OK, I’m ready to throw in the towel. I just made the mistake of checking Drudge. His website is frequently shameless, but you have to admit he often picks up the zeitgeist. All the news about the economy is dreary. Then I looked at Bloomberg and here are the latest TIPS spreads:
5 year conventional T-bonds 1.33%, Indexed bonds 0.08%, TIPS spread 1.25%
10 year conventional T-bonds 2.50%, Indexed bonds 1.03%, TIPS spread 1.47%
Both have been falling like a stone. This suggests that a sharp slowdown in NGDP growth is very likely. Until now I’ve tried to remain an optimist, disappointed in the pace of recovery, but assuming that we were at least muddling forward. But it is now clear that we are no longer recovering.
So let’s put this fiasco into perspective. What can we compare it to? As far as I know, there are four great recessions/depressions with near zero rates:
- The 1929-33 contraction
- The 1937-38 contraction
- Japan since 1994.
- The US since 2008.
The real economy did grow after 1938, but mild deflation continued. A serious recovery only began with WWII intensifying in mid-1940. Japan never really had a satisfactory recovery, although there were some reasonably good years such as 2003-07. And of course the recovery from 1929-33 only began when the dollar was sharply devalued. The bottom line is that zero interest rate malaises don’t seem to end like ordinary recessions; short of some sort of dramatic shock like dollar devaluation or World War, they seem to linger. What can we learn from that?
Before explaining my analogy (actually Nick Rowe’s analogy) considering the following paradox:
- Near-zero nominal rates are always associated with economic malaise: a weak economy with deflation or disinflation. So we don’t want near-zero rates.
- Lowering nominal rates below zero is impossible.
- Directly raising nominal rates through monetary policy is contractionary, and will make the recession/deflation worse.
So what do we do? As you know I think there is a simple answer. Indeed I think there are lots of simple answers (massive QE, negative IOR, explicit NGDP targeting, etc.) But I think we need to face the fact that for some reason our monetary authorities don’t see it this way. They view all these ideas as exceedingly risky, as exceedingly reckless, as exceedingly expansionary.
Go back and review the history. Short of World War, the only escape from zero rate deflation was in 1933, with dollar devaluation. Your history books never gave you any idea how controversial that was. Think about this. FDR basically had the Federal government take over the economy through programs like the NIRA and AAA. They controlled almost everything. And yet there was little objection from Wall Street. People just went along. But dollar devaluation was different. It wasn’t just the conservatives who were apoplectic. The unions were opposed. FDR saw one top economic advisor after another resign in protest. And these were his supporters. The program was highly successful in raising prices (and output until the NIRA raised wages 20%), but nevertheless was the most controversial thing FDR ever did. Even more than the Court packing.
Milton Friedman once noted that ordinary people were shocked when told that unelected Fed officials were free to simple double the money supply anytime they wished. I think the same thing is true of changing the value of the dollar, as when FDR arbitrarily decided each dollar would be worth 60 cents (in gold terms.) People seem OK with interest rate targeting, but anything else seems radical. But interest rate targeting doesn’t work anymore. So we are stuck.
Nick Rowe uses the analogy of balancing a long pole in your hand. If you want the top to go left, you move your hand right. By analogy, if the Fed wants inflation/growth (and long term rates) to go up, they lower the fed funds rate. But if you bump up against a tall wall, then you may not be able to move your hand in the direction required to move the pole in the other direction. You are stuck. The only solution is to rely on some other method–such as directly grabbing the top of the pole.
The Fed needs to raise NGDP growth by some method other than lowering nominal rates. It is up against the wall. That means they need some other policy tool. It might be the printing press (QE), negative IOR, price level or NGDP targets, dollar devaluation, etc. But it can’t be done by manipulating the fed funds rate. And for some reason the Fed seems paralyzed.
I guess because I have spent my whole life studying unconventional policy tools, and because I never favored interest rate targeting in the first place, these alternatives don’t seem at all scary to me. FDR created inflation when he raised the price of gold. And the inflation basically stopped when he stopped raising the price of gold. Excluding WWII, no one has ever overshot toward high inflation coming out of a zero rate trap. That’s why Krugman and I can have such serene confidence that the inflation scare-mongers will be proved wrong. I’ve seen this movie already. Several times.
Because deflation make rates low, and leads to cash and reserve hoarding, it makes money seem really loose when it is actually very tight. Fed officials currently argue that money is very loose. They are wrong, but that’s what they think. Now we need to convince conservative central bankers, who are devoted to price stability, to take what seems like ultra-loose monetary policy, and make it far looser. The thought makes me despair. That’s why it is so tragic that Milton Friedman died in late 2006. He was a voice that central bankers would listen to. He was a respected conservative. An inflation hawk. Regarding the Japanese malaise, he said:
Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.
. . .
After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.
That’s right Dr. Friedman, it’s just too counter-intuitive for people to accept. And that’s precisely why we are fated to suffer through the Great Recession. It’s a real pity.