The Great Clusterfuck

What Caused Great Recession? Household Deleveraging or ZLB? by David Beckworth

Stephen Williamson Gets Stuck at the Zero Lower Bound by David Glasner

bubbles (updated)

Secular Stagnation, Coalmines, Bubbles, and Larry Summers by Krugman

Bubbles Are Not Funny by Dean Baker

Bubbles, Regulation, and Secular Stagnation by Krugman (Sept. 25, 2013)

Need to increase demand to achieve full employment without bubbles or above moderate inflation. Inflation will help with deleveraging. Increase demand via more exports. Via monetary policy (see Abenomics). Via fiscal policy. State and local governments are now small tailwind. Federal has the sequester but deficit/debt no longer and issue so probably less austerity going forward. Via supply (shorter hours) and organized labor.

zero lower bound / liquidity trap & the monetary base

ZLB Denial by Krugman

Yes — if back in 2007 you denied the existence of liquidity traps, that is, denied that the zero lower bound on short-term interest rates places limits on monetary policy, you should long since have acknowledged that you were very, very wrong: 

Since late 2007 the monetary base has risen more than 300 percent, while GDP and consumer prices have risen less than 20 percent. And no, the disconnect is not all due to the 0.25 percent interest rate the Fed pays on reserves.

You can argue that the Fed could have done more — it could have expanded its balance sheet even further, and/or moved into riskier assets, and/or done more to change expectations. But I don’t see how you can deny that making monetary policy effective has been far harder since we hit the ZLB than it was before, and that this retroactively casts great doubt on Friedman’s claims that the Fed could easily have prevented the Great Depression.

Economic History

Panics of 1792, 1796-97, 1813, 1819, 1825

Panic of 1837

Panics of 1847, 1857, 1866

Free-Banking Era (1837-1862)

The Long Depression (1873-1896)

Starting with the adoption of the gold standard in Britain and the United States, the Long Depression (1873–1896) was indeed longer than what is now referred to as the Great Depression, but shallower. However, it was known as "the Great Depression" until the 1930s.

...Many argue that most of the stagnation was caused by a monetary contraction caused by abandonment of the bimetallic standard, for a new fiat gold standard, starting with the Coinage Act of 1873.

The Great Deflation (1870-1890)

Panics of 1884, 1890, 1893, 1896, 1901

1884 - a panic within the context of the Long Depression and Great Deflation. Fun. (By the way, did you notice that the Great Deflation is dated as beginning 3 years earlier than the Long Depression and ending six years earlier?)

Panic of 1907

Such is his power that JP Morgan single-handedly organizes a private sector bailout, rescuing the American economy. In 1910, America's leading financiers decide to create a National Reserve Bank to prevent future panics from getting out of hand. The "most interesting man in the world" won't always be around to save the day, they reason.

The British Empire maintained the gold standard until Franz Ferdinand's assassination and the onset of World War I.

By the end of 1913, the classical gold standard was at its peak but with the advent of World War I in August 1914, many countries suspended or abandoned the gold standard. According to Lawrence Officer the main cause of the gold standard’s failure to resume its previous position after World War 1 was “the Bank of England's precarious liquidity position and the gold-exchange standard.” A run on sterling caused Britain to impose exchange controls that essentially neutered the international gold standard; convertibility was not legally suspended, but gold prices no longer played the roles that they did under the Classical Gold Standard.

David Glasner argues

According to the Hawtrey-Cassel explanation, the source of the crisis was a deflation caused by the joint decisions of the various central banks — most importantly the Federal Reserve and the insane Bank of France — that were managing the restoration of the gold standard after World War I.

The earlier countries left the gold standard, the earlier they exited the Great Depression. There was also the fiscal government stimulus of arming for World War II.

The Bretton Woods system (1944-1971)

Triffin's Dilemma

In 1960 Robert Triffin, Belgian American economist, noticed that holding dollars was more valuable than gold because constant U.S. balance of payments deficits helped to keep the system liquid and fuel economic growth. What would later come to be known as Triffin's Dilemma was predicted when Triffin noted that if the U.S. failed to keep running deficits the system would lose its liquidity, not be able to keep up with the world's economic growth, and, thus, bring the system to a halt. But incurring such payment deficits also meant that, over time, the deficits would erode confidence in the dollar as the reserve currency created instability.

