Why I Agonize About The Zero Bound

I increasingly agonize about the zero lower bound.  It’s really no secret that I believe that the faster we normalize interest rates, the better.  Such a goal should appeal to those who believe current monetary policy is reckless.  To be sure, the Fed’s forecast that US economy will be stuck at the zero bound into 2015 does not leave me filled with confidence; the risks are all too high that the economy will experience a recession before then.  But I very much doubt the Fed can simply raise interest rates to normalize the yield curve.  That would simply invert the yield curve, and such inversion is a harbinger of recession.  As long as the economy is operating at sub-optimal levels, monetary policy will be constrained by the zero bound.  To lift the economy well clear of the lower bound, we need greater cooperation between fiscal and monetary authories.  I suspect this will require making explicit what is often viewed as crazy but many would argue is already implicit in recent policy, the monetization of some fiscal spending.

Japan serves as a role model for the zero bound problem.  As Paul Krugman notes, fiscal policy has been effective in staving off the worst consequences of the Japanese financial crisis.  But the associated fiscal deficits appear never ending; the Japanese economy never gained enough strength to eliminate the dependency on fiscal stimulus, leading to what looks like an excessive build-up of government debt that now exceeds 200% of GDP.

We frequently see concerns that a build-up of government debt will lead to a new Japanese financial crisis.  Peter Boone and Simon Johnson are the latest addition to that long line of thought.  On the surface, it might be easy to dismiss such concerns, as they have been regularly voiced over at least the past 12 years, so far proving to be incorrect.  Japanese interest rates have not skyrocketed, the crisis has not arrived.

That said, I would not bet against that crisis over the decade, and I think that the longer the economy is stuck at the zero lower bound, the more likely it becomes.  Boone and Simon note:

Japan’s taxpayers are already rebelling against small tax increases needed to limit escalating deficits. This leaves little room for hope that future taxpayers will accept the larger tax increases needed to repay debts.

Japan’s demographic decline will be hard to reverse…

…A crisis in Japan would most likely manifest as a collapse of confidence in the yen: At some point, Japanese citizens will decide that saving in any yen-­denominated asset is not worth the risk. Then interest rates will rise; the capital position of banks, insurance companies, and pension funds will worsen (because they all hold long-maturing bonds, which fall in value when rates rise); and fears of insolvency will surface.

The basic story is straightforward.  Japan has a fiscal problem, but cannot find the political will to fix it via tax increases or spending cuts.  I am not surprised.  It is too easy to claim that this is simply the outcome of a broken political system.  Fiscal austerity will be met with a recession, just as it has been elsewhere.  And with the economy operating at the zero bound, the Bank of Japan will have relatively few tools to counteract the recession (actually, no, but more on that later).  Fiscal austerity is easy to say, hard to do.

It is hard to believe, however, that the debt situation in Japan is sustainable indefinitely (see Noahpinion here).  At some point the Japanese will not be able to finance their deficit without deep budget cuts, hard default, or soft default in the form of outright monetizing of debt.

Austerity will prove to be ineffective; I don’t think it will be politically possible.  Too many people starving in the streets.  Eventually, the hit will be taken by bondholders.  It is simply a question of whether they take that hit in the form of hard or soft default.

And herein lies the problem with the zero bound.  Japan has long moved past the point where their citizens can worry only about the lost income from low interest payments.  Now it is all about capital preservation, making it harder to implement either a hard or a soft debt default.  In effect, the outcome of being at the zero bound is an every increasingly large political class that has a lot to lose by anything that increases interest rates, inflation or a drop in confidence.

Worse, that large political class makes it increasingly difficult to do what seems to be the best path, a gradual erosion of the real value of that debt through inflation.  The failure of generate inflation over a period of decades actually makes it more difficult politically to create that inflation as the capital losses would be borne more intensely by an ever increasing part of the population.  They are all taxpayers and bondholders.  They take the hit in taxes, spending, or capital position.  The longer they wait to take that hit, the bigger it will be.

What I expect to happen is this:  The Bank of Japan will be forced into outright monetization at some point; a soft default in the form of higher inflation will occur.  And dramatically higher inflation, I fear.  Japan has not had inflation for two decades.  I suspect they will experience all that pent-up inflation in the scope of a couple of years.

In other words, you can take your inflation medicine a little bit at a time, or a whole bunch at once.  But a even a little bit at a time becomes increasingly more difficult politically as the debt load grows larger.

Now, how does this apply to the US?  After all, the US does in fact have inflation, with prices projected to grow at something less than 2% annually.  But this argument assumes that 2% is the “right” inflation rate.  I would argue that it is not the right inflation rate if it is insufficient to lift the economy from the zero bound.  The Fed’s own forecasts, and the fear of the fiscal cliff and the subsequent recession, says we are not yet there.

I suspect the US needs higher inflation, just like Japan.  The commitment to ultra-low inflation seems to be a pendulum that has swung too far.  Policymakers need to take the danger of the zero-bound seriously.  And I think the Fed’s forecast imply they are not taking it seriously.

Think we can’t create inflation?  Think again.  Federal Reserve Chairman Ben Bernanke gave the answer:

There is no unique solution to the problem of continuing declines in Japanese prices; a variety of policies are worth trying, alone or in combination. However, one fairly direct and practical approach is explicit (though temporary) cooperation between the monetary and the fiscal authorities. Let me try to explain why I think this direction is promising and may succeed where monetary and fiscal policies applied separately have not…

…My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt–so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent….

…The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about “broken” channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank “lacks the tools” to reach a price-level or inflation target.

Isn’t it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ’s purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan’s fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.

Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example….

Lifting off the zero bound probably requires a high degree of cooperation between the fiscal and monetary authorities that may, gasp, require some outright monetization of government debt.  Such monetization is what Bernanke advocated for Japan, but this advice fell on deaf ears.  Because such cooperation is feared, it is essentially off the table.  For now