DRAFT: Did Macroeconomic Policy Play a Different Role in the (Post-2009) Recovery?: Monetary Policy: Options at the Zero Lower Bound
J. Bradford DeLong
October 15, 2016
But there is more to monetary policy than just interest rate policy constrained by the zero lower bound. There had been substantial thought back before 2008 about what to do at the zero lower bound. It is not that economists had a consensus on what the policy rule was, or would be. But there were definite points of view as to what the policy rule at the zero lower bound should be.
I count six different currents of thought about what monetary policy would, or ought, to do were the economy to hit the zero lower bound in a serious way:
- Don’t hit the zero lower bound Keep the inflation target higher than 2%—not much lower than 5%—so that there is always plenty of room to make short-term real safe interest rates negative via standard open market operation interest rate policy when that is needed, because it will be (DeLong and Summers (1992)).
- We won’t hit the zero lower bound in a significant way. Shocks to the North Atlantic economies are unlikely to be that large (Reifschneider and Williams (1999)).
- Keep expanding the money supply by buying bonds for cash—eventually cash burns a hole in people’s pockets, and so expansionary open market operations are not qualitatively different at the zero lower bound (Friedman (1997)).
- Open market operations are qualitatively different at the zero lower bound—they work through different and weaker channels—but by arbitrage they must work, as shown by the last-resort thought experiment of “helicopter money” (Bernanke (2000)).
- A flex-price full employment economy preserves full employment at the zero lower bound by generating future inflation. A central bank needs to do the same thing: make credible promises to be irresponsible in the future in order to deliver that inflation (Krugman (1998)).
- At the zero lower bound monetary policy no longer has the power to stabilize the economy: fiscal policy needs to be brought back in.
To the extent that I had views about what the implicit policy rule was that we were following back in 2008 they were roughly this: It would have been nice to follow (1) or if (2) were true, but we hadn’t and it wasn’t. However, any shock large enough to cause a lengthy excursion to the zero lower bound would generate a New Deal-like response. In the New Deal, Roosevelt had tried everything that might make sense and some things that could never have made sense, and reinforced success. The same, I thought back in 2008, would be true for us. A large enough shock would be followed by conventional expansionary fiscal policy, helicopter money, quantitative easing of a previously unimagined magnitude, and forward guidance and attempts to make credible commitments to carry nominal GDP back to its pre-2008 forecast path. And whichever of those seemed to be working would be reinforced, and strengthened.
Now in the world in which we live, and however much some of us wish it would come back on, (6) is off the table. (1) is off the table as well. And (2) is no longer relevant. We can argue why (1) and (6) are off the table and why (2) turned out to be wrong. These questions still greatly puzzle me. But we will reach no conclusions. And we will still have(3), (4), and (5) to assess.
Milton Friedman’s (3) is, at bottom, his belief that there are reasonably-tight limits on the possible values for the velocity of money. There is, Friedman thought, a sense in which money is a very special commodity that burns a hole in people’s pockets. They will spend it, if you print enough of it, and get it into people’s hands by any means—in fact, the means by which you get it into people’s hands does not matter much. The government can buy useful things with it. The central bank can buy bonds with it. You can drop it from helicopters. Because the interest elasticity of money demand never becomes infinite, open market operations never lose their power, even at the zero lower bound. As is written in Friedman (1997), at the zero lower bound:
The Bank of Japan can buy government bonds on the open market. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand…loans and open-market purchases. But whether they do so or not, the money supply will increase…. Higher money supply growth would have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately…
Ben Bernanke’s (4) rejects Friedman's monetarist fundamentalist belief that the quantity of money by itself is (close to being) a sufficient statistic for the effect of asset prices and quantities on spending. Bernanke sees that at the zero lower bound a conventional open market operation is simply the swap of one zero-yielding government asset for another zero-yielding government asset in an environment in which the liquid spendability of cash has no value at the margin. Yet he rejects the claim that monetary policy is then impotent. Bernanke (2000):
Contrary to the claims of at least some Japanese central bankers, monetary policy is far from impotent today in Japan…
Why is it not impotent? Because of:
what amounts to an arbitrage argument —-the most convincing type of argument in an economic context…. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but… quite corrosive of claims of monetary impotence…
In Bernanke’s arbitrage thought experiment the central bank is not just swapping one zero yielding government asset for another. If it were, the argument would not go through: the government could issue an indefinite amount of cash and acquire an indefinite amount of zero-yielding assets as the mirror to a private-sector balance sheet that has an indefinite amount of cash balanced by being short an indefinite amount of government discount bonds value at par, and the price level would not change. What makes the arbitrage argument work is the word goods. The government prints money, and buys roads, bridges, the bearing of duration risk, biomedical research, human capital for twelve-year olds—whatever. This is helicopter money.