The rise of Japan and Europe.

In the late 1960s, the dollar was overvalued with its current trading position, while the Deutsche Mark and the yen were undervalued; and, naturally, the Germans and the Japanese had no desire to revalue and thereby make their exports more expensive, whereas the U.S. sought to maintain its international credibility by avoiding devaluation.[21] Meanwhile, the pressure on government reserves was intensified by the new international currency markets, with their vast pools of speculative capital moving around in search of quick profits.[20] 

In contrast, upon the creation of Bretton Woods, with the U.S. producing half of the world's manufactured goods and holding half its reserves, the twin burdens of international management and the Cold War were possible to meet at first. Throughout the 1950s Washington sustained a balance of payments deficit to finance loans, aid, and troops for allied regimes. But during the 1960s the costs of doing so became less tolerable. By 1970 the U.S. held under 16% of international reserves. Adjustment to these changed realities was impeded by the U.S. commitment to fixed exchange rates and by the U.S. obligation to convert dollars into gold on demand.

Nixon cancels the dollar's direct convertibility into gold.

Stagflation

Misery Index

Okun found by adding the unemployment rate to the inflation rate.

1 percent inflation better than 4 percent inflation? Really? Deflation reduces misery? Really?

Misery Index (band) - a deathgrind band from Baltimore, Maryland

Jimmy Carter and Ronnie Raygun deregulate as a means to promote growth (or what their wealthy campaign contributors want). Carter's deregulation and inflation czar was Alfred E. Kahn. Reagan signals war on organized labor by breaking PATCO. Income redistributes upwards. Volcker breaks inflation and tosses many people out of work.

Kahn's strong advocacy of deregulation stemmed largely from his understanding as an economist of marginal-cost theory. In his time at the New York Public Service Commission he was instrumental in using marginal costs to help price electricity and telecommunications services; this was novel at the time but is routinely performed today.

Deregulation (privatization)

LBJ privatizes Fannie Mae (housing)

Jimmy Carter's Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) phased out a number of restrictions on banks' financial practices, broadened their lending powers, allowed credit unions and savings and loans to offer checkable deposits, and raised the deposit insurance limit from $40,000 to $100,000 (thereby potentially lessening depositor scrutiny of lenders' risk management policies). 

In October 1982, U.S. President Ronald Reagan signed into law the Garn–St. Germain Depository Institutions Act, which provided for adjustable-rate mortgage loans, began the process of banking deregulation, and contributed to the savings and loan crisis of the late 1980s/early 1990s. 

In November 1999, U.S. President Bill Clinton signed into law the Gramm–Leach–Bliley Act, which repealed part of the Glass–Steagall Act of 1933.

W. Bush attempts to privatize Social Security but fails.

Obama makes noises about "reforming" Social Security (via price index) and Medicare but hasn't yet. 

Obamacare incomplete (far from it) step in right direction towards single-payer.

Creation of Consumer Finance Protection Bureau 

Krugman says real interest rates were above historic norms during the 80s and 90s.

Savings and loan crisis (1980s)

Black Monday (1987)

Early 1990s jobless recovery Unlike Volcker's recovery, similar to subsequent recoveries after the dot-com and housing bubbles.

Japanese asset price bubble (1980s)

Lost Decade (Japan, 1990s-)

Abenomics

End of the Soviet Empire. West Germany absorbs East Germany. China abandons Marxism, embraces Capitalism. TINA.

European common currency (1 January, 1999)

Swedish banking crisis (early 1990s)

Latin American debt crisis (late 1970s and 80s)

1994 crisis in Mexico Improvised bailout of U.S. banks works.

1997 Asian financial crisis Harsh IMF-imposed structural adjustment programs (courting "investor sentiment") don't work well. China resolves to build up reserves even as its capital controls helped it avoid currency run.

