Tag Archives: zero lower bound

Deleveraging and monetary policy

Few popular terms irritate me as much as “deleveraging”.

Yes, the concept is important. In fact, it’s probably central to understanding why we’re in such a rut. But almost everyone talking about it fails to understand why it matters, and why it’s intimately related to monetary policy.

Sure, most people know the basic idea: during the crisis, consumers and businesses experienced an enormous hit to net worth, and now they want to improve their balance sheets. To do so, they spend less—but since lower spending means lower income somewhere else in the economy, in the aggregate balance sheets barely improve at all. The economy is depressed as it gradually returns to the correct level of leverage, and we experience the  “long, painful” process of deleveraging. (In the words of, well, every blogger and amateur econ pundit in the world.)

Great story. Too bad it ignores everything else we know about macroeconomics.

After all, why should the desire to spend less and save more hurt the economy? If I want to save, I hand my money over to someone who wants to borrow or invest it. Net saving is channeled into productive investment. If consumers want to save more, we’ll see lower consumption but an investment boom—hardly a disaster for the economy.

Sure, you say, but maybe no one wants to invest this money. Won’t an increase in savings then mean that the economy crashes? After all, the money isn’t being spent on consumption, and it has nowhere else to go.

Although this sounds plausible, it doesn’t really make sense. At the micro level, economists don’t worry about weak demand causing a supply glut: instead, they correctly say that prices will adjust to clear the market. The same is true for macro as well. There’s a price—the real interest rate—that determines willingness to save and invest. Like all prices, this price has a market-clearing level: at a sufficiently low real interest rate, the supply and demand for savings will equate, and consumers’ desire to save will translate into an investment boom, not an economic downturn.

The hitch is that the “market” doesn’t quite control interest rates: the Fed does. It controls both nominal interest rates (by setting them) and real interest rates (by shaping inflation expectations). Worse, nominal interest rates can’t go below zero. And if a real interest rate of -X% (0% nominal minus X% inflation) isn’t enough to clear the market and channel money from savers to investment, we’ll see a downturn after all.

So yes, deleveraging can be very bad for the economy. But this is only because monetary policy doesn’t adjust enough to match the market.

In failing to understand this core logic, most commentary about “deleveraging” is rather bizarre. At some level, it’s the same cluelessness that we once saw from central planners: they’d trip over themselves in the complexity of fixing a shortage in one market or a glut in another, never quite realizing that the price mechanism would do their work for them. Right now, historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That’s what every macro model tells us is associated with contractionary policy by the Fed. Yet we see pundits lost in all kinds of complicated, small-bore proposals to stimulate the economy—when the fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.

This isn’t to say that non-monetary proposals should be abandoned entirely. Monetary policy doesn’t stop working at the zero lower bound, but it is a lot harder. Even an ideal Fed would probably find itself constrained. This means that we should be open to other policies that affect demand—possibly via government spending, transfers, or tax incentives. But once we recognize that the fundamental problem is monetary, the issues become much clearer. The Fed’s failure to use all the tools at its disposal—in particular, its failure to make a conditional commitment like the one proposed by Chicago Fed President Charles Evans—is by far the most serious failure of economic policy today.


Note: High on the list of people who do understand deleveraging are Gauti Eggertsson and Paul Krugman. It’s even obvious from the title of their paper: “deleveraging” comes right before “the liquidity trap”, i.e. the zero lower bound making it difficult for the Fed to properly accommodate the effects of deleveraging.



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Why the zero lower bound matters

The zero lower bound is not an insurmountable obstacle: by shaping expectations of future interest rates, the Fed can have a tremendous influence on the macroeconomy, even when the current interest rate can’t go any lower. But it’s not irrelevant either: instilling the right expectations is trickier than simply moving around the federal funds rate, and a central bank unprepared to make a visible commitment can be remarkably ineffective.

Some economists argue that the zero lower bound is irrelevant, or at least overrated, for other reasons. In his response to an earlier post of mine, for instance, David Beckworth suggested that the Fed’s ability to buy other assets (e.g. long-term Treasuries, or corporate bonds) even when short-term interest rates are zero means that monetary policy retains its effectiveness. This has historically been one of the main arguments against a “liquidity trap”: sure, the Fed can’t do any more by buying 6-week T-bills, but why not 20-year corporate debt?

