Professor Kimball, you argue for deep negative interest rates as a tool for monetary policy. Now the Fed has moved to raise rates. Do you think it is regrettable that the pressure on central banks to innovate in monetary policy has gone?
Central banks still should keep working hard thinking about how to expand the monetary policy toolkit. It is their job to be ready for the next recession. They shouldn’t just pat themselves on the back that the economy finally climbed out of the Great Recession and its aftermath. Things might have been worse if it hadn’t been for monetary policy innovations such as Quantitative Easing, QE. But in absolute terms it was a terrible performance for monetary policy with very bad outcomes. Next time such a performance would be totally unacceptable. I worry that central bankers think that now they figured everything out—that it is good enough to use the same approach next time.
Why was it that Quantitative Easing was implemented relatively quickly, but not deep negative rates?
The conceptual framework for Quantitative Easing was already sitting there in 2008, but the framework for deep negative rates was not ready. I hope I contributed somewhat toward getting the conceptual framework for deep negative rates ready for the next time it is needed. I worry that the concept of deep negative rates has to compete with QE in the future. If the concept had been ready in 2008, things might have played out better.
In Switzerland we have quite low interest rates already. Is the Swiss National Bank ready to go deeper?
The Swiss National Bank is very sophisticated in its understanding of negative rate policy, including what needs to be done to effectively implement deep negative rates. When I visited the Swiss National Bank in late 2016, they demonstrated a thorough understanding of my approach and my arguments. But, as they emphasized, the Swiss National Bank operates under serious legal and political constraints. That there could be a referendum on anything is very much on their minds.
In June Swiss people will vote on such a referendum. The proponents of «Vollgeld» – similar to 100%-reserve banking – want to prohibit banks from creating money when issuing new loans. What is your opinion on that?
I don’t have any objection in principle against this initiative. In theory, as long as the central bank creates enough base money to keep the overall money supply the same, such a proposal can work. Fractional-reserve banking is mainly a way to throw seigniorage to the private banks. In 100%-reserve banking, the government keeps all the seigniorage for itself. Implementing such a reform will take an adjustment process. There are unknowns, but to experiment with theoretically reasonable things might be valuable. On the other hand, there is more cautious and also reasonable view «If it isn’t broken, don’t fix it.»
I think the Swiss people might not like the idea to be part of an experiment in monetary policy.
Presumably somebody thinks there is an upside to 100%-reserve banking, or they wouldn’t be advocating it. Why do people advocate a «Yes» vote on this referendum?
One argument is that it makes the financial system safer as bail-outs of banks would not be necessary anymore.
I wish they would devote their energies to something that can do a lot more for the safety of the financial system than that! If you want to make the banking system safer, you should advocate dramatically higher capital requirements. I explain this to my students with toppling dominoes. You can compare the ratio of capital to a bank’s balance sheet to the width of a domino. If a bank has only 3% equity relative to your balance sheet, that’s comparable to a very thin domino and it falls over easily. If you have 30% equity, that would be a very fat domino which would not fall over easily. Even if one falls over, it will not propagate the same way, as other dominoes will not be affected so easily.
You argue for a very active monetary policy which could result in large swings of interest rates. Would it not make sense to aim for stable interest rates?
The goal for monetary policy is not to stabilize interest rates, but to stabilize prices and employment. Stable prices and low unemployment are the things which matter for economic welfare. Forward guidance by central banks is much less necessary if they say that there could be large swings in interest rates for short periods of time whenever needed. Central banks have a desire to smooth interest rates – and I strongly believe this is misguided.
But financial markets react strongly even to small changes in rates.
Central banks are cognitively captured by the financial industry in their concern with having smooth interest rates. Those in the financial industry want to have a placid life. They would have to get used to large movements in rates. The economy overall ought to be more stable after people get used to this new style of monetary policy. If interest rates move, it would be for a short period of time. Once people understood that, they would react less strongly to any given movement in interest rates. Today every quarter point move signals a big changes in the path of interest rates for the future. In my proposal, people would infer less for the future path of interest rates from interest rate movements now. They would not have to read the tea leaves so carefully.
