On Friday (February 7, 2014), Bill Woolsey posted a serious discussion of my proposal to eliminate the zero lower bound on his blog. Overall, Bill’s review is quite positive. First, he agrees that eliminating the zero lower bound would allow central banks to bring trend inflation down to zero. Here is Bill’s account of my reasoning:
Kimball also says that electronic money will end inflation. Here he depends heavily on the notion that the reason for having trend inflation is to keep nominal interest rates higher on average and reducing the chance of hitting the zero nominal bound. In other words, again, the "problem” with zero trend inflation is that it interferes with central banks’ “business as usual." That is, focusing on periodic changes in a short and safe interest rate.
Bill emphasizes the significance of what he calls a ”‘bills-only’ monetary policy.“ That is, under my proposal "A central bank can focus on a short and safe interest rate,” making it possible to conduct monetary policy
- by open market operations involving 3-month Treasury Bills or the equivalent, along with correspondingly
- changing the interest rate on reserves held with the central bank, and I would add
- changing the central bank’s lending rate and
- changing my systems novel policy lever: the paper currency interest rate created by a crawling peg exchange rate with electronic money.
Although I think we agree on the value of eliminating the zero bound, Bill and I disagree about the optimal monetary policy after that constraint is removed. Bill also questions whether every recession is amenable to amelioration by appropriate monetary policy.
Returning to the Great Moderation
Bill is responding most directly to my Wonkblog interview with Dylan Matthews. Bill points out that Dylan’s title “Can We Get Rid of Inflation and Recessions Forever?” is overhyped. I agree. Indeed, I distanced myself from Dylan’s title by answering Dylan’s title question this way:
- Yes, by changing the way we deal with paper currency, we can safely have inflation hover around zero, instead of hovering around 2% per year.
- No, we can’t prevent all recessions, but we can make them short if we are prepared to use negative interest rates. If we repeal the zero lower bound, we should be able to do at least as well as we did during what macroeconomists called The Great Moderation: the period from the mid-1980s to the first intimations of the Financial Crisis that culminated in 2008.
- Indeed, with sound policy we should be able to stabilize the economy somewhat better than during The Great Moderation, both because we keep learning more about the best way to conduct monetary policy and because eliminating the zero lower bound makes it safe to strengthen financial regulation and thereby prevent some of the shocks that might cause recessions.
But I go further than Bill’s judgment that negative interest rates could “at best make potentially deep recessions that drive the nominal interest rate to zero a bit milder.” In addition to arguing that eliminating the zero lower bound plus high equity requirements for financial firms will allow us to at least the level of stability experienced during the great moderation,
Even without the ZLB, there would have been some hit from the financial crisis that ensued with the bankruptcy of Lehman Brothers on Sept. 15, 2008, but negative interest rates in the neighborhood of 4% below zero would have brought robust recovery by the end of 2009.
Are There Supply-Side “Recessions”?
Bill raises another interesting issue about the ability of monetary policy unhobbled by the zero lower bound to tame recessions. He writes:
I don’t think all recessions are associated with the zero nominal bound. Surely, there are some supply side recessions.
Actually, contrary to conventional wisdom, I am not persuaded that there are many events commonly called “recessions” that have supply-side causes, except when supply shocks led to inappropriate monetary policy responses. For example, bad (in the sense of worse-than-average) technology shocks cause outcomes much worse than recessions lasting for the same length of time, but in our AER paper “Are Technology Improvements Contractionary?” Susanto Basu, John Fernald and I find that these outcomes don’t look like typical recessions at all. Just look at the impulse responses we find from technology shocks and compare that to the typical notion of a recession. (The graphs are for positive technology shocks. Mentally flip the graphs upside down for negative technology shocks.) Terms like Tyler Cowen’s book title The Great Stagnation express well the effects of slowdowns in technological progress. The word “recession” just doesn’t capture the real-world effects of a slowdown in technological progress, either in ordinary English usage, or in NBER dating. (Let me hold off on saying more until some future post focusing on this issue.)
The other usual suspects for supply-side recessions are a recession caused by oil shocks. But my former and current colleagues Bob Barsky and Lutz Kilian argue in “Oil and the Macroeconomy Since the 1970s” that instead of being prime movers, oil price shocks are often caused by monetary policy actions. Loose monetary policy lowers interest rates, increasing the present-discounted-value of oil left in the ground to be extracted later, and so pushes up oil prices now. If monetary policy tightens thereafter, the high oil prices caused by the loose monetary policy can inappropriately get the blame for the economic contraction that results. (Those who want to dig deep into this issue should pay attention to Lutz’s other research on oil shocks as well.)