1998 Russian financial crisis

Dot-com bubble followed by jobless recovery in 2000s

Argentine crisis of 2001-2002

US housing bubble (2002-2006)

Global financial crisis of 2007-2012

European Feedback Cycle of Doom

Republicans in Congress push sequestration and fiscal austerity while the Fed maintains ZIRP and quantitative easing.

Liquidity Trap

There Is No Liquidity Trap: Understanding 21st Century Monetary Policy by Joseph E. Gagnon

(via DeLong)

Andy Harless comments on Japan and the liquidity trap:

These fancy-schmancy DSGE models just lead to confusion. I have a pretty good intuitive idea of what's happening in Japan. There is a hypothetical bad equilibrium -- essentially a speculative bubble with money as the bubble asset, although, since money is the unit of account, most people think of the bubble as a "loss of confidence" in everything except money -- but you never really get to the bad equilibrium (we kind of did in 1929-1933, until devaluation popped the bubble), because central banks (which either won't or can't do what's needed to pop the bubble) stir up the water as much as possible to avoid moving toward equilibrium, and also because nominal wages are sticky downward, which slows down the progress of the bubble, and also probably because, if the bubble were allowed to progress, people would eventually realize that it's silly to hoard an asset without intrinsic value. (The 1929-1933 contraction was essentially a bubble in monetary gold. I imagine that bubble would eventually have ended on its own, as people realized how ridiculous the value of gold was getting relative to everything else, but it might have taken a whole lot of deflation to get to that point.) The ability to capture my intuition in an DSGE model is limited, because we're always far away from the actual bad equilibrium. Maybe a DSGD model, but that's even more confusing.

Krugman vs. Noah Smith: the first rule of macro is that it's folly to disagree with Krugthulhu

Japan and the liquidity trap by Noah Smith (July 16, 2013)

Wage-Price Flexibility in a Liquidity Trap, Again Again Again by Krugman

Japan's stagnation: demand-side or supply-side? by Noah Smith (July 15, 2013)

ZLB and safe assets

Why is There Still a Shortage of Safe Assets? by David Beckworth

Still can't make sense of this.

The Liquidity Trap and Macro Textbooks by Simon Wren-Lewis

Recovery in their time by Ryan Avent

Based on this Mr Crafts reckons that central-bank independence could be self-defeating at the zero lower bound. That's interesting, and quite a different argument from the more common recent case against central-bank independence: that at the zero lower bound (and especially when banking systems are in trouble) the central bank needs fiscal help to get the transmission mechanism operating. But is it right? 

When I look at the Fed, for instance, I see three possible ways in which the "foolproof way" has failed to win support. One is an intellectual failure: central bankers may have learned and even supported the foolproof strategy when applied on other economies or in other time periods, but when the solution is put to them as policymakers they are reluctant to abandon inflation targeting, presumably because they perceive the gains to low and stable inflation to be so substantial. In this case, the problem with the foolproof method is that it has not been tried. 

A second possibility is that the Fed has in fact done quite a lot to signal to markets that inflation expectations should be higher. But it has failed to raise inflation expectations much above 2% because of the credibility it has earned as an inflation fighter and the time inconsistency problem mentioned by Mr Crafts. In this case a reduction in political independence may improve central bank policy. 

But a third possibility is that the central bank recognises and would like to try the foolproof strategy but feels constrained by the government, presumably because there is a strong domestic political constituency against higher inflation. In an older population, for example, where the old are generally net creditors and more politically active than young debtors, resistence to higher inflation could be strong. In this case the problem is that the central bank isn't politically independent enough. 

I don't know which problem afflicts which economies. I would have said that Japan falls into the third category; perhaps it did until something—a destabilising catastrophe for example—disturbed that equilibrium. I do appreciate Mr Crafts' reminder that we know how to escape our current doldrums, or used to at any rate.

Which Textbook Is That, Exactly? by Krugman

Floor System Paradigm Shift Genealogy*

I have an updated list here.

