Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 2 February 2019

The Interest Rate Lower Bound Trap and the ideas that keep us there

Japan’s short term interest rate set by its central bank has been near zero since the mid-1990s. The UK’s equivalent short interest rate has been near zero since 2009, and the Eurozone’s since 2014. This in turn reflects core inflation being well below its target rate in Japan and the Eurozone over the same period. [1] This is not how it is meant to be. And because the short term interest rate in the US is above zero, it is not getting the attention from a US-centric macroeconomic community that it should.

We all know about interest rates hitting the lower bound after the GFC. But macroeconomic theory is quite clear. Governments can always, just always spend their way out of such a trap. The reasoning is simple. If the government cutting taxes and spending more on public services was not at some point inflationary, then why are we not having both? There must be a point at which demand exceeds supply by enough to make inflation meet its target.

I’ve often heard an objection that fiscal stimulus is not appropriate because these countries no longer have an output gap. But the output gap is difficult to measure. If these countries really did have a zero output gap, then why is inflation below target? Inflation, not the output gap, is the ultimate constraint on whether fiscal stimulus is needed. [2] If inflation is stuck below target and your measure of the output gap says that gap is zero, you should ignore the output gap measure and enact a fiscal stimulus.

So why has this not happened in Japan, or the UK, or the Eurozone? The answer has to be that for some reason governments in those countries have not done what they should have done, and therefore wasted a lot of resources that could have gone to their citizens. It takes quite a lot to convince governments not to spend when they should and to tax when they need not. So what is this force that stops these governments spending their way out of the interest rate lower bound trap?

There are three candidates I can think of.

The first is what I call the consensus assignment. The idea that monetary policy, and only monetary policy, can be used to stabilise the economy to hit the inflation target. It was the macroeconomic policy consensus until the GFC. It left governments unused to dealing with stabilisation themselves, because they had contracted out the problem to the central bank.

But this cannot explain it all. After all, all three countries/zones have used fiscal policy to expand the economy after the GFC, and Japan on many occasions. So something else must be inhibiting these countries from using fiscal policies by enough.

The second candidate is something that came with the consensus, and that is ‘deficit bias’. When interest rates controlled the level of inflation (and, contrary to MMT thinking, they were pretty effective at doing this job) many governments tended to allow government debt to gradually rise, for reasons that are hardly complicated. Rules were created and then institutions set up to prevent this happening. It may be that too many governments have internalised the idea that deficit bias is bad and therefore it is good to run down debt.

Of course that idea only makes sense when the consensus assignment is operating, and it does not apply when interest rates are stuck at their lower bound. When rates are stuck at around zero we need to reverse the assignment and use fiscal policy to stabilise the economy until rates are well clear of their floor. But perhaps some governments fail to see that and still think it is good for them to be reducing debt. 

To be honest I think this might apply to officials working for governments (including central bank governors), but not to politicians themselves. Officials who had learnt their economics when the consensus assignment was dominant and never read the footnotes (if they were there) about the interest rate lower bound. But that still matters, because officials play a big part in advising politicians. In particular, officials helped design a currency union which has no contingency for situations where monetary policy is ineffective.

The third and final reason is a phobia about government debt. Now there are good economic reasons why building up a large stock of government debt relative to GDP may have unfortunate side effects, but they all operate when the interest rate on government debt exceeds the growth rate (r > g for short). High government debt can crowd out private investment by raising interest rates, but inadequate demand is much more effective at suppressing investment and rates cannot be crowding out investment when they are at their floor! In short, the economic reasons for worrying about government debt fall aside at the lower bound. [3]

Now perhaps public officials and some others are influenced by the economic case against high debt to GDP and fail to see that it does not apply when interest rates are at their lower bound. But I think there are two more important reason for deficit phobia. The first comes from watching countries get into serious difficulties, and often resorting to the IMF, because they could no longer finance their debts. But this concern does not apply to a currency issuer whose debts are in their own currency, as Japan, the Eurozone and UK all are. However I suspect officials can be a little economical with the truth about this when it suits them (see the UK 2010 Coalition negotiations for example).

