Does the zero bound bind?

Paul Krugman argues that being in a liquidity trap reverses many of the usual rules of economic policy. Virtue becomes vice: attempts to save more actually make us poorer, in both the short and the long run. Prudence becomes folly: a stern determination to balance budgets and avoid any risk of inflation is the road to disaster. Mercantilism works: countries that subsidise exports and restrict imports actually do gain at their trading partners’ expense. For the moment — or more likely for the next several years — we’re living in a world in which none of what you learned in Econ 101 applies. According to Krugman, you’re in a liquidity trap when conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero. Although there are other things central banks can do, the reality is that unconventional monetary policy is difficult, perceived as risky, and never pursued with the vigour of conventional monetary policy. The point is that while you can think of things the Fed can do even at the zero lower bound, that lower bound is in practice a major constraint on policy. And by that criterion, essentially the whole advanced world, accounting for 70 percent of world GDP at market prices, is in a liquidity trap.

Ryan Avent writes that he is increasingly convinced that it is the commitment of a central bank to continue stimulating that is important, rather than the room that central banker has to cut rates. The determined central banker doesn’t blink at 0%; he or she simply switches policy tools. And if this is right, then perpetuation of zero lower bound idea simply provides cover to central bankers who aren’t willing to continue easing. That’s a decision which should be justified on policy grounds, not chalked up to some imagined constraint.

Sloped Curve takes market rates to suggest that Paul Krugman is wrong about the liquidity trap argument. Krugman is taking the fact that the US is in a liquidity trap for granted, and that the US is wrestling with the zero-lower-bound for interest rates, even though there are obvious reasons for why you would argue that the US is not in or near a liquidity trap. The economic actors are not exposed to 0% interest rates. No final loans to private individuals or companies are made at or near a 0% interest rate. There is another phenomenon, that is not a liquidity trap, but that can also create disinflation and even short-lived deflation. The phenomenon is a credit crunch. The difference between a liquidity trap and a credit crunch is that in a liquidity trap people have ample access to cheap credit and still choose to not borrow money, while in a credit crunch people do not borrow money either because they can't or because they view borrowing as too expensive.

Scott Sumner writes that the problem with second best policies is that they are usually implemented by third best economists and achieve fourth best results.   If central bankers don’t do their job how can we keep fixing the problem with all these second best policies, whether they are fiscal stimulus, bank bailouts, or threats of protectionism.  In previous posts, Summer has consistently argued that central banks continue to have plenty of options for boosting the economy after the federal funds rate neared 0%.

Nick Rowe writes that if the zero lower bound were such a problem he would have expected both Australia and New Zealand to have done much better than Canada. The Bank of Canada hit the notorious "Zero Lower Bound" on nominal interest rates (or felt it had). That's supposed to matter. A central bank that hits that constraint cannot loosen monetary policy enough to offset a decline in aggregate demand. The Reserve Banks of Australia and New Zealand didn't even come close to the lower bound. So seeing how the otherwise similar Australia and New Zealand did compared to Canada should tell us if the ZLB matters. Australia seems to have done better than Canada, which fits the theory. But New Zealand seems to have done worse.

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