Jan. 2

Debt in a Time of Zero by Krugman

Jan. 7

On The Folly of Inflation Targeting In A World Of Interest Bearing Money by Ashwin Parameswaran

The end of RoRo, or is it? by Izabella Kaminska

Jan. 8

The liquidity trap heralds fundamental change by Frances Coppola

Jan. 9

Platinomics by Greg Ip

Jan. 12

On The Disruptiveness of the Platinum Coin by Tim Duy

Jan. 13

There’s no such thing as base money anymore by Steve Randy Waldman

A Trap of My Own Making by Tim Duy

Jan. 14

All Our Base Are Belong To Us (Wonkish) by Krugman

Floor Systems by Stephen Williamson

Jan. 15

Do we ever rise from the floor? by Steve Randy Waldman

All Your Base Are Belong To Us, Continued (Still Wonkish) by Krugman

Yet more on the floor with Paul Krugman by Steve Randy Waldman

Money and Debt, Continued by Tim Duy

Do sofas refute monetarism? by Nick Rowe

Currency matters, even with IOR by Scott Sumner

The Waldman-Krugman-Sumner Debate: It's the IOER Path by David Beckworth

Base money basics by Merijn Knibbe

Unifying The Fiscal And Monetary Functions: A Policy Proposal by Ashwin Parameswaran

All Your Bases and Dead Presidents Are Belong to the Government? by Cullen Roche

More on Floor Systems by Stephen Williamson

Jan. 16

Once you turn base money into short-term debt, can you go back? by Izabella Kaminska

Understanding the Permanent Floor—An Important Inconsistency in Neoclassical Monetary Economics by Scott Fullwiler


Jan. 17

All Your Base Are Belong To Us: What Is the Question? by Krugman

All Your Dorks Are Belong to This by Cullen Roche

Krugman, Kaminska, and Waldman by Scott Sumner

Monetary Policy: From Managing the Monetary Base to Setting an Interest Rate Floor by Peter Dorman

Let’s Talk About Interest on Reserves by Josh Hendrickson

Jan. 18

A confederacy of dorks by Steve Randy Waldman

THE PERMANENT FLOOR 2004 by Scott Fullwiler

Two extreme fiscal/monetary worlds by Nick Rowe

AND NICK ROWE IS THE LATEST ECONOMIST TO JOIN THE INARTICULATE DORKS... by Brad DeLong

The Coin is Dead! Long Live the Coin! by Michael Sankowski

Furthering Understanding of the Permanent Floor by Joshua Wojnilower

Shinzo and the Helicopters (Somewhat Wonkish) by Krugman

Jan. 19

Waldman Thinks Bernanke Will Go for (Flawed) Exit #1 by Robert Murphy

Murphy of the bad inflation bet, I think.

Jan. 28

Safe Assets and Financial Crises by Carola Binder

19JAN

---------------------
*provisional. Times are not sorted.

the complete Floor System timeline link list

Updated: This is outdated. Go here for the complete list.


Debt in a Time of Zero by Krugman

Platinomics by Greg Ip

On The Disruptiveness of the Platinum Coin by Tim Duy

There’s no such thing as base money anymore by Steve Randy Waldman

Floor Systems by Stephen Williamson (links to Waldman)

Currency matters, even with IOR by Scott Sumner (H/T Tim Duy)

The Waldman-Krugman-Sumner Debate: It's the IOER Path by David Beckworth

[I bracketed these links off because neither Krugman nor Waldman engage with or link to them. Update: Waldman did respond. see below.]

All Our Base Are Belong To Us (Wonkish) by Krugman

Do we ever rise from the floor? by Steve Randy Waldman

All Your Base Are Belong To Us, Continued (Still Wonkish) by Krugman

Yet more on the floor with Paul Krugman by Steve Randy Waldman

Money and Debt, Continued by Tim Duy

Once you turn base money into short-term debt, can you go back? by Izabella Kaminska

All Your Base Are Belong To Us: What Is the Question? by Krugman

Update:

A confederacy of dorks by Steve Randy Waldman (lots of links therein)

All Your Base Are Belong To Us: What Is the Question? by Krugman

My questions involve whether interest on excess reserves changes any of the fundamentals of monetary policy and its relationship to the budget. That is, does IOER change the fact that the Federal Reserve has great power over aggregate demand except when market interest rates are near zero, and the related fact that when we’re not in a liquidity trap there is an important distinction between debt-financed and money-financed deficits?