What role does the exchange rate play in your ideal monetary policy framework? The SNB is looking at the exchange rate when conducting monetary policy.
What applies to the interest rate also applies to the exchange rate. It should not be a goal for monetary policy. When there are shocks to the exchange rate because of capital flows, a central bank would need to react to that. But this is not because of what happens to the exchange rate, but because of what happens to prices and unemployment.
In one of your papers you argue that monetary policy should take technological progress into account. Why should central banks think about such long-term developments as technological progress?
Shocks to technology, which are defined as unpredictable movements in productivity, can matter in the short term. Real business cycle theory is an extreme which argues that business cycles are mostly caused by technology shocks. I don’t believe that. But I think technology shocks matter in the short run. There are substantial fluctuations in technology.
How can that be?
One might think that technology improves only gradually. The data seems to say otherwise. There can be speedy changes in technology. What shows up as a technology shock in the aggregate data is not the invention of new things, but rather the adoption of a new approach by a large share of businesses in some sector of the economy. Economists define technology very broadly. It doesn’t have to be high tech, it can be any new way of organizing production that allows more output to be produced with the same inputs or the same amount of output to be produced by fewer inputs. Adoption follows an S-shaped curve: First there are only a few early adopters, but later on the adoption curve becomes very steep.
That means at one point in time there can be rapid changes in technology?
Robert Solow said in 1987, you can see the computer revolution everywhere but in the productivity statistics. But the productivity growth was coming later. For example, the spread of e-mail allowed a bigger span of control. One manager could have more direct-reports. As a result, companies didn’t need as many levels of managers, and many mid-level managers became obsolete.
Another nice example of a big change in technology that is easy to understand is the containerization of shipping. Having standardized containers that could go straight from ships to the back of a truck dramatically improved the efficiency of transporting goods.
What is the right response of monetary policy to an improvement in technology?
If you need less factor inputs to produce the same economic output, you can have the same output with fewer people, which would create unemployment. Or you can produce more with the same level of employment and overall, people are richer. Monetary policy determines if a major technology improvement leads to unemployment or not.
So the effects of technological change on employment can be neutralized by central banks?
Even if monetary policy is done right, there will be shifts in employment and pains of adjustment. Some people need to find new jobs as sub-sectors made obsolete by technological improvements need less labor. Some people’s wages will go up and some people’s wages will go down. But it is completely unnecessary for technological improvement to create more unemployment overall. If there is an increase in unemployment overall after a technogical improvement, the central bank hasn’t done enough to increase aggregate demand when facing increased aggregate supply.
Did central banks do this wrong in the past?
In theory, improvements in the efficiency of producing machines should result in a stronger boom, because investment should increase. But the US data do not show this: There is a larger improvement if there is an improvement in producing non-durable consumption goods. One plausible reason for this is that the Fed was staring at the consumption deflator. If productivity in manufacturing nondurable consumption goods goes up, consumer prices fall and the Fed shifts to a more expansionary monetary policy. A comparable reduction in the prices of machines for factories didn’t show up as a decline in the consumption deflator, so the Fed underreacted, leading to unemployment.
So they did not do the right thing in response to improvements in the productivity of producing investment goods such as machines?
Right. Theory tells us that prices of investment goods should be more important for monetary policy than their share of GDP would seem to indicate. But a central bank staring only at the consumption deflator is treating investment goods as less important than their share in GDP would suggest.
Unfortunately, the literature on sticky prices, which is an important basis for monetary policy, have emphasized the importance of consumer goods prices and neglected investment good prices. Also, most models of optimal monetary policy don’t have investment goods in them at all. This is a big problem with these models.
So what has all this meant for how monetary policy is done in practice?
Central banks have to keep the price level stable. But what the US data shows is that after a technology improvement inflation typically went down. Inflation shouldn’t go down, if a central bank is doing the right thing. Inflation should be stabilized. It is a monetary policy mistake to have inflation decline after a technological improvement. There are a lot of early warnings that a technological improvement is coming if central banks look carefully. Due to the S-shaped adoption curve, you see early on when firms first start to adopt new technologies. You should be able to see early adoption a couple of years before the steep part of the S-curve when a technology quickly becomes widespread.