Interest Rates and Slumps: Competing Views

As Paul Krugman notes here, the nominal interest rates on U.S. Treasuries are at historic lows. He seems to take this as vindication for his view that more government “stimulus” was/is needed. (I take “stimulus” here to mean deficit-financed government purchases of goods and services.) Well, let’s think about it.

First of all, I think that Krugman (along with many others) deserve credit for recognizing that money-bond swaps (Fed policy) are largely irrelevant in very depressed environments. He (again many others too) also deserve credit for understanding the special “safe haven” role that U.S. Treasury debt plays in today’s world economy. But does understanding all this necessarily lead to the conclusion that what the economy needs is more (it never seems to be enough) government “stimulus?”

Some of our economic theories suggest that the answer is yes, while some suggest no. What Krugman is suggesting is that the latter group of theories should be discarded because their predictions on nominal interest rates have been completely wrong. He is getting a little ahead of himself here.

Unfortunately for Krugman, there are theories out there that generate predictions broadly consistent with the data but which do lead to the same policy conclusion.  One such theory is the “new monetarist” model I published for the Bank of Japan (during my visit there in 2002): Monetary Implications of the Hayashi-Prescott Hypothesis for Japan.

The basic story is this. First, it is conceivable that “real” factors are contributing to a “growth slowdown.” Here, one is free to pick your favorite bogeyman. Maybe it’s becoming more difficult to expand the technological frontier (see, for example, Tyler Cowen). Maybe it’s the fear that people (via their political representatives) will become more interested in appropriating wealth, rather than creating it (see, for example, The Grabbing Hand).  Whatever the case may be, the upshot is that people–investors, in particular–are rationally pessimistic (over the future after-tax return to their investment activities today).

In the model I used in my BoJ paper (an overlapping generations model), rational pessimism generates a “flight to quality”–people begin to substitute government money/debt for private assets. The effect is deflationary (driven by the increase in real money demand). The economy looks like it is suffering from “deficient demand” (it is not). There is downward pressure on the real interest rate (as the demand for investment contracts). These are not crazy predictions.

In my model economy, the central bank has control over the real interest rate, and cuts in the interest rate stimulate investment and (future) GDP. When the nominal interest rate hits zero, the central bank can no longer influence the real interest rate via money-bond swaps (i.e., there is a “liquidity trap”). Real activity may be stimulated, however, by increasing the inflation target (the operation must be undertaken by the fiscal authority in my model; the monetary authority is powerless in a liquidity trap). It might also be possible for increases in G to expand GDP (as is the case in many neoclassical models). All of this is true. And yet, it does not follow that any of these “stimulus” programs are necessarily desirable (among other things, it depends on what social welfare function one adopts).

Now, I’m not absolutely sure about the empirical relevance of my little model. This is because I can think of another theory that generate predictions that are observationally equivalent to my model, and yet delivers very different policy prescriptions.

The model is the one evidently used by Krugman, DeLong, and others (Nick Rowe?). In a nutshell, recessions are caused by an increase in money (treasury) demand. That’s just like in my model. But there is a big difference. In their view (as far as I can tell), the pessimism that drives up the demand for money is attributable to “irrational” fear. And if the private sector is afraid of spending, maybe the government sector should step in and take its place.

But perhaps this is not entirely fair. There is, in fact, a literature that explains how expectations can become self-fulfilling prophesies. I could, for example, modify my model to incorporate a form of increasing returns to scale in the economy’s production technology. This could generate what economists call “multiple equilibria.” Each equilibrium is determined by expectations. If  people are optimistic, good things occur. If people are pessimistic, bad things occur. The pessimistic expectations are “rational” at the individual level, but not at the social level. There is potentially a role for policy here.

Krugman, DeLong and Rowe do not frame things in quite this way, so I’m not sure if this is what they are talking about. But Roger Farmer has been working in this area for a long time and I think his ideas are finally starting to gain some traction; see The Fear Factor.

Anyway, my basic point here is, as always, that we need to be more circumspect in our claims about what we know for sure. Beware of economists that make claims like this.

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