The second reason for debt phobia is ideological. Debt phobia is a means of keeping a lid on the size of the state. We see this in its most blatant form in the US from the Republican Party, but I think it is powerful everywhere. This is particularly the case under neoliberalism, where a key goal is reduce many activities of the state so taxes can be cut for the already well off.

The importance of this cannot be overemphasised. Two major economies and one economic block are wasting resources that could have gone to their citizens because of some all all of these factors. And perhaps even more importantly, they and other countries like the US are wide open to a negative demand shock creating a recession without effective [4] tools being ready to combat it.

[1] The UK is complicated by two large currency depreciations, but once you take out their effect everything here applies equally to the UK.

[2] With a Phillips curve, the only reason inflation can remain below its target besides deficient demand is if people and firms think the real target is below the official target. But if that is the problem, then policy makers should increase demand and inflation to show this is not true.

[3] Some may worry that high deficits will be difficult to wind down once we are off the lower bound. But a good fiscal stimulus is temporary, so this should not be a problem.

[4] Quantitative Easing is not a reliable tool. 


  1. Have you looked at Japan's debt to gdp? Japan has been using substantial fiscal stimulus. You can't really club Japan with Eurozone.

    1. Get with the programme - this is Economics.
      Just cherry pick your data and forecast the past. Simples.

  2. Hurray!

    Not about Brexit.
    Advocates a fiscal stimulus.
    Top post.

    Many thanks

  3. Ah, but do you rule out political cynicism? You write somewhere about how George Osborne once read a briefing paper on the consensus agreement, and then repeated it in a speech but missing out about fiscal policy at the ZLB. Now, whatever one might think about Osborne - personally, he strikes me as a deeply unpleasant human being - it’s indisputable that he’s a smart cookie: he certainly would have understood the argument, and could only have missed that out deliberately. Is it possible that his austerity chancellery knew perfectly well that the standard model recommended fiscal expansion at the ZLB, but chose to ignore that to reinforce his small-state beliefs? In other words, all these ideas that keep us at the ZLB are not so much reasons, but excuses - arguments used to justify what they’d do anyway? I think it’s possible. All the evidence of Brexit indicates to me that many politicians put their party and party ideology above the country’s interests.

  4. John Maynard Keynes understood that to cut public spending in a recession is to increase the decline in the economy, due to the fact that when the so called private sector stops spending, if the government doesn't intervene then the inevitable decline continues.

    We have been bouncing along the bottom of a depression ever since the GFC precisely because of that policy. It really isn't rocket science.

    The question that is never asked by conventional economists is why a government with all the historical and empirical evidence now available should pursue a policy it knows will create these conditions. The obvious answer of course is that is the outcome they desire.

    Poverty is a political policy, finance does not lend to people with large savings, it creates money through debt, thereby makes its profits from debt, the more borrowers the more profit it earns. So the financialisation of the economy has now produced a vicious circle that it can never get itself out of unless the government intervenes, and spends directly into the economy.

    Again this is not rocket science.

    What this country needs is a government that invests in people rather than the present one that only looks after corporate interests. People are the real economy and finance sucks the life out of it, competition is destroying the world economy not boosting it.

    The other point about market philosophy is - the market is dying because of the market, markets do not self regulate as some would have us believe, so if we need to reverse this downward spiral, then we need planned investment that puts money into productive use and rebuild the infrastructure that is currently in a state of decay. We also need to tax the very rich because for no better reason than they are presently out of control and need reining in.

    The other major factor never raised by conventional economists is that our planet is on the verge of catastrophe, and the market is not doing anything about it, unless governments around the world act swiftly enough,(ie immediately) our planet will make all economic theories redundant.

  5. Thankyou for a very interesting article. I think counter acting the austerity message is one of this generations biggest challenges.

    To buy a new car maybe extravagant but if it uses less fuel then its a good investment.

    So why is government investment so wrong.


  6. I think the neoliberal mindset is a major factor here and I agree that debt phobia has been used for political purposes to reduce the size of the state and to reduce taxes on the rich. As you say the macroeconomic rationale for using fiscal policy in these circumstances is clear so the reasons for deviation must be mainly political in nature.

    The fact that monetary policy has borne the adjustment burden has of course inflated asset markets to unsustainable levels and almost guarantee a GFC 11. One has to hope that the egregious dysfunctionality in the current system will be addressed if we do have GFC11. Monetary policy has been largely exhausted so logically one would assume that fiscal policy would be centre stage in any GFC but the debt phobia seems quite entrenched so this may not be the case.

