Part one will have some fun with a golden oldie from 1998. Part two will be more serious, and might be the first journal article to come out of this blog. Nothing earthshaking, but a different way of thinking about the zero rate bound. I’ll let you guys be the referees.
Part 1. The following quotation was taken from a longer discussion of a 1978 paper (JMCB, by Joan and Richard Sweeney) that used the example of a babysitting co-op to illustrate the monetary model of recessions. The price of babysitting services was arbitrary fixed by the co-op. Who said this about their paper in 1998?
Now what happened in the Sweeneys’ co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple’s decision to go out was another’s chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.
In short, the co-op had fallen into a recession.
Since most of the co-op’s members were lawyers, it was difficult to convince them the problem was monetary. They tried to legislate recovery–passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy. Eventually, of course, the co-op issued too much scrip, leading to different problems …
If you think this is a silly story, a waste of your time, shame on you. What the Capitol Hill Baby-Sitting Co-op experienced was a real recession. Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year’s worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op’s story, to play with it and draw out its implications, it will change the way you think about the world.
For example, suppose that the U.S. stock market was to crash, threatening to undermine consumer confidence. Would this inevitably mean a disastrous recession? Think of it this way: When consumer confidence declines, it is as if, for some reason, the typical member of the co-op had become less willing to go out, more anxious to accumulate coupons for a rainy day. This could indeed lead to a slump–but need not if the management were alert and responded by simply issuing more coupons. That is exactly what our head coupon issuer Alan Greenspan did in 1987–and what I believe he would do again. So as I said at the beginning, the story of the baby-sitting co-op helps me to remain calm in the face of crisis.
Or suppose Greenspan did not respond quickly enough and that the economy did indeed fall into a slump. Don’t panic. Even if the head coupon issuer has fallen temporarily behind the curve, he can still ordinarily turn the situation around by issuing more coupons–that is, with a vigorous monetary expansion like the ones that ended the recessions of 1981-82 and 1990-91. So as I said, the story of the baby-sitting co-op helps me remain hopeful in times of depression.
That’s right; it’s Paul Krugman, back in the days he wrote for Slate.com. Back in the days when right-wing economists looked forward to reading his delightful posts. Back before he became a political analyst. You know; the sort of guy who now thinks Obama’s biggest problem is that he hasn’t moved far enough to the left. How does such a first rate international economist forget about the concept of comparative advantage?
[I know. Who am I to talk?]
My favorite parts are his counter-intuitive assertions that even if a recession seems to be caused by some sort of real factor, it is actually caused by too little money:
Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of “Capitol Hill values” or “crony baby-sittingism.” It had a technical problem–too many people chasing too little scrip–which could be, and was, solved with a little clear thinking. And so, as I said, the co-op’s story helps me to resist the pull of fatalism and pessimism.
Yes, there was a time when Krugman found it easy to avoid fatalism and pessimism. But here I can’t blame him for changing his stripes, in those halcyon days I shared his optimism that the Fed could and would, do what’s necessary to avoid a shortfall in AD.
So banking crises may appear to cause recessions (the crony remark was a reference to recent banking problems in East Asia) but the real problem is monetary. Where have we heard that idea before? Not only have I been arguing that monetary policy is the real problem, I’ve also been arguing that with each new recession most economists initially get fooled into thinking real shocks are the problem.
Krugman fans will say; “Scott, he still believes this, but only if we aren’t in a liquidity trap.” Sorry to tell you this, but he’s got that base covered too:
But what about Japan–where the economy slumps despite interest rates having fallen almost to zero? Has the baby-sitting metaphor finally found a situation it cannot handle?
. . .
The basic problem with the winter co-op is that people want to save the credit they earn from baby-sitting in the winter to use in the summer, even at a zero interest rate. But in the aggregate, the co-op’s members can’t save up winter baby-sitting for summer use. So individual efforts to do so end up producing nothing but a winter slump.
