How to Normalise Monetary Policy
It’s an easily observable fact that central bankers become irrationally cautious once interest rates get close to zero. Even if you believe, as I do, that unconventional policies such as QE or the MC Rule are equally effective means of conducting monetary policy, it’s clear that policymakers would rather operate within-sample, on the familiar territory of short-term interest rate pegs as the monetary policy implement. It’s no coincidence that the developed countries that have succeeded in keeping NGDP growth mostly on target – Israel and Australia – have avoided hitting the dreaded zero lower bound. There's also the concern that extremely low interest rates can sustain 'zombie companies' and prevent the structural adjustment of the economy. As the debate begins to turn to unwinding the large expansion in central bank balance sheets since 2008, it’s worth considering the various strategies that might work for countries that want to exit the zero lower bound and thus escape the scary world of unconventional monetary policy.
Perhaps the simplest and most conventional way to get away from the ZLB would be for the fiscal authorities to step up and borrow more. Government borrowing would reduce the amount of funds available for private-sector borrowing. In normal times, this would have negative effects, raising the cost of borrowing for the private sector and so reducing private sector investment – the ‘crowding out’ effect. What the zero lower bound means, though, is that there is more money available to be lent than the private sector ‘wants’ to borrow. The market is failing to clear because interest rates cannot fall below zero. Therefore, when the government drives up the cost of private borrowing, it pushes the equilibrium interest rate up into positive territory. This allows monetary policy to act without the constraint of the zero bound – and hopefully, when the economy returns to growth, the equilibrium interest rate will stay above zero.
The problem with using fiscal policy to raise the equilibrium real interest rate is that it’s a short-term measure. The government can’t borrow and run deficits forever. The problem encountered in Japan, which policymakers in other developed countries may soon run into, is that fiscal expansion is limited by the government’s long-term budget constraint – it can’t run huge deficits forever. If the low equilibrium real interest rate is the result of a long-term secular decline, rather than resulting from short-term factors, then other policies will have to be pursued to permanently escape the zero bound.
We’re currently at the zero bound for a mixture of short and long-term reasons, and it remains to be seen whether we’re stuck permanently. It depends a lot on the long-term growth rate of the economy – if there really is a Great Stagnation in productivity then it’s far more likely that we’re stuck forever. It’s also quite hard to tell how much of the decline is demand for safe assets following the financial crisis, which might reverse if and when the economy returns to growth. Part of the long-term decline might also be because of the ‘savings glut’ in East Asia, which might be expected to reverse itself as an aging population starts to draw on those savings to sustain itself in retirement. There’s evidence that this is already increasingly happening in Japan.
If the equilibrium real interest rate cannot be raised, then it might be practical to raise expected inflation, so that the nominal interest rate consistent with that market clearing real interest rate becomes positive. Economists assume that the welfare costs of higher inflation are substantial and nonlinear, but it may be that a long-term trend inflation rate of 4-5% imposes costs which are small relative to the potentially enormous benefits of efficient monetary policy. It might be worth putting up with modestly higher inflation in order to avoid the nasty hysteresis effects and human cost of elevated unemployment associated with bad monetary policy and the zero lower bound.
However, adopting a higher target for NGDP and inflation might be politically difficult for central bankers and the governments which set their mandate. Governments will not want to be accused of a return to stagflation, or of trying to inflate away the country’s problems. Higher inflation may pass a cost-benefit test, but there are costs, and there might be better ways of escaping the zero bound.
Increasing the Marginal Productivity of Capital
The easier way to solve the problem of the zero bound would be to raise the long-run growth rate. That would increase the expected value of new investments and also expectations of future income, raising the willingness of both firms and consumers to borrow. Of course, raising long-term growth seems pretty difficult. Economic opinion is divided on the best ways to promote growth, and even those they near-unanimously agree on, such as freer trade and looser planning regulations, can be extremely difficult for politicians to implement. But long-run equilibrium real interest rates don’t depend only on productivity growth, they depend on the overall growth rate of the economy. That suggests one foolproof tactic for escaping the zero lower bound – increased immigration.
The immediate effect of an increase in immigration would be to lower the ratio of capital to workers. That increases the value of building new houses, new factories and new office blocks – which in turn pushes up the demand for – and cost of – borrowing. Even if productivity is not increased by immigration, one side-effect it would have would be to help normalise the monetary policy environment. There are a host of reasons to favour dramatically freer migration, but improving demand-side policy in the medium run is another very good one.