Taylor Rule would have suggested.
So far it looks like a good policy choice even though the US economy is still performing poorly by historic standards.
The Barnanke comments about dropping money out of a helicopter, etc, were made when the worries that we were following the Japanese were at their peak.
Lancelot Finn
Jun 13 2005 at 9:23am
I was always under the impression that a negative interest rate is impossible.
The argument is simple. If I just hold cash, I get a 0% nominal interest rate; my real interest rate is the opposite of the inflation rate. I can only be persuaded to deposit my money somewhere if they offer a positive nominal interest rate. Deflation means that people get a positive real interest rate just by holding cash. That discourages them from saving and investing.
Is a negative nominal interest rate possible? How would saving and lending operate, and why would they happen?
Chris Bolts
Jun 13 2005 at 10:13am
[quote]I was always under the impression that a negative interest rate is impossible.[/quote]
There’s a bunch of poor folks in Africa who would tell you otherwise.
dsquared
Jun 13 2005 at 2:55pm
This would indeed be a solution if the liquidity trap was an artefact of the fact that nominal rates cannot go below zero. However, it isn’t; this mistake was introduced (I think) by Tobin and popularised by Paul Krugman. Liquidity traps can arise at any level of nominal or real rates if firms’ anticipated demand schedule for their product (“effective demand” in the language of the General Theory) is such that they prefer to hold liquid resources rather than buy investment goods.
Phil
Jun 13 2005 at 5:05pm
Why not just print up new $100 bills and send one to every American?
I am serious.
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