Long-Run and Short-Run Price Level Targets
Bill and I agree that even after trend inflation has been brought down to zero appropriate monetary policy will involve some short- to medium-run fluctuations in the price level. In my Slate column last Monday, “Governments Can and Should Beat Bitcoin at Its Own Game,” I write that after eliminating the zero lower bound, a central bank should “bring its inflation target down to zero over the course of 15 years and to forever afterward keep the value of a dollar in terms of goods and services within an unchanging narrow band.” I am imagining a band going, say, 5% either way in non-emergency situations, extending to maybe 10% either way in emergencies, in which the price level being targeted in the long-run could fluctuate, if necessary. One reason this is necessary is that the price level that should be targeted in the short run may be different from the price level that should be targeted in the long run. For example optimal monetary policy probably involves the short-run stabilization of a price index emphasizing (a) especially sticky prices (since the need to move sticky prices causes frictional distortions one way or the other) and (b) prices for goods that have a higher elasticity of intertemporal substitution (roughly goods whose demand is more responsive to interest rates). But for long-run planning purposes, stability of some version of the consumer price index may be most important. Differential trends can be accommodated by a trend in the short-run target price with no trend in the long-run target price. But stochastic movements in the ratio between the two price indices need to be accommodated by some willingness to let the long-run price index fluctuate within a band.
How Should Monetary Policy Respond to Supply-Side Disturbances?
When it gets to the details of how to allow the price level to vary in the short-run, Bill and I differ. But this is a disagreement about optimal monetary policy that doesn’t have that much to do with eliminating the zero lower bound. Whatever one’s views on optimal monetary policy in the absence of the zero lower bound, it should improve over optimal monetary policy when facing the extra constraint of the zero lower bound. There may be some whose preferred monetary policy cannot win out in a reasoned policy argument who need the zero lower bound to get what they want. But those of us willing to come together on a consensus or compromise monetary policy based on the outcome of reasoned deliberation among people who disagree should bet on the virtues of the outcome of such a deliberation unfettered by the zero lower bound over the outcome of such a deliberation taking the zero lower bound as a constraint.
In any case, Bill raises an issue about optimal monetary policy worth discussing. He writes:
I favor a stable price level on average, but I think that the price level should rise with adverse supply shocks and fall with favorable supply shocks. Trying to keep the price level fixed would result in deeper recessions with adverse supply shocks and tend to cause booms with favorable supply shocks, even with electronic money. Negative interest rates to prevent unusually rapid growth in productivity from causing deflation seems like a very bad idea.
The theory of optimal monetary policy is fairly straightforward on this. There are some costs from leapfrogging of sticky prices over one another. Those militate in favor of keeping an index of sticky prices steady. Aside from that, the key is stabilizing the distance of output from the “ideal” level of output that would be optimal in the absence of worries about inflation.
Technology shocks. Technology shocks are by far the most important supply shock. Technology shocks often leave the magnitude of distortions in the economy unchanged, so that the natural level of output consistent with stable inflation changes by roughly the same percentage as the ideal level of output. If the natural level of output changes in tandem with the ideal level of output, then (among non-inflationary policies) keeping the economy the natural level of output is what stabilizes the distance away from the ideal level. So (contrary to Bill’s intuition) optimal monetary policy really should accommodate increases in output driven by favorable technology shocks, and lower output driven by unfavorable technology shocks. And staying at the natural level of output typically does involve stabilizing a short-run price target for some index emphasizing sticky prices.
Oil shocks. Although actual monetary policy responses to oil shocks are probably very different from responses to technology shocks, optimal monetary responses to oil shocks are similar. As Susanto Basu, John Fernald, Jonas Fisher and I argue in “Sector-Specific Technical Change,” if terms of trade worsen, the effect the economy once all prices adjust will be just like the effects of a bad technology shock. Optimal monetary policy is likely to involve quicker adjustment toward the situation that will prevail in any case once prices adjust. Since oil prices are flexible, the quickest way to get to the relative prices that will prevail in the medium-run is to have those flexible oil prices adjust, while the short-run price index emphasizing sticky prices stays unchanged. (This is why I am in favor of the Fed’s emphasis on “core inflation,” though I think the Fed does too little to focus on the especially important prices associated with especially interest-rate-sensitive goods.)
Preference and Household Technology Shocks. Preference shocks or the shocks to the technology of household production that have similar effects would not typically change the size of distortions in the economy in a big way. So ordinarily the correct monetary policy response to them, too, would be to stay at the natural level of output.