Reading Izabella Kaminska with Krugman's focus in mind:

For the record, FT Alphaville has long argued that IOER’s role as a sterilisation tool is under appreciated. (This, by the way, is why we believe it’s naive to argue that ECB liquidity operations are somehow less inflationary than Fed operations. Both are in reality sterilized.) 

It’s the icing that entices banks to hold excess liquidity rather than chasing secured loans or safe assets. This is needed to compress rates during a crisis — that is, to bolster secured (collateralised) rates so that they don’t plunge below zero and therefore distance themselves from positive, near-zero unsecured rates. 

This is important because banks that are frozen out of the unsecured market depend almost entirely on private collateralised markets for funding. 

If a bank can’t borrow unsecured for less than 5 per cent even when official rates are at zero, it has three options: 1) seek emergency funds (with the associated stigma) at a punitive rate from the Fed, 2) pawn its liquid collateral at the going repo rate, or 3) in the event it doesn’t have good enough collateral, either borrow the correct collateral from the Fed or (as happened in 2008) exchange poor quality collateral for better collateral via an emergency programme.
But the problem that really struck markets in 2008 wasn’t one of insufficient liquidity. Rather, it was the problem of collateral market bifurcation. 

Banks which previously had adequate amounts of collateral for use in repo markets suddenly found their collateral unusable. This led to genuine liquidity shortfalls in some quarters, which propagated fear in the unsecured funding markets, which subsequently froze the entire market.
Banks with plenty of liquidity, on the other hand — scared of lending to potentially insolvent banks — turned entirely to secured markets instead. But here they were presented with a different problem. There were suddenly not enough safe assets to lend against, at least not at rates comparable to or better than the Fed Funds rate. 

As healthy banks began to crowd each other out for any chance to lend against a diminished pool of safe assets, and/or just opted to keep excess reserves at the Fed for zero, repo rates understandably began to tank well below target. 

The following chart from the New York Fed illustrates the story well:

[graph] 

In short, the problem wasn’t insufficient liquidity, per se. It was too much liquidity in some quarters and not enough in others. 

The challenge for the Fed was how to equalise the distribution of liquidity in the system, without putting further pressure on an already stressed-out repo market, on the verge of taking the “risk-free” funding rate negative. 

Offering interest on excess reserves was seen as an effective solution. Not only would IOER ensure that all banks holding excess liquidity could now benefit from a stable and positive rate — thus suspending the panicky capital destruction process — it would allow the Fed to continue adding liquidity until all shortfalls were covered, and more importantly all fear of potential shortfalls was removed from the market. 

In short, IOER was the key factor that compressed the spread between the risk-free and risky rate. But not because the risky rate was being suppressed. Rather, because the risk-free rate was being propped up with the IOER floor. 

Going back to Waldman’s argument, it’s at this point that “base money” became fully substitutable with short-term US debt. But, we would add, interest-bearing reserves even became preferable in some cases. 

Nevertheless, the entire debate really relates to liquidity preferences. 

The way we would put it is that IOER skewed the usual preferences in play. It’s the key reason why the proportion of reserves to currency in “base money” suddenly skyrocketed. The situation would undoubtedly reverse quickly if IOER was ever to drop to zero (or negative territory), since an opportunity cost would immediately be associated with holding reserves over zero-yielding currency. 

In fact, we would go one step further and argue that IOER was the key factor that stopped private rates turning negative, and in so doing suspended a process that could otherwise have led to a money market fund breaking the buck or even stacks of physical banknotes being hoarded and vaulted all over the United States. 

In this way, we agree with Waldman that the moment IOER created a preference for excess reserves over short-term debt assets or cash, was the moment excess reserves became a new type of safe asset security in their own right. 

Excess reserves became the equivalent of state debt. But, very importantly, a state debt taken with the intention of never being spent, but rather for the purpose of creating safe assets instead.

 On the exit strategy:

But there are other problems associated with unwinding such a huge position on the market, too. Especially if you view this as tantamount to either “spending” the money borrowed, or paying it off. 