But the price level is independent of money issuance if one raise the money supply via open market operations and the marginal dollar of cash is held as a savings vehicle…
Paul Krugman’s (5) follows a different line of argument. Krugman (1998) starts by asking what happens when a flex-price full-employment economy finds itself with a Wicksellian real neutral rate below the inflation rate and so hits the zero lower bound. The answer is one of those things that is obscure before but obvious after the fact: the real interest rate must be at its equilibrium value; the real interest rate is the nominal interest rate minus the inflation rate; the nominal interest rate is zero and cannot drop; so the inflation rate must jump up. How can the inflation rate jump up? The price level must jump instantaneously down now so that inflation can be higher in the future and the economy be on the full employment path:
In a flexible price economy, the necessity of a negative real interest rate does not cause unemployment…. The economy deflates now in order to provide inflation later…. If the… nominal rate is zero, but the real rate needs to be negative, P falls below P*…. This fall in the price level occurs regardless of the current money supply, because any excess money will simply be hoarded, rather than added to spending. At this point one has a version of the liquidity trap: money becomes irrelevant at the margin…
Now move from a flex-price economy that automatically obeys Say’s Law to a sticky-price economy that does not, but that has a central bank with the job of manipulating prices to make Say’s Law true in practice even though it is false in theory. The central bank does this by manipulating its control variables to make the key prices and quantities—the real wage level, the real interest rate, etc.—equal to what they would automatically be in the full employment flex-price economy so that economic agents make full employment-attaining decisions in spite of the stickinesses and the rigidities.
In the case of the zero lower bound, the flex-price economy automatically generates the future inflation it needs to drive the real interest rate to its Wicksellian neutral level. A central bank that wishes to set prices to mimic their flex price-economy values needs to artificially generate the same future inflation. And this is the source of Krugman’s observation that the job of the central bank is to make a credible promise to behave irresponsibly in the future—to generate in the future the inflation the economy needs to foresee now, even though when that future comes the equilibrium in which that inflation is generated will no longer be subgame-perfect. It is the mirror image of Kydland-Prescott: instead of a government that values employment getting into trouble by being unable to commit to keeping inflation low, a central bank that values price stability can get into trouble by being unable to commit to keeping inflation high.
Those (3), (4), and (5)—Friedman (1997), Bernanke (2000), and Krugman (1998)—seem to me to have been the intellectually-respectable and possibly practically-applicable candidates for what our monetary policy rule at the zero lower bound was, or perhaps should have been, back in 2008. And, as I wrote above, my expectations were for a convex combination of them—and then for the reinforcement of success.
And here I, at least, see a substantial difference between the convex-combination-and-reinforcement and what the actual policy outcome has been. The Federal Reserve, under Bernanke, Kohn, Yellen, Fischer, Dudley, and company, has gone well beyond the extra mile as far as (3) is concerned. The expansion of its balance sheet and the extent of the quantitative easing it has engaged in have been financial and asset market marvels indeed. And I believe they have been effective, even if the effects have been at the low end of the range I would have thought plausible ex ante.
Yet the conversation about helicopter money—or “social credit”, or limited amounts of money-financed government purchases or tax rebates—has not yet really been joined in a way that might move it toward implementation, in spite of all of Adair Turner’s (2016) attempts to do so. The closest approach has been the considerable jawboning in committee testimony that the “headwinds” generated by fiscal policies that are positively contractionary have not contributed to the situation.
And if there is one constant in Federal Reserve communication since the end of 2008, it is that it does not anticipate, does not want, and would be, in fact, alarmed if its quantitative easing policies were to lead to what Ben Bernanke (2000) thought would be desirable at the zero lower bound: for “money issuance… [to] ultimately raise the price level, even if nominal interest rates are bounded at zero…”
Does this focus on and willingness to go beyond the extra mile on quantitative easing but not on helicopter money or on either nominal GDP or inflation targeting make monetary policy “different” than the policy rule we thought we were following back before 2008, or than we would have thought we were following had we thought to think about what would happen on this branch of the game tree? That is, I think, a matter of taste.