I tend to think of Tyler Cowen as some kind of extraordinary economic sage: even though he isn’t active in mainstream research, he seems to know about every new development, and he can provide a capable survey of the literature on command. If I find myself disagreeing with him, my first instinct is to assume that I’ve gotten something wrong. (And since he’s one of the only reasons I have readers in the first place, I’m also a little biased.)
But his skeptical posts about the idea of a liquidity trap continue to baffle me. One representative example is this post, where he states:
Short-term interest rates being zero, and short-term interest rates being almost zero, are very different cases, especially for understanding nominal shocks and whether they can stimulate aggregate demand. Unless short-term rates are literally the same as the rate on cash, asset swaps still can succeed. And QEII isn’t be the same as simply switching the term maturity of the debt, as Krugman has suggested. There will be nominal effects also.
In a sense, the first sentence is correct. As long as short-term rates are above zero—even if they’re slightly above zero—it is still technically possible for conventional monetary policy to do more. The problem comes when we think about the magnitude of its impact. Conventional open-market operations affect the economy by altering one key intertemporal price: the short-term real interest rate. (To be precise, they control the nominal interest rate, and since inflation doesn’t adjust one-for-one in the short term, this changes the real interest rate.) All else being equal, these operations will have an economic effect whose magnitude roughly corresponds to the change in the short-term real interest rate.
And if monetary policy has real effects through its impact on the real interest rate, you wouldn’t expect anything interesting to happen when the nominal rate is around zero. Suppose that inflation is currently 1.5%. Then a 0.05% nominal rate corresponds to a -1.45% real rate; a 0% nominal rate corresponds to -1.5%. Is there any reason to think that the change from -1.45% to -1.5% would make much more difference than the change from -1.4% to -1.45%, or from -1.35% to -1.4%? I doubt it. Yet Tyler’s claim that there is no “liquidity trap” seems to rest on the premise that as we approach the zero nominal bound, we can get a sizable economic impact from every last infinitesimal decline in interest rates—or, in mathematical terms, that the derivative of macroeconomic variables with respect to the real interest rate approaches infinity as the real interest rate hits exactly -1.5%. This just doesn’t seem plausible.
The only way that Tyler’s claim makes sense is if he has a different model for the real effects of monetary policy—maybe he thinks that the nominal interest rate itself, independent of its effect on the real interest rate, has real effects. In the lingo of macroeconomic models, this is equivalent to saying that consumption and real money balances are non-separable in the utility function. While this is surely true to some degree, the overwhelming consensus in macroeconomics is that it’s quantitatively insignificant: see Ireland (2004) for an empirical test. And even then, there’s unlikely to be any large effect from the last few basis points in the nominal rate, unless Tyler has some very strange specifications in mind.
To make this more concrete, let’s try to imagine the possible channel at work here. Nonseparability of consumption and money in the utility function usually means that base money is a complement to consumption. The idea is that you need liquidity to buy stuff, so that when the nominal interest rate is lower and it’s cheaper to hold your money in a liquid form (cash, checking accounts), you’ll buy more.
Since the Fed is paying interest on reserves, however, the nominal interest rate has virtually no effect on the costs of holding money in checking accounts with a 10% reserve requirement. This leaves us with cash. And that is where the proposed mechanism becomes really, really implausible. Are consumers going to change their spending habits in any appreciable way because it’s 0.2% cheaper per year to carry around cash? (So that if you carry around $1000 in your wallet, at the end of the year you’ll have saved $2?) I’m one of the most robotically economic-minded people I know, but this is such a miniscule effect that I’ve never even thought about it. Most purchases, particularly the ones that go down most in a recession (durable goods, residential and nonresidential investment) are not made with cash. And it is impossible to imagine that in a $14 trillion economy, a ($1 trillion)*(0.2%) = $2 billion decrease in the cost of holding cash will manifest itself as anything other than a rounding error in GDP.
So yes, conventional monetary policy can suffer from a liquidity trap. Nominal interest rates have only a minor economic impact on their own (even near 0%), and the inability to push real interest rates below a certain level is a legitimate constraint on monetary policy.
This doesn’t mean that all hope is lost: the Fed can still make a difference by shaping expectations of the future trajectory of nominal interest rates, or by making unconventional bond purchases so large that they trigger portfolio balance effects and drive down interest rates on longer-maturity assets. (You’ll hear plenty about this from me in the coming weeks.) Just don’t go around claiming that 0% isn’t a barrier—because sadly, it is.