Consequently Waldman’s argument is essentially: why bother if you don’t have to? Let the excess reserves, just like state debt, roll on:

Why go to the trouble of unwinding the existing surfeit of base money, which might be disruptive, when doing so solves no pressing problem? 

And since not moving quickly enough poses too great a risk, the alternative would be committing to IOER as a long-term rate-steering alternative instead. 

As Waldman sums up:

If the Fed adopts the floor system permanently, then the Fed will always “sterilize” the impact of a perpetual excess of base money by paying its target interest rate on reserves. As Krugman says, this prevents reserves from being equivalent to currency and amounts to a form of government borrowing. So, we agree: under the floor system, there is little difference between base money and short-term debt, at any targeted interest rate! Printing money and issuing debt are distinct only when there is an opportunity cost to holding base money rather than debt. If Krugman wants to define the existence of such a cost as “non-liquidity trap conditions”, fine. 

But, if that’s the definition, I expect we’ll be in liquidity trap conditions for a very long time! By Krugman’s definition, a floor system is an eternal liquidity trap. 

Krugman, for now, remains unconvinced. 

Waldman has opted for the cunning use of apple analogies in one final attempt to explain. But we think we’ll leave it here.

Krugman's point is that the Fed's sterilization amounts to a form of government borrowing. And in non-liqudity trap conditions there's is a limit on borrowing. He seems to be arguing against the MMT position while Kamiska and Waldman are predicting we'll be in a liquidity trap for a long time.

Less than Zero by Yglesias

Paul Krugman says he’s been a bit surprised about inflation dynamics during the Great Recession. Of course the people who thought a giant increase in the monetary base would automatically be inflationary have been proven wrong, but we haven’t seen the kind of “clockwise spiral” that would have pushed us below zero:

He attributes this to “[d]ownward nominal rigidity — the great difficulty of actually cutting wages and many prices.” I agree that this is an important factor. But I think an equally important role is being played by the Federal Reserve’s meandering behavior. As Krugman has shown elsewhere, monetary policy near the zero bound is all about expectations and credibility. What I think’s happened is that with Ben “Making Sure ‘It’ Doesn’t Happen Here” Bernanke at the helm, the Fed has successfully embedded the expectation of non-deflation. People (or at least the people who matter) know that the Fed will push the panic button and show Rooseveltian resolve to set things aright. But contrary to what I would have expected three years ago, he’s shown no inclination to reach into the Helicopter Ben toolkit to actively reflate a depressed economy that’s not teetering on the brink of a deflationary spiral. So we kind of bounce along, with no new disasters really striking after the terrible winter of 2008-2009 but no catchup and real recovery either.

Through the Zero Bound
(maybe this is the way to get back to my "real" timeline)

Wikipedia entry on the Fisher equation.

Irving, Maynard and Me (Wonkish) by Krugman

I know Krugman has discussed Fisher favorably before.

Why Hasn't the Fed Lowered the Rate It Pays on Reserves? by Mark Thoma


Ryan Avent tweets: "Maybe the Fed should open retail banking locations branded "The Discount Window", offering loans to individuals at negative interest rates."


Deflation and the Fisher Equation by William T. Gavin, Vice President and Economist at the St. Louis Fed (Oct. 2010)

[St. Louis Fed President] Bullard Warns Additional Stimulus Risks Emergence of 1970s-Style Inflation

If [Europe] blows up in a big disorderly way, which is what everybody is worried about, then that could come back to haunt the U.S.," he told CNBC. "If it just kind of tumbles along for a long period of time, which is the most likely outcome, then I am not sure you would get much feedback to the U.S.”

So Europe could blow up but the Fed shouldn't take out insurance? Makes no sense. Richmond Fed President Lacker also see risk of runaway inflation where none exists.

Republican candidate Herman Cain and President of Godfather's Pizza was on the Kansas City Fed's board of directors which explains a lot.

Why does Missouri get two Federal Reserve Banks? Because at the creation of the Fed, the Susan Collins / Olympia Snow holdout was from Missouri.


