Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 20 November 2013

Is zero the new normal?

Larry Summers talk on secular stagnation has led to a burst of discussion on whether nominal interest rates may be at their Zero Lower Bound (ZLB) for longer than we might have thought. I would like to use this post to clarify a number of different ideas that may be involved here. Crucial to this discussion is the concept of the natural real interest rate (NRR). I will define this as the real interest rate that keeps inflation constant. (Sometimes economists define the NRR as the real interest rate that would occur if all prices were flexible, but I think that can be misleading when we are at the ZLB.) There are important issues about risk and different real rates that Tyler Cowen mentions which I will have to ignore.

Crucial to Summer’s argument is that our problems did not all start with the recession. However it may be worth just noting some arguments that the ZLB may be around for some time that do begin with the recession.

1) It takes a long time to adjust balance sheets

One way many economists think about the current recession is that it involves balance sheet adjustment: consumers and firms need to save to reduce their borrowing or increase their wealth. Ideally we would try and offset this by encouraging them to make this adjustment more slowly, or encouraging others to offset this, through negative real interest rates. If adjusting balance sheets takes a decade rather than five years, this may mean that the NRR is negative for much of this period, so we will be stuck at the ZLB for some time to come.

2) Fiscal policy

Tightening fiscal policy lowers the NRR. One of the unusual features of this recession relative to earlier downturns is fiscal austerity, and this will reduce the NRR.

3) Financial intermediation

There has been a lot of discussion about how recessions that result from a financial crisis may be longer lasting. In some countries there is a concern that banks are still carrying a large amount of bad loans, and that this may inhibit their lending for some time. Others worry that tighter regulation could have the same impact, although this is disputed. Just as a reduction in credit rationing can lead to a prolonged economic boom, an increase in rationing can have the opposite effect. There are also more complicated arguments involving a shortage of safe assets (like government debt) that can be used as collateral.

 4) Pessimistic expectations

The way the global economy eliminates deficient demand is not through price flexibility per se, but through movements in real interest rates. If the ZLB means that output is below the natural rate for some time, this could lead consumers and firms to revise down their estimate of what long run output will be. (We can see this happening already when some argue that productivity has permanently fallen as a result of the recession.) If these expectations are more pessimistic than those of policymakers, interest rates might have to be at the ZLB until these expectations are revised. (I discuss some related ideas here.)

All these stories generally start with the recession. However in the decade before the recession, the real interest rate associated with stable inflation appeared to be much lower than before: this is Bernanke’s savings glut. It seems clear that we have to take a global perspective on this, otherwise we end up chasing contradictory red herrings: worrying about the lack of investment in the US, and also worrying about overinvestment in China. The importance of thinking globally is emphasised in Daniel Alpert’s book, and by many others.

One straightforward possibility is that the long run equilibrium NRR has fallen. In standard macroeconomic models, this rate is usually related to impatience, population growth, and technical progress. We know that population growth has shown substantial declines in the developed world, and will show similar declines in the developing world, so that world population may eventually stabilise in around 100 years. Some have also argued that the rate of technical progress has already, or is about to, decline. So there are good reasons for believing that the long run equilibrium NRR has fallen. It might be possible to construct demographic arguments for the medium term NRR to be below the long run NRR, but I will leave that to those who know more about savings behaviour in China and its neighbours.

Another, but rather different, popular argument relates to inequality. It is often put very simply: as the rich have a lower propensity to consume out of income, shifts in the distribution of income towards the rich will tend to reduce aggregate consumption. For a more sophisticated discussion, see Interfluidity.

Often solutions to problems depend on a good diagnosis of why these problems have arisen, but I can think of two solutions that appear to be robust to any of the stories outlined above. The first, discussed by Ryan Avent and made fairly explicitly in recent remarks by Blanchard, is to raise the inflation rate. The second, which a great many economists would sign up to even if they swear they are not Keynesian, is a sustained increase in public investment. The advantage of the latter over the former is that the former has clear costs, whereas the latter could have clear benefits. Of course we may need to do both.

