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Friday 12 July 2013

The two arguments why the Zero Lower Bound matters

I think it is important to distinguish between two arguments why the Zero Lower Bound (ZLB) for nominal interest rates matters. I will label these the first and second, and economists and statisticians will soon [1] see why these labels have some significance. The first argument is debatable, but the second is I believe very difficult to argue against.

The first argument why the ZLB matters is that unconventional monetary policy either does not work, or hits limits on what it can do, and these constraints bite. In short, monetary policy at the ZLB cannot fully achieve monetary policy goals. The second argument about why the ZLB matters is that the impact of monetary policy becomes more uncertain. Under the second argument, it is possible for some particular dose of unconventional monetary policy to duplicate what interest rate policy might otherwise achieve, but there is more uncertainty about what that appropriate dose is. The impact of any unconventional monetary policy action is therefore more unpredictable than the impact of conventional policy.

Much of the discussion of unconventional monetary policy involves the first argument. An important feature of Quantitative Easing (QE) is that its size is potentially unbounded - the central bank can create as many reserves as it likes. So if the impact of each unit of QE on the economy is constant, even if this constant is small, if we knew what that constant was we just scale up the programme so it has the desired effect. However, it seems to be much more likely that the policy involves diminishing returns, but to be honest I have no idea whether that means there are limits to what the policy can currently do. There are also some who worry that unconventional monetary policy has dangerous side effects on financial stability if it becomes too large. As I said, the first argument is debatable.

What seems clear to me is that we know much less about the impact of QE, or other kinds of unconventional monetary policy, than we do about conventional monetary policy. This almost follows by definition: we have well established models for conventional policy, and much more data to check these models against. What data we have also suggests the impact of unconventional monetary policy is more uncertain. (This is the conclusion drawn by John Williams, who has done a good deal of work on their impact, and I have never heard anyone argue against this view.) That is why I think it is very difficult to deny that the impact of monetary policy at the ZLB is much more uncertain compared to monetary policy outside the ZLB. [2]

Why do I make this distinction? Good policy tries not only to achieve the best outcome for the economy, but it also tries to reduce the uncertainty associated with that outcome. Indeed, we might well be prepared to sacrifice some of the former for some of the latter: uncertainty is in general undesirable. A standard way to judge the merits of a particular rule for macro policy, for example, is to ask whether it reduces the variance of output or inflation when the economy is hit by a standard set of shocks.

Let me return to an old friend. Suppose you are a doctor, and you have two medicines to treat a disease. One is reliable, but the other requires trial and error to get the correct dose, and occasionally has nasty side effects. In these circumstances, you would rather not run out of the reliable medicine. Indeed, you would want to go out of your way to avoid running out of the reliable medicine.

Seen from this perspective, it becomes almost undeniable that fiscal austerity at or near the ZLB is a dangerous policy. By making us more reliant on unconventional monetary policy it increases macroeconomic uncertainty. It makes it more likely that we will have to resort to the unreliable medicine. I think too much of the argument over whether monetary policy is all you need focuses on the first reason why the ZLB may be important, and ignores the second. [3]

[1] I was tempted to write ‘in a moment’ rather than ‘soon’, but decided a bad pun might detract from the main text.

[2] The Williams paper also elaborates on a well known idea that uncertainty about the impact of policy instruments should make policy makers cautious in using those instruments. I think this is an additional consideration, which would reinforce the point I’m making here. I also agree that good policy should take into account the characteristics of uncertainties arising from the economy, and have used this to argue - for example - that policymakers should over rather than under estimate the size of the output gap at the ZLB.

[3] This is not an argument about whether fiscal stimulus is more or less reliable than monetary stimulus, interesting though that question is. All I require is that an austerity policy reduces short run aggregate demand, which it clearly does. It also does not say that there are no circumstances in which we should undertake austerity at or near the ZLB - in theory the benefits of austerity could be so great that they outweigh the costs of putting us in a dangerous place. In the absence of a significant and rising default premium on debt, I do not think those benefits exist, but that is a separate argument.


  1. Isn't this just down to there being fewer years in which economies have been in the ZLB than not?

    I did a little search on the BBC website (as of July 7th 2013) and these are the results I got for the three men who predicted the US housing bubble and want immediate fiscal stimulus:

    Paul Krugman All Results (148)
    Joseph Stiglitz All Results (140)
    Robert Shiller All Results (17)

    However, here are the numbers on the BBC for the 3 think tanks who do not release their donor lists:

    TaxPayers' Alliance All Results (616)
    Institute of Economic Affairs All Results (309)
    Adam Smith Institute All Results (168)

    This is why, presumably, Osborne yesterday can say that opposition to his policies are "crumbling", while Krugman can write that "it’s definitely true that in sheer intellectual terms, this is looking like an epic rout" (April 24, 2013, Evidence and Economic Policy).