The answer is to make it clear that points earned in the winter will be devalued if held until the summer–say, to make five hours of baby-sitting credit earned in the winter melt into only four hours by summer. This will encourage people to use their baby-sitting hours sooner and hence create more baby-sitting opportunities. You might be tempted to think there is something unfair about this–that it means expropriating people’s savings. But the reality is that the co-op as a whole cannot bank winter baby-sitting for summer use, so it is actually distorting members’ incentives to allow them to trade winter hours for summer hours on a one-for-one basis.
But what in the nonbaby-sitting economy corresponds to our coupons that melt in the summer? The answer is that an economy that is in a liquidity trap needs expected inflation–that is, it needs to convince people that the yen they are tempted to hoard will buy less a month or a year from now than they do today.
But it is a bit misleading to call this proposal “expected inflation.” The price level is fixed in the co-op, one unit of script pays for one hour of baby-sitting. Rather his proposal is analogous to expected inflation. What is it actually? A negative nominal interest rate on money. Silvio Gesell’s idea, rediscovered last year by a grad student at one of those Ivy League econ PhD programs that don’t think it is worthwhile to study monetary history. And of course there are technical barriers to actually paying negative interest on currency, but not on bank reserves. Negative interest on reserves; hmmm . . . where have we heard that idea before?
Part 2. Reflections on the end of the zero rate bound.
A few days ago I did what I thought was one of my more important posts, pointing out that the Fed’s likely new operating target will eliminate the problem of the zero rate bound. There are always some misunderstandings in the comment section when I bring up negative rates on reserves. What about vault cash? What about the impact on bank profits? What if firms don’t want to borrow even at very low rates? The simple answers are vault cash can be dealt with in many ways–it isn’t a problem. And the system can be set up in a way that bank profits aren’t hurt. And the purpose of the plan is not to get firms to borrow more, but to reduce bank demand for the medium of account. This is all discussed in earlier posts like this one.
But I also anticipate some push-back from serious economists on another point. Negative interest rates on reserves would not drive free market short term rates significantly below zero. So have we actually solved the problem of the zero rate bound? The answer is an emphatic yes. But it doesn’t seem that way, and it is worth considering why.
I am pretty sure that many economists are confused about the nature of the liquidity trap. In particular, they confuse two very distinct issues:
1. The inability of the Fed to move the fed funds target lower once it has reached zero.
2. The inability of monetary policy to boost AD once rates hit zero.
Krugman and I both agree that monetary policy can still be highly effective once rates hit zero. And we both agree that conventional monetary policy is ineffective once rates hit zero, if ‘conventional monetary policy’ is defined as adjusting the fed funds target, and/or a temporary injection of reserves into the banking system. But if the Fed doesn’t use either fed funds targeting or temporary base injections as the policy lever, then monetary policy doesn’t become ineffective once short term rates hit zero. To explain this, it will be helpful to consider some potential operating targets for the Fed:
1. The fed funds rate
2. The interest rate on reserves (IOR)
3. The monetary base
4. The exchange rate (or price of gold)
5. CPI or NGDP futures targeting
Although there appear to be zero bounds on the exchange rate and the monetary base, in practice there are no limits to either policy lever. No matter how low the base or exchange rate fall, they can always be cut another 10%. Of course if you think of absolute changes there is a lower bound of zero. But if that were the exchange rate it would mean the Fed handed out free money to anyone that wanted it. I think we can assume that policy would boost NGDP (to infinity.) And as you approach a zero monetary base, you would approach hyperdeflation. So I think we can rule that one out as well, as few governments are frustrated by an inability to create hyperdeflation. Indeed few want any sort of deflation. So for all practical purposes there are no zero bounds, except for the fed funds target.
But then you might wonder; “What happens if the Fed increases the monetary base and short term rates stay stuck at zero?” Doesn’t this mean you are still stuck in a liquidity trap, even if the policy lever can still be moved around?” If you think this way, you are probably confusing the two issues I discussed above. You are probably thinking (in the back or your mind) that the fed funds rate is part of the transmission of monetary policy, and that without a lower fed funds rate you cannot get a boost in AD, in NGDP. But in fact the fed funds rate does not play an important role in the monetary transmission mechanism. When you are deciding whether to buy a new car, a new house, or construct a new office building, the last thing you care about is the nominal fed funds rate. Rather, you care about expected RGDP growth, or asset prices, or real wages, or perhaps longer term real interest rates.