Marginal Tax Rate Shocks, Unionization Shocks and Industrial Organization Shocks. That only leaves things like changes in marginal tax rates, unionization shocks, and what I like to call “industrial organization” shocks that change the size of the gap between ideal output and natural output by changing the level of distortions in the economy. (Even temporary deficit-financed changes in government purchases tend to leave the level of distortions unchanged if the tax changes necessary to finance them are spread out over a long-enough period of time.) Optimal monetary policy in response to such shocks could lead to some output stabilization relative to the movements in the natural level of output, and corresponding movements in the price level within its band.
Bill is much more of an advocate of free banking than I am. Like JP Koning, he makes the point that free banking would be unlikely to create a zero lower bound.
… I favor the private issue of hand-to-hand currency. As long as private currency isn’t government insured, the interest rate on central bank reserves and Treasury-bills might be quite negative before anyone decides that bank-issued currency is a better store of wealth.
It may be that by creating a zero lower bound, central banks and their early precursors have, overall, done more harm than good. But to me it seems within reach to have the benefits of central banks without the serious harm of a zero lower bound. As I wrote in “How governments can and should beat Bitcoin at its own game,”
Keeping the value of money constant over time is difficult and requires strong, capable institutions like central banks.
All the arguments that free banking gets monetary policy right seem to me only arguments that certain forces work in the right direction, not that those forces actually get things where they should be.
Suspension of Currency Payments?
Bill is much more favorable toward suspensions of currency payments than I am. He writes:
Kimball is very skeptical of suspending currency payments as a solution to the zero nominal bound. Perhaps the reason I find it less troubling is that I know that free banks in the 18th century had an option clause to allow the suspension of currency payments. Governments interfered with freedom of contract, and the option clause disappeared. But in practice, suspensions occurred regularly in the 19th century. They were just illegal.
I fully agree that suspension of convertibility between bank money and hand-to-hand currency eliminates the zero lower bound (as long as bank interest rates are allowed to go negative). But I don’t relish the thought of a jagged diffusion process for the relative price of paper money and electronic money, let alone a jagged diffusion process plus Poisson jumps. By having the central bank choose the paper currency interest rate for the next few weeks at each of its regular meetings, my recommended policy makes the exchange rate between paper money and electronic money not only continuous but differentiable on every day except the days on which the monetary policy committee meets. I very much like what Marvin Goodfriend says about suspensions:
In principle, as an alternative to imposing a carry tax on currency, banks could agree to suspend the payment of currency for deposits whenever a carry tax was imposed on electronic reserves at the central bank. Currency and deposits each have a comparative advantage in making payments. Currency is more efficient for small transactions made in person, and checkable deposits are useful for making larger payments at a distance. The respective demands for the two monies would be well-defined. The imposition of a negative nominal interest rate coupled with a suspension would cause the deposit price of currency to jump to the point that the expected negative deposit return to holding currency matched the negative nominal rate on deposits.
This mechanism is reminiscent of the temporary suspensions that occurred in the US prior to the establishment of the Federal Reserve. For instance, currency went to a few percent premium over deposits for a few months during the suspension that occurred in the aftermath of the banking panic of 1907.
Suspending the payment of currency for deposits would avoid the cost of imposing a carry tax on currency. After the initial capital gain, however, currency would bear the same expected negative return as deposits. Moreover, the proposal would involve the inconvenience of dealing with a fluctuating deposit price of currency. Furthermore, the possibility of making a capital gain on currency relative to deposits when a suspension occurs would create destabilizing speculative runs on the banking system. Such attacks would be annoying and costly for banks. Effort invested in attacking banks would be a waste of resources from society’s point of view.
Despite how leery I am about suspension of convertibility between electronic money and paper currency, it may have real importance as a threat point for relatively independent central banks that already have the legal authority for such suspensions, but do not yet have the legal authority for the policies I recommend.
I appreciate Bill’s thoughtful discussion of my proposal for eliminating the zero lower bound. In replying, I have been drawn into a useful discussion of business cycle theory and optimal monetary policy, raising many issues that I hope to address at greater length in future posts, over many years of blogging to come.
Ending recessions quickly and ending long-run inflation forever is a worthy, but limited goal. As I wrote in “Governments Can and Should Beat Bitcoin at Its Own Game”:
… make no mistake: Giving electronic money the role that undeserving paper money now holds will only tame the business cycle and end inflation. Fostering long-run economic growth, dealing with inequality, and establishing peace on a war-torn planet will remain just as challenging as they are now. But every time one set of problems is solved, it allows us to focus our attention more clearly on the remaining problems. It is time to step up to that next level.