  2. 1. Donot believe that QE is unbounded. It is a fiatsystem it operates in (basically based on trust). 'Printing' as it usually is called can only go so far as markets in general keep trust in the system.
    You can see with the present rate of QE that trust eroding. China, Russia, Arabs are moving to other systems outside the USD and in several areas (paymentsystems, investments, reserves). Clearly not run out of hand yet, but it is a clear indication that that there are limits.
    When you start to slide downhill QE is basically useless as eg your imports wil have to be paid in then 'real money'.
    As I see it it works basically as a straight line the first part (or the part of the curve that is almost straight). Subsequently it gets real 'curvish' until it moves like most curves from horizontal to vertical (or the other way around). That is where the whole thing falls of the cliff.

    2. Monetary stimulus looks clearly to work better. QE ends up with a group of people that relatively consume little and invest mainly financially not in the real jobcreating stuff. Plus dripping down effect looks minimal. US example looks pretty clear in that respect. Monetary stimulus can be much better directed to direct real investments and consumption.

    3. Not only uncertainty. It is also imho the differences in downside risk that can be important. Risks can be substantially different. Better something can possibly go bust, but in very different ways depending if it is monetary or fiscal.
    Can put that with uncertainty, but it is not strictly that. Say only Italy would have to be saved and Germany backs that. hardly risk on the monetary front (ECB doing it) however if the fiscal alternative is more own Italian debt it will be a real risk. Examples possible in all directions.

    4. Monetary policies are easier to do than fiscal ones. The latter generally are in the spotlight, especially now. Probably one of the reasons it is done this way. Monetary policies is probably too difficult to grasp for most. Cuts, (potential)tax increases etc. are not.
    Like we see with the ECB this erodes the credibility of the CB. Credibility as having a popular platform for the whole thing. It is simply eroding at the moment. Not only btw imho by lack of democratic legitimacy.

    5. Monetary policies in general look easier to reverse. Comfort for alot of people. However the massive QE we see now will be carried with us for probably a decade or 2. As selling the stuff will lead to huge losses and makes the losses even bigger. Will be something like wait till maturity.

  3. Truly unlimited QE would be irreversible, hence would be equivalent to a credible increase in the central bank's price level target. If the central bank buys everything, then money can't continue to be a safe asset (at the old price level), since the CB would be hyper-leveraged, and also too big for a taxpayer bailout.

    Well, that's all theoretical. QE in the real world works in a very simple way: it reveals information about the central bank's intentions. It doesn't require any financial frictions to "work", since it is nothing more than non-verbal communication.

  4. A more compelling reason for me as to why the ZLB matters is that it leads to market segmentation between transaction assets and other assets:

  5. We can estimate the size of macroeconomic uncertainty by looking at market prices, for example VIX index. This exercise is very recommended, and we can see that fiscal stimulus in 2009 was potentially very powerful in reducing the macroeconomic uncertainty. On the other hand, the uncertainty is much lower today and it is very likely that slight fiscal consolidation is completely offset by monetary policy, at least in the US and UK.

  6. I have argued previously that current modelling is insufficient to deal with our present open economy. Fiscal stimulus is unlikely to be very effective. Much of the impact will be dissipated globally. It is not just the usual difficulty of pulling in imports; there is now the bigger problem of a weak investment response. British companies are likely to invest abroad to meet local demand. On top of that, I believe there is an outgoing flow of productive capital that has dominated capital formation over the recovery phase. This has progressively reduced the output gap. So in my view, the scope for expansion is more limited than might otherwise be expected.

    What to do? Inflation is less of a constraint in a globalized economy. Many domestic prices are determined internationally, giving less scope for domestic inflationary expectations. This should allow for accommodative monetary policy - including quantitative easing. In a liquidity trap (ZLB), QE will help in a number of ways, largely through creation of mild inflation. Here are the (admittedly questionable) benefits:

    1. A reduction in real wages - important in lowering unemployment in the short term. This works to the extent that wages are inflexible downwards but not hedged against inflation. No central bank will admit to this as a policy objective - but there it is.

    2. Currency devaluation. Promotes exports and retards imports.

    3. Incentives for domestic spending and investment. With moderate inflation and low interest rates, delaying expenditure or investment may seem like a costly idea.

    4. Inflate away government debt. Complex issue this one - but with careful management can probably achieve partial success. Added benefit where debt is held by foreigners (oh joy).

    QE is all about "smoke and mirrors". It cannot be used continuously without reservation. This will quickly build expectations. Much better to start and stop. Declare recovery is around the corner and QE will end. Wait a month, then roll the presses. Sound familiar? When confusion reigns, hopefully, people will be reactive rather than rationally proactive. Will this boost output? Doubtful, but it may calm markets and allow greater internal flexibility. These are necessary to support the structural changes enforced by the discipline of a global market.

    Personally, I would not bother with either fiscal or monetary policy. I would directly protect and support local industry - at least until global factor prices are more closely aligned.

  7. QE is centered on "smoke and also mirrors". Structured supply continuously without having booking. This can swiftly build expectations. Much better to start which will help prevent. Declare restoration is just about the actual place and also QE can certainly. Wait around per month, and then roll the squeezes. Sound familiar? Any time frustration rules, ideally, individuals will become sensitive as opposed to rationally positive. Will certainly this kind of enhance result? Unsure, nonetheless it might quiet marketplaces and enable higher inner overall flexibility. These are required to support the structurel alterations forced through the discipline of your global market place.
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