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Five On The Floor [View all]
We’re coming up on the fifth anniversary of an important moment: the point at which US interest rates hit the zero lower bound, and we entered a liquidity trap. Five years! Yet many people, even many economists, are still in denial over what that means.
First of all, about that date: Officially, the Fed established a target rate between 0 and 0.25 percent on December 15, 2008, but the effective Fed funds rate (the rate at which banks lend reserves to each other) plunged to near-zero in late October:
As some of us tried to argue right from the beginning, hitting the zero lower bound changes everything. It’s not just that the rules change for monetary policy, although they do: some people have been warning for the whole five-year period that the surge in the monetary base will cause runaway inflation, and it keeps not happening. It’s also true that we enter the territory of paradoxes; the paradox of flexibility, but also, and more crucially, the paradox of thrift, in which attempts by some players in the economy to save more end up leading to less, not more, investment.
For those who don’t know or don’t get the paradox of thrift, it’s actually very simple: if people (or the government) cut their spending, and the Fed can’t offset this move by cutting interest rates, the economy will contract — and the economy’s contraction will reduce the incentive to invest, so that investment actually falls.
I know that many economists just refuse to accept this proposition, which seems absurd to them. But what, exactly, is their alternative? If you believe that a cut in spending under current conditions — it doesn’t matter whether it’s public or private spending — leads to more rather than less investment, what is the mechanism? How does my spending cut give businesses a reason to spend more rather than less (other than via the confidence fairy)? Remember, interest rates can’t fall — the zero lower bound isn’t a theory, it’s a fact, and it’s a fact that we’ve been facing for five years now.
http://krugman.blogs.nytimes.com/2013/10/15/five-on-the-floor/
First of all, about that date: Officially, the Fed established a target rate between 0 and 0.25 percent on December 15, 2008, but the effective Fed funds rate (the rate at which banks lend reserves to each other) plunged to near-zero in late October:
As some of us tried to argue right from the beginning, hitting the zero lower bound changes everything. It’s not just that the rules change for monetary policy, although they do: some people have been warning for the whole five-year period that the surge in the monetary base will cause runaway inflation, and it keeps not happening. It’s also true that we enter the territory of paradoxes; the paradox of flexibility, but also, and more crucially, the paradox of thrift, in which attempts by some players in the economy to save more end up leading to less, not more, investment.
For those who don’t know or don’t get the paradox of thrift, it’s actually very simple: if people (or the government) cut their spending, and the Fed can’t offset this move by cutting interest rates, the economy will contract — and the economy’s contraction will reduce the incentive to invest, so that investment actually falls.
I know that many economists just refuse to accept this proposition, which seems absurd to them. But what, exactly, is their alternative? If you believe that a cut in spending under current conditions — it doesn’t matter whether it’s public or private spending — leads to more rather than less investment, what is the mechanism? How does my spending cut give businesses a reason to spend more rather than less (other than via the confidence fairy)? Remember, interest rates can’t fall — the zero lower bound isn’t a theory, it’s a fact, and it’s a fact that we’ve been facing for five years now.
http://krugman.blogs.nytimes.com/2013/10/15/five-on-the-floor/
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