We’re coming up on the fifth anniversary of an important moment: the point at which US interest rates hit the zero lower bound, and we entered a liquidity trap. Five years! Yet many people, even many economists, are still in denial over what that means.
First of all, about that date: Officially, the Fed established a target rate between 0 and 0.25 percent on December 15, 2008, but the effective Fed funds rate (the rate at which banks lend reserves to each other) plunged to near-zero in late October:
As some of us tried to argue right from the beginning, hitting the zero lower bound changes everything. It’s not just that the rules change for monetary policy, although they do: some people have been warning for the whole five-year period that the surge in the monetary base will cause runaway inflation, and it keeps not happening. It’s also true that we enter the territory of paradoxes; the paradox of flexibility .. http://krugman.blogs.nytimes.com/2013/10/13/wage-flexibility-in-doctrine-and-policy-wonkish/ , but also, and more crucially, the paradox of thrift, in which attempts by some players in the economy to save more end up leading to less, not more, investment.
For those who don’t know or don’t get the paradox of thrift, it’s actually very simple: if people (or the government) cut their spending, and the Fed can’t offset this move by cutting interest rates, the economy will contract — and the economy’s contraction will reduce the incentive to invest, so that investment actually falls.
I know that many economists just refuse to accept this proposition, which seems absurd to them. But what, exactly, is their alternative? If you believe that a cut in spending under current conditions — it doesn’t matter whether it’s public or private spending — leads to more rather than less investment, what is the mechanism? How does my spending cut give businesses a reason to spend more rather than less (other than via the confidence fairy)? Remember, interest rates can’t fall — the zero lower bound isn’t a theory, it’s a fact, and it’s a fact that we’ve been facing for five years now.
What’s more, the turn to austerity that began in 2010 gives us an opportunity to observe the paradox in action. Take the estimates of fiscal contraction 2009-13 from the IMF Fiscal Monitor in fall 2012 (Figure 13), and compare this with changes in real fixed investment over the same period (from Eurostat). It looks like this:
That’s Greece in the lower right corner, of course — but even without Greece there’s a clear negative correlation between government austerity and investment. Yes, you can try to explain away the results with endogeneity, but it’s a strain.This is prima facie evidence of crowding-out in reverse, aka the paradox of thrift.
The thing is, this topsy-turvy world we’re living in, where virtue is vice and prudence is folly, may violate many intuitions — but it’s a world thoroughly mapped out by textbook macroeconomics in advance, and it’s a world we’ve been living in for five years. It is, in fact, the new normal. What will it take for economists, let alone policymakers, to accept reality?
Macroeconomic Advisers has a new report out about the effects of bad fiscal policy since 2010 — that is, since the GOP takeover of the House. The way it’s written, however, might confuse some people. They say that combined effects of uncertainty in the bond market and cuts in discretionary spending have subtracted 1% from GDP growth. That’s not 1% off GDP — it’s the annualized rate of growth, so that we’re talking about almost 3% of GDP at this point; cumulatively, the losses come to around $700 billion of wasted economic potential. This is in the same ballpark as my own estimates.
And they also estimate that the current unemployment rate is 1.4 points higher than it would have been without those policies (a number consistent with almost 3% lower GDP); so, we’d have unemployment below 6% if not for these people.
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