Let me finish with a point about government debt. A major reason why high government debt is a problem in the medium to long term is that - unless Ricardian Equivalence holds - it crowds out private capital. It does that by raising the NRR. Too much saving goes into buying government debt, so there is not enough to invest in private capital. Yet if the NRR is actually negative, and likely to stay very low for some time, and this is a problem because of the ZLB, then the fact that government debt is currently raising the NRR is useful. To put it another way, this means we have plenty of time to deal with the problem of government debt. Which is good, because all the analysis suggests that it is optimal to reduce debt slowly. In the short term, high public debt is helping, not hurting. (Similar arguments can be made in relation to unfunded social security schemes.) 


  1. Simon,
    Falling labor share of national income needs to be added to your list. More so then inequality of income. Capital income has a much lower propensity to consume than even the labor income of the rich. And capital income share has risen quite a bit.
    I have a model to show that low labor share is keeping the prescribed Central bank rate below 0%. The CBs are fighting a losing battle. Labor share has not just fallen, it has actually anchored into a new lower normal after the 2001 and 2008 recessions. The result is that the utilization of labor and capital are both constrained to lower levels. The CB rate then goes lower in a vain attempt to raise them back up, but they won't go back up because low labor share is constraining them.
    Labor share continues to fall as countries try to increase national savings in an attempt to raise exports. Lowering labor share so broadly is bringing down the global economy, and more specifically the workable range of the Central bank rates.
    My view to resuscitate the CB rates is to either raise labor share, or shift the Central bank policy to a lower standard of expectations for the utilization of labor and capital. If the CBs acknowledge the constraining effect of low labor share on the utilization of labor and capital, they would realize their hopes for success of the ZLB are futile. They would realize that the costs will outweigh the benefits of the ZLB since there is not as much spare capacity as they think.
    Central banks would then fit their rate policy to the new lower range of labor and capital utilization. By surrendering to this sub-optimal truth, CBs would be obliged to raise their rates. The new sub-optimal reality would start to function correctly, albeit with more marginalized workers. Then attempts can be made to restore the former reality. But that would require coordination on a global scale.
    As for now, CBs are drowning in the delusions that they are still in the former reality. The truth is hard to accept, especially this truth.

    1. This is interesting. Marxian theory would also provide some very interesting insights into this.

  2. Raising the inflation rate has clear costs? What clear costs? Why is an inflation rate of, say, 4% more costly than one of 2%?

    I might buy that there are significant costs for 10% or 15% inflation, but not 4%-7% inflation.

    For example, in a situation where we have the possibility of financial crashes, a 2% inflation rate is vastly more costly than a 4% inflation rate because if the rate of inflation is 4%, the central bank will have more room to cut interest rates than one that starts with a rate of inflation near 4%.

    1. That last bit should read, "than one thst starts with a rate of inflation near 2%"

  3. All four of the problems listed in the blog are addressed if the central banks develops the mechanism to conduct heli drops directly with the public. Money can be expanded at a pace which will allow it to achieve its goals while remaining independent of the gov.

    The general public have a much higher MPC and lower liquidity preference than the current asset holders or CB counterparties therefore expansions of money result in increases in demand not just portfolio rebalancing. People receiving money will mean balance sheet repair and greater accessibility to credit.

  4. According to a study by McKinsey, the winners of QE are government, business and banks, while the losers are households and pensioners.

    No wonder they consume less and/ore save more
    How are negative interest rates, or more inflation, going to make households and pensioners consume more?

    1. In that study, they basically just found a meaningless correlation. Of course the banks and large businesses are going to do well in an environment where there is economic growth but inflation is low and wages are depressed due to an over-abundance of qualified workers, and of course workers aren't going to do nearly as well due to the same reasons.

      They would have to do a much more detailed study to tease out the benefits the banks and businesses are getting from the persistent depression from the impacts of quantitative easing.

