Friday, May 10

Krugman Perpetuates Myth of the Zero Lower Bound

Professor Paul Krugman
Professor Krugman just published a column where he deserves kudos for sticking his neck on the line and predicting that the Bernanke Fed is not creating a bubble in bonds, and "probably not" in stocks either.

While the argument on whether or not Bernanke is blowing bubbles is interesting and worthy of discussion (although only time will tell for sure), that's not what this post is about.

In the column Krugman makes a somewhat tangential comment about what economists often refer to as the 'zero lower bound problem' on where a central bank can set interest rates. Here's Krugman's quote:
"True, it (the Fed) can’t cut rates any further because they’re already near zero and can’t go lower. (Otherwise investors would just sit on cash.)"
Krugman's statement is problematic for several reasons:

First, it's misleading and patently false of Dr. K to say that the Fed "can’t cut rates any further" when in fact it can. There is no economic or natural law which prevents the Fed from setting nominal rates at exactly zero, or at a negative rate.

Whether they should be set at zero or negative is another question. In short, Dr. K needs to replace "can't" with something like "could but shouldn't because...".

Second, I suggest that it would be helpful if Dr. K was a little more precise so that people understand why the Fed "can't" (shouldn't) set zero or negative rates but Denmark's central bank can set a negative deposit rate, and now Drahgi at the ECB is openly discussing this as well.

To be clear, I'm not endorsing negative rates. I'm only saying that negative rates are possible and that some central banks are experimenting with negative rates as a policy tool.

And finally, yes, perhaps if the Fed were the only central bank to pursue a negative rate policy then investors may sit on cash, move their money elsewhere, etc. But if enough central banks around the world kept driving rates further and further into negative territory then it would be very surprising if this didn't help generate inflation, in which case people would probably not be sitting on cash as Dr. K suggests but rather spending it before money lost its purchasing power.

The long perpetuated myth of the zero lower bound is starting to be challenged more and more, and for a more detailed academic discussion of the zero lower bound myth see here

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