"You Say "Fischer Effect Under Delfationary Expectations," I Say "Liquidity Trap" by Daniel Kuehn

One thing I've been pondering more and more lately is "how long do you keep spending time discussing this with people who don't get it?". There are lots of people who get it who just have a problem with the whole Keynes packaging and perhaps some of the politics that go along with Keynesianism - many of the NGDP targeters are like this. But I read this post by Glasner, and I know he is worried about the same problem as I am, and that he has basically the same solution. But many people don't get it - do we still invest time in interacting with them, even if we're heading towards a double dip?? I think you still do.

Tony Crescenzi of PIMCO writes:

Irving Fisher developed a theory about the relationship between nominal and real (inflation-adjusted) interest rates determined by borrowers and lenders. When borrowers and lenders agree upon a nominal interest rate, they have an expectation of inflation but do not know what inflation will be realized over the term of their agreement. As inflation is assumed to be unknown, the nominal interest rate has therefore a component of an expected real interest rate and expected inflation rate. This became known as the “Fisher equation” that says when expectations of real rates and inflation change, nominal market and contractual rates change.

Recently, St. Louis Fed President Bullard used the Fisher equation to identify two combinations of nominal rates and inflation known as “steady states,” one of which occurs in the absence of any shocks, where nominal rates remain in a “steady state.” In cases where the inflation rate is either very low or negative, nominal short-term rates can move to an “unintended steady state.” Figure 1 from the St. Louis Fed shows these steady states occurring where the Fisher relationship crosses the line representing the Taylor rule.   

With the policy rates near zero percent in the developed world and inflation expectations now at around 3% (as measured by the five-year break-even rate on inflation-indexed bonds five years forward – a fancy way of looking past current inflation to where markets believe inflation expectations will be in five years looking five years out) global central bank rates (except for Japan) are currently in-between steady states as depicted in Figure 1. However, unlike what the Fisher equation would describe, even with firmer inflation expectations it has become less natural for nominal policy rates to adjust higher. When the sovereign debt crisis intensified, the construct of the policy rate became further embedded into the real interest rate demanded on government bonds. Since the debt crisis enforces severe austerity onto economies, a risk of deflation remains high and could increase expectations of higher future real borrowing costs. According to the Fisher theory, the borrower and lender would have to agree to a new nominal rate that could be significantly higher. With much higher debt levels and lower growth, higher nominal rates may carry greater risk of insolvency and cause financial instability.

Izabella Kaminska at FT Alphaville on September 14:

Why cutting IOER Could Be Suicidal

As we’ve noted, the introduction of the FDIC fee in April eliminated a very well exploited arbitrage for banks, which saw them borrowing cheaper than 25bps (the IOER rate) from Agencies, who did not have access to IOER, and parking the cash at 25bps at the Fed. The difference was a risk-free profit, and helped to keep the Fed funds in and around 25bps. The FDIC fee ate into those profits, however, discouraging banks from conducting the trade — a fact which immediately put negative pressure on repo rates.

The FDIC fee, however, doesn’t apply to foreign banks, which means they are the main ones left exploiting the IOER arbitrage. Cut the IOER, and that kills that trade, says RBC:
...

To think of it another way, it would introduce a cost on money.

Which of course is possibly what the Fed wants to do to encourage the money to flow into the real economy — but it also runs the risk of kicking off a deflationary spiral that will be impossible to stop, especially if market expectations catch up with Fed thinking as regards deflation risks.

As Lars Svensson, deputy governor of Sweden’s Riksbank,  noted in a paper in December 2003:

Nominal interest rates cannot fall below zero, since potential lenders would then hold cash rather than lend at negative interest rates. This is the socalled “zero lower bound for interest rates.”
The problem is that the economy is then satiated with liquidity and the private sector is effectively indifferent between holding zero-interest-rate Treasury bills and money.

In other words, money loses the unique characteristic that makes it the optimum liquid instrument for exchange. It loses velocity and instead becomes a store of value.

People don’t differentiate between it and zero-interest-rate Treasury bills.

Vaults of the stuff would accumulate, leading to legislation possibility prohibiting stockpiling or a ban on reserve convertibility into banknotes (a ban which never happened during the Great Depression, and which some say made the crisis worse).

