Gauti Eggertsson, a NY Fed Economist has done considerable research on Great Depression, Liquidity Trap and Zero-bound interest rates. It is fascinating to see so many economists still doing so much research on great depression. With the crisis, I am sure more is to follow. No wonder, Fed Chairman Bernanke in his book on Great Depression said:
To understand the Great Depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also—to an extent that is not always fully appreciated—the experience of the 1930s continues to influence macroeconomists’ beliefs, policy recommendations, and research agendas. And, practicalities aside, finding an explanation for the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge.
We do not yet have our hands on the Grail by any means, but during the past fifteen years or so substantial progress toward the goal of understanding the Depression has been made.
I came across this superb primerfrom Eggertsson on a topic which is going to increase going ahead – liquidity trap. It is slightly technical with equations etc but one can skip it.
A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective.
The modern literature, in contrast, emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future money supply in states of the world in which interest rates are positive.
To recall, Keynes main ideas came in force as US faced liquidity trap and Keynes said monetary policy is ineffective as interest rates had become zero. And then came the idea of using fiscal policy – govt expenditure, tax cuts etc to pump-prime the economy. And we had a set of policies popularly called as Keynesian.
Then came the new theory post Milton Friedman, which said monetary policy is far from ineffective in liquidity trap. Even at zero interest rates monetary policy can do wonders (see this Vincent Reinhart speech for details). It is this second view which continues to be debates hugely by economists. It was debated during Japan’s deflation, US deflation scare in 2003 and is being debated now (debate is expected to grow severe going ahead).
What Eggertsson points out is the need to shape expectations in liquidity trap/zero interest rates.
The lesson of the irrelevance results is that monetary policy is ineffective if it cannot stir expectations. The previous section illustrated, however, that shaping expectations in the correct way can be very important for minimizing the output contraction and deflation associated with deflationary shocks. This, however, may be difficult for a government that is expected to behave in a discretionary manner. How can the correct set of expectations be generated?
This shaping expectations is what is very difficult to do as Kazuo Ueda points in Japan’s case. The policies should be credible enough which leads to positive inflation expectations in the economy. Eggersson says government/central banks should follow a policy rule to stir expectations and it better be credible:
If the central bank, and the government as a whole, has a very low level of credibility, a mere announcement of future policy intentions through a new ‘policy rule’ may not be sufficient. This is especially true in a deflationary environment, for at least three reasons.
First, the deflation bias implies that the government has an incentive to promise to deliver future expansion and higher inflation, and then to renege on this promise.
Second, the deflationary shocks that give rise to this commitment problem are rare, and it is therefore harder for a central bank to build up a reputation for dealing with them well.
Third, this problem is even further aggravated at zero interest rates because then the central bank cannot take any direct actions (that is, cutting interest rate) to show its new commitment to reflation.
It is like going in circles. What are the suggestions for way out?
Perhaps the most straightforward way to make a reflation credible is for the government to issue debt, for example by deficit spending. It is well known in the literature that government debt creates an inflationary incentive
Jeanne and Svensson (2006) and Eggertsson (2006a) show that foreign exchange interventions also have this effect, for very similar reasons.The reason is that, if the government prints nominal liabilities (such as government bonds or money) and purchases foreign exchange, it will incur balance-sheet losses if it reneges on an inflation promise because this would imply an exchange rate appreciation and thus a portfolio loss.
Real government spending, that is, government purchases of real goods and services,can also be effective to this end (Eggertsson, 2005).
Very interesting paper.
P.S. One can even see Paul Krugman’s superb paper on liquidity trap. It is quite detailed though.