In fact, I agree to an extent: unconventional asset purchases can make a small difference in yields, and possibly a larger difference in times of financial disarray. But they are vastly, vastly less effective than the Fed’s traditional tools, and it takes an extraordinary expansion of the Fed’s balance sheet to have much effect at all.

Why is this? The Fed is a monopolist in the market for base money: no other institution is allowed to print paper currency that’s legal tender, or create electronic reserves that satisfy reserve requirements. Although base money is a relatively small market (about $1 trillion pre-QE), it has a dramatic effect on the rest of the economy because prices are quoted in money, in much the same way that Snickers bars would become pivotal if prices were quoted and transactions conducted in units of candy. By wielding its monopoly power in this market, the Fed can change a key rate (the federal funds rate) that determines the cost of credit across the economy.

At the zero lower bound, however, base money is no different from all other short-term, riskless assets. And that’s a much larger market, one that’s no longer dominated by the Fed. There’s $1.5 trillion in Treasury bills, $1 trillion in commercial paper, $2.7 trillion in money market funds, $900 billion in checkable deposits at commercial banks, more than $1 trillion in Treasury notes with less than a year until maturity, at least $1 trillion in the federal funds and repo markets, and a several trillion more in liquid savings deposits. To be sure, this involves a little double counting: for instance, money market funds invest some of their money in Treasuries. But the total is still very large: even if you take out the $1 trillion in currency, “Money Zero Maturity” is estimated at almost $10 trillion, and that excludes many assets. It’s a big market!

Just as importantly, short-term assets aren’t in fixed supply: financial intermediaries create them when they become sufficiently profitable. Maybe a bank holds a 5-year Treasury note using funds obtained through repo, effectively transforming a 5-year asset into a zero-maturity one. This makes the Fed’s job even harder. If it creates money and buys up Treasury notes in the hope of bringing down yields, financial institutions may start to unwind their own positions, offsetting much of the effect.

Here’s an extreme example: suppose that banks are only willing to borrow short and lend long (i.e. hold longer-maturity Treasuries) when the spread between short and long is at least X%. Then the Fed will have an extremely difficult time bringing the spread below X%; every bank will unwind its positions first, and the Fed will be forced to purchase even more to compensate.

This is why unconventional policy is so difficult, and why the best empirical estimates suggest that its effects are measurable but small. Away from the zero bound, a $400 billion purchase would immediately revolutionize monetary policy, forcing the fed funds rate down to zero (even if it started at a very high level). But at the zero bound, you’re lucky if a $400 billion purchase reduces long-term yields by 15 basis points.

There are two ways to spin this. First, we can’t pin all our hopes on quantitative easing: it’s fundamentally different in character from ordinary monetary policy, and much less likely to have a substantial effect.

On the other hand, we should recognize that normal intuition about magnitude doesn’t work for quantitative easing. I often hear statements like the following: “The Fed has engaged in absolutely unprecedented monetary policy, more than doubling the size of its balance sheet, and there wasn’t much of an impact. Clearly the Fed is out of ammunition.”

This sounds reasonable at first blush, but it doesn’t really make sense. When it’s purchasing assets at the zero lower bound, the Fed is participating in a market that’s fundamentally different from the market in which it usually intervenes—a market that’s far bigger, in which the Fed is no longer a monopoly player. There’s no reason to think that even a doubling or tripling of the Fed’s balance sheet is enough to achieve a meaningful stimulus. And there is still plenty of room for action: after all, there’s still more than $6 trillion of T-notes and T-bonds that the Fed doesn’t own, and even more in the market for agency securities and other debt. (But don’t expect $6 trillion in purchases anytime soon.)

Summing up: life at zero is hard. No longer can the Fed simply nudge rates up or down. It must either commit to lower rates in the future (testing its credibility in the process), make extraordinarily large asset purchases, or both. This requires courage and flexibility—qualities that Ben Bernanke is known to possess, but that the Fed has not consistently displayed.

Edit: I’ll be away starting in a couple days for my wedding and honeymoon. Despite my normal attachment to the internet, I do not plan on blogging or responding to comments during this period! I’ll be back in September.


Filed under macro