"Sterilization" is basically the Fed keeping the money supply or velocity of money unchanged even though it's is giving money to the banks and providing liquidity it is cancelling it out at the government level. The private market becomes more liquid, the government less so as it "retires" debt so the overall liquidity level of the economy remains unchanged?

DeLong sends us to Miguel Almunia, Augustin S. Bénétrix, Barry Eichengreen, Kevin H. O’Rourke, and Gisela Rua: 18 November 2009:

The effectiveness of fiscal and monetary stimulus:

There is one important source of information on the effectiveness of monetary and fiscal stimulus in an environment of near-zero interest rates, dysfunctional banking systems and heightened risk aversion that has not been fully exploited: the 1930s.... [W]here fiscal policy was tried, it was effective.

...
Cross-country comparisons can thus help us untie the Gordian Knot and move the debate from the realm of ideology to that of evidence. Our project therefore focuses on assembling annual data on growth, budgets and central bank policy rates, mainly from League of Nations sources, for 27 countries covering the period 1925-39....

The details of the results differ, but the overall conclusions do not. They show that where fiscal policy was tried, it was effective. Our estimates of its short-run effects are at the upper end of those estimated recently with modern data; the multiplier is as large as 2 in the first year, before declining significantly in subsequent years....

The results for monetary policy are less robust but point in the same direction. A positive shock to the central bank discount rate leads to a fall in GDP... [that] just misses statistical significance at conventional levels.... This result is notable, given the presumption, widespread in the literature, that monetary policy is ineffective in near-zero-interest-rate (liquidity trap) conditions. On the contrary, in the 1930s it appears that accommodating monetary policy helped, by transforming deflationary expectations (Temin and Wigmore 1990) and by helping to mend broken banking systems (Bernanke and James 1991). Given the prevalence of both problems circa 2008, we suspect that the results carry over...

So ... fiscal policy gives more bang for the buck with a multiplier of 2 and monetary policy is less robust but pointing in the same direction. "Accomodating monetary policy helped, by transforming deflationary expectations and by helping to mend broken banking systems."

Ivan Werning - Managing A Liquidity Trap: Monetary and Fiscal Policy

(via DeLong)

Krugman on QE

Well, here we are: Ben Bernanke is now Master of the Universe Fed chairman, and he has just conducted an experiment — QE2 — in asset purchases. That experiment is now widely viewed as a disappointment; to the extent it worked, it did so mainly by changing expectations, and once markets realized that the Fed wasn’t actually going to sustain expansion, the expectational effects wore off.

So now we have Woodford (not a household name, but one of our leading, perhaps the leading, macro theorist working now) arguing in the FT that Bernanke needs to stop fiddling with balance sheets and start making explicit announcements about future policy. The key thing to understand, reading Woodford, is that this isn’t some shoot-from-the-hip piece, it’s the culmination of a debate that goes back more than a decade.

Meanwhile, Cullen Roche makes much the same argument, although he insists that you need MMT to make it, which would be news to Woodford (and me).

I’ve labeled this post wonkish, because it is. But this is really important. And as FT Alphaville says, all the fears about QE have been misplaced. The danger isn’t that it’s wildly inflationary; it is that it’s symbolic rather than real, at a time when we desperately need substance.

Depends on the Context

Interesting point made by DeLong in one of his Socratic dialogues that he pulled from his archives. Krugman has made this point repeatedly in his columns and blog posts when he says that we're in a "liquidity trap" or unique circumstances. A convenient aspect of the Internet is the ability to go back a year into the archives and see that DeLong and Krugman were proven correct.

DeLong writes:

Adeimantos: Once again back to Hicks (1937). When the unemployment rate is high and the nominal interest rate on Treasury bonds is very very slow, adjustment comes in the form mostly of changes in spending and only slightly in changes in interest rates--the world is then "Keynesian." But when the unemployment rate is normal or low and the nominal interest rate on Treasury bonds is near its normal levels, adjustment comes in the form mostly of changes in interest rates and only slightly in changes in spending--the world is than "Classical." That's why the title of the article is "Mr. Keynes and the 'Classics'."