So the real question isn’t whether the fed funds rate might stay at zero in response to changes in some alternative policy lever, but rather whether these alternative policy levers can boost AD. Almost everyone agrees currency depreciation is a foolproof way of boosting NGDP; the only question is whether it is politically feasible. And even Krugman concedes that increases in the monetary base that are expected to be permanent will be expansionary, even at the zero bound.
[BTW, I've never heard anyone else note that money supply increases that are expected to be temporary will have little or no impact on the price level, even if you aren't at the zero rate bound. So the question of temporary currency injections is essentially unrelated to the zero bound problem.]
But the interest on reserve lever is different from all the other policy levers discussed above. It is a policy lever that works by changing the demand for base money, not the supply. In addition, it only applies to the portion of the base that is held by banks. Thus once the IOR goes a couple points below zero, further decreases have essentially no impact on excess reserves. This is because at even a negative 2% IOR, banks will cut excess reserve holdings to the bare minimum, and further rate cuts will not have any additional impact on ER demand, or market interest rates. So isn’t that a sort of zero bound?
One answer is that changes in the IOR can have a huge impact between 0% and negative 2%, whereas the fed funds rate is already spinning its wheels at 0%. Between 0% and negative 2% almost all of the monetary base (except required reserves) moves out into circulation. But I don’t find that a satisfactory answer.
The best way to think of the IOR policy lever is that it is analogous to reserve requirements. In most money and banking textbooks reserve requirements are the only Fed tool that impacts the demand for base money, not the supply. I have a feeling that textbooks are about to change. IOR also affects the demand for base money. And just as reserve requirements cannot lower the demand for required reserves below zero, no change in the IOR can lower the level of excess reserves below zero. So again, why isn’t that a sort of zero bound to expansionary monetary policy?
The answer is that like reserve requirements, the IOR allows another degree of freedom. The Fed can still control the supply of base money. If the Fed wants to boost AD, it can lower the IOR enough to drive ERs to the bare minimum, and then any further open market purchases will go straight to currency held by the public, or to required reserves and hence the broader aggregates. And of course there is no zero rate bound problem for changes in the monetary base, which can be increased as much as the central bank wishes.
Indeed the Fed has already begun this two-track policy. They prefer to have a large monetary base for the time being, and plan to tighten by raising the IOR in the future. But the same macro objectives could be achieved through open market sales, if they so desired. They now have one extra degree of freedom. Personally, I don’t think the IOR tool is very valuable, but if it ends the silly superstitions about zero rate bounds, it will all have been worthwhile.
Perhaps the best way to summarize all this is to go back to Nick Rowe’s observation that the fed funds rate (and hence the zero bound) matter if people believe they matter. Ironically just one day before I noticed the article hinting at the Fed’s imminent policy change, Nick made this cryptic statement:
There are probably two (stable) equilibria: one in which monetary policy *is* interest rates, and we can get stuck in liquidity traps; and a second in which it isn’t, and we don’t get stuck. Social construction of reality, again, which is just an extreme form of a convention, which not only affects how we behave, but how we see the world. It defines the “social facts” of what central banks “do”.
Question: if this (above) view is correct, what exactly is it that Scott Sumner is *doing* (on this blog)? What *is* he? Not a policy advocate, in the standard sense.
And, if this view is correct, forget about trivia like cutting the overnight rate by 0.25%. Banning all public mention of the overnight rate would be a more effective policy!
It didn’t take long for the Fed to see the wisdom of Nick’s suggestion. So thank you very much Nick Rowe. Now perhaps Rasputin, I mean Nick, could do the following post:
Mr. Bernanke, look into this glass ball
Repeat after me
There is no such thing as inflation
There is no such thing as inflation
There is only NGDP
HT: Marcus Nunes