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.