  5. I’d define NRR as the rate that exists where there is no artificial interference in rates by government.

    But governments cannot avoid raising rates when they borrow. Now borrowing to cover CURRENT spending is clearly unjustified. So can we say that NRR is the rate that exists where governments borrow just to fund capital investments? Not necessarily.

    Kersten Kellerman argued that it doesn’t make sense for governments to borrow even to fund capital investments. See:

    And worse still, if you think capital purchases by government should be funded by borrowing, what about the fact that the total assets of government (roads, bridges, military hardware, etc) greatly exceeds national debts?

    I suspect Warren Mosler and Milton Friedman were right to suggest that government should issue no interest yielding debt: i.e. the only liability they should issue is monetary base. So my provisional definition of NRR is, “the rate charged by a private sector lender to a private sector borrower for a virtually risk free loan, and in a scenario where government issues no interest yielding debt, but does issue enough monetary base to bring full employment without excess inflation.” Oxford Dictionary of Economics, please note..:-)

    1. Add to your excellent comment Martin Wolf's pertinent comment that the mega-exporting economies of China and Germany "import" their home demand which has to be paid for by sovereign government creation of money and/or non-government sector borrowing by other countries and a way forward from stagnate or low growth becomes visible.

  6. Japan has raised government debt/GDP by more than 100% over the last two decades. They are still at the ZLB. If that experiment does not falsify the theory that raising public sector debt is "helpful" in raising the natural rate at the ZLB, what would?

  7. "Japan has raised government debt/GDP by more than 100% over the last two decades. They are still at the ZLB. If that experiment does not falsify the theory that raising public sector debt is "helpful" in raising the natural rate at the ZLB, what would?"

    As a sovereign currency creator it has the power to raise its base rate any time it wants.

  8. The secular stagnation thesis was put forward by C.C. von Weizsaecker in 2011:

  9. I am sorry, but this does not work for me. I think you need to try to break down the problem into comprehensible parts. I would have thought that the natural rate should be defined at the micro-level - the balance of investment opportunities and preferences. If you want to think about the natural rate as the background to setting monetary policy, I guess you need to exclude the role of money as another - state provided - investment opportunity. To the extent that employment is about current income and expenditure, the natural rate is a separable issue from unemployment. Since sticky prices do not seem to affect inter-temporal items, like commodity prices, I would abstract from them too.

    And when you have done that, before you just accept how the NRR might have changed, and what that means for economic policy stimulus, I think it would be wise to consider whether the changes in NRR are acceptable, and if not whether there might be micro measures that could be taken to reverse or offset those changes.

    This is my beef with the Keynesians; they jump straight from postulating NRR changes to macroeconomic policies that might, in response, stabilise the macroeconomy. But if these macroeconomic policies are not sustainable, they are just storing up trouble for the longer term, while the underlying microeconomic problem remains unfixed.

  10. How can the natural real rate of interest ever be below zero? The implication of this is that in aggregate we prefer consumption in the future to consumption today, something which is logically impossible.

    1. Not at all. When I taught monetary economics, I used an example of a squirrel to explain this. A squirrel does not (at least to a first approximation - I don't want to go into natural selection here!) bury nuts instead of eating them with a view to growing nut trees which return many more nuts years in the future. Even though it may well lose many of them (ie make a negative return), the ones it can find in winter, when there is not much other food around, may save its life.

      To try to extend the analogy, let us suppose that the squirrel has another investment project to help it survive winter - lending nuts to the forester, who won't lose them and will plant some for his future. This gives the squirrel a better return than burying nuts, allowing it a little time to play in the autumn sun. Monetary policy is a bit like giving the forester so many nuts that he will borrow less from the squirrel, in the hope that the squirrel works harder burying nuts.

  11. the problem is growth as it existed pre 2008 can never occur again regardless of montary or fiscal policy

    we live on a finite planet and as such there are limits to how much energy we have on this planet

    in this case we have essently hit a situation where economic growth is impossable short of getting another planet of oil etc


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