  7. So... why are some countries immune to this?

    Australia, New Zealand, Canada, Singapore, for example. Did they just get lucky in the GFC and not fall in the trap (yet)? Or is there more to it?

    1. Australia has kept out of recession for 24 yrs due to pumping up house prices each time, the new borrowing is a source of demand in the economy. That can't continue forever because the ratio of debt to income can't become unpayable. See Steve Keen. Other countries with high private debt await the same fate.

  8. Perhaps an analogy might help. The world of quantum mechanics is strange, it is entirely at odds with our lived experience. Can I "relate" or "understand" it? Not sure I can and I am a working scientist. A better question is do I believe QM provides a much better framework to predict, interpret and apply atomic level processes that guide much of my work, absolutely. Everyday I do things that work only because of the "strange" stuff that if I used the everyday what I familiar with, (Newtonian mechanics) just do not work.

    Its similar with macro economics I fear. Everyone is familiar with in their life with debt going out of control, either they or a family member has been there. The consequences are dire; high debt countries imploding & low debt prospering seem (seem!!) to support this. I accept and do follow the insights of Keynes on this point, but my concern is that it is outside the lived experience of most people. In an era where experts are not to be trusted, where everyone has an angle and where all personal experience trumps reason, then I think the notion debt = bad; is so compelling powerful that politicians will reach to it.
    Sadly until we move to a more rational world where expertise is valued (trust) as much as much as pilot (can you imagine choosing a pilot because they had a good Instagram account but no flying experience) or a surgeon (you sound posh and funny, feel free to cut me open and have a poke inside) then we might be howling in the wind.

    Science has the problem, the epidemic of measles in rich countries and global warming are exactly this problem.

    Back to my pilot, imagine someone said hey, I have sailing yachts my whole life, I can fly; this is what the media do they drag on a "scientist" with no expertise in the relevant field and they "bravely" challenge consensus. The media loves absolutely loves the maverick truth seeker vs "big" conspiracies; this has killed people (HIV, MMR) and the responsible media (Private Eye, Times etc) should have these deaths on their conscience for the blood certainly is

  9. How is demand-side fiscal stimulus supposed to work with an independent, inflation-targeting central bank? What about monetary offset?

    If a central bank falls short of its inflation target, it's due to some combination of having the wrong regime and timidity. There's no doubt a monetary authority can stimulate inflation. Otherwise, it could buy up all the assets in the world with few, if any real costs.

    Let central banks adopt NGDP level targeting and do whatever it takes to keep NGDP on its desired path, and success should be achieved.

  10. Regarding downsides of large debt/GDP not applying at ZLB, is there not a risk of complacency here, as the intention is clearly to get off the lower-bound... at which point the previously unproblematic debt becomes an issue?

  11. Could it not be more related to a country feeling that it has more to gain from a stronger-valued currency? Could it be that central-bank policy "coordination" among the developed-world countries plays a major role, thus allowing all developed world economies to benefit, for as long as humanly possible, from the benefits that accrue to these nations because they are the printers of the world's reserve currencies?

  12. Osborne pushed austerity not because he believed in expansionary austerity but because his electoral success depended on making the crisis appear to be the fault of the Labour party. I don't think it requires any deeper analysis.

    Falling interest rates on UK gilts between 2010-2013 clearly signal that the market had no concerns that either a) the UK would be unable to finance its debt in future, or that b) inflation was on the horizon.

  13. "But this concern (insolvency) does not apply to a currency issuer whose debts are in their own currency, as Japan, the Eurozone and UK all are." You are correct about the UK and Japan. I do not believe this is the case with the Eurozone. Basically, the Eurozone has recreated the gold standard, and it is working as well as the gold standard did, historically.

  14. Many thanks for a post not about Brexit

  15. Why should the short-term interest rate not be set to zero permanently? A currency sovereign's debt is risk-free and will always have a market. Automatic stabilizers like the job guarantee and greater financial sector regulation are superior to monetary policy anyway so I fail to see why there is such reliance on crude interest rate manipulation as the tool of choice by the mainstream.


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