“Die Hard”

It´s not about Bruce Willis´ John McLane character but about the ZLB.


The International Monetary Fund, having just downgraded its forecast for global growth, warned the assembled G20 attendees that yet another downgrade was pending. Despite this, all that emerged from the meeting was an anodyne statement about pursuing structural reforms and avoiding beggar-thy-neighbour policies.

Once again, monetary policy was left – to use the now-familiar phrase – as the only game in town. Central banks have kept interest rates low for the better part of eight years. They have experimented with quantitative easing. In their latest contortion, they have moved real interest rates into negative territory.

The motivation is sound: someone needs to do something to keep the world economy afloat, and central banks are the only agents capable of acting. The problem is that monetary policy is approaching exhaustion. It is not clear that interest rates can be depressed much further.

The solution is straightforward. It is to fix the problem of deficient demand not by attempting to further loosen monetary conditions, but by boosting public spending.

Brad DeLong:

At the zero lower bound on safe nominal short-term interest rates, an expansionary fiscal policy impetus of d percent of current GDP will:

  1. raise current output by (μ)d,
  2. raise future output by (φμ)d, and
  3. raise the debt to GDP ratio by a proportional amount ΔD = (1 – μτ – μφ)d,

where μ is the Keynesian multiplier, τ is the tax rate, and φ is the hysteresis coefficient.

It will then require a commitment of (r-g)ΔD percent of future output the service the additional debt, where r is the real interest rate on government debt and g is the growth rate of the economy. The debt service can be raised through explicit and fiscal deadweight loss-inducing taxation, through inflation–a tax on outside money balances accompanied by disruption of the unit of account–or through financial repression–a tax on the banking system but also imposes financial distortions.

That is the simple arithmetic of expansionary fiscal policy in a liquidity trap.

The question of whether and how much expansionary fiscal policy a government facing a liquidity trap should engage and then becomes a technocratic one of calculating uncertain benefits and uncertain costs.

Larry Summers:

Today’s risks of embedded low inflation tilting towards deflation and of secular stagnation in output growth are at least as serious as the inflation problem of the 1970s. They too will require shifts in policy paradigms if they are to be resolved.

In all likelihood the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates and, in extremis, further experimentation with unconventional monetary policies.

Krugman (3 years ago):

I’ve often argued on this blog and in the column that now is a particularly bad time to cut spending, because unlike in normal times, the adverse effects on demand can’t be offset by cutting interest rates. One way to highlight the point is to compare where we are now with a historical episode: the fairly large cuts in federal purchases of goods and services that took place in the early 1990s, as the US military shrank with the end of the Cold War. Here’s federal consumption and investment spending as a share of potential GDP (blue, left scale) versus the Fed funds rate (red, right scale):

Die Hard_1

The Fed could and did cut rates, helping to cushion the impact of spending cuts. It can’t do anything like this now, because the Fed funds rate has already been cut more or less to zero in an attempt to fight the effects of financial crisis.

Austerity right now is a really, really bad idea.

They all “forget” that monetary policy is the “Bruce McLane” in this story. Larry Summers evokes monetary policy experimentation “in extremis”! But that´s the present situation, when everyone else has “given up” on it!

The charts below indicate, contra Krugman (and all ZLB advocates), that it was monetary policy as defined by NGDP growth, not interest rates, that allowed RGDP growth to come back robustly from the 1990/91 recession, even while government expenditures was being crushed.

Die Hard_2

At present, tight monetary policy (despite extremely low interest rates), even if accompanied by relatively (to the 1990s) high government expenditures, is what keeps real growth compressed!

Important advice from Eichengreen

The economics profession was arguably the first casualty of the 2008-2009 global financial crisis. After all, its practitioners failed to anticipate the calamity, and many appeared unable to say anything useful when the time came to formulate a response. But, as with the global economy, there is reason to hope that the discipline is on the mend.


These developments amount to a sea change in economics. As recently as a couple of decades ago, empirical analysis was informed by relatively small and limited data sets. To be sure, analytical frameworks are still needed to help make sense of the data. But now there is reason to hope that, in the future, economists’ conclusions and policy advice will be shaped not by those frameworks’ elegance, but by their ability to fit the facts.

Eichengreen weighs in on the “ Control of the Fed debate”

I think the tell tale paragraphs are these two:

These reforms reflected an overwhelming consensus that the Fed had been derelict in fulfilling its duties. It had failed to prevent the money supply from contracting in the early stages of the Great Depression. Heedless of its responsibilities as an emergency lender, it had allowed the banking system to collapse. When financial stability hung in the balance in 1933, the Reserve Banks’ failure to cooperate prevented effective action.

Given such incompetence, it is not surprising that subsequent reforms were far-reaching. But these reforms went in precisely the opposite direction from today’s proposed changes: fewer limits on policy makers’ discretion, more power to the Board, and a larger role for the New York Fed, all to enable the Federal Reserve System to react more quickly and robustly in a crisis. It is far from clear, in other words, that the right response to the latest crisis is an abrupt about-face.

A few months back, Ryan Avent made a clear statement:

We can debate whether the Fed has the right target or not; that’s an open and interesting question on which there are plenty of views worth considering. Do you know what’s not up for debate? Whether what we have experienced in America over the last few years represents good monetary policymaking. It doesn’t. Setting a public target, consistently missing that target, projecting that the target will be consistently missed in future, and conducting policy so as to make sure the target is in fact missed: that is lousy monetary policy making. And I cannot understand why the Fed does not see this record as detrimental to the recovery and highly corrosive of the Fed’s credibility.

The Fed needs a change in behaviour, a change in target, or a change in personnel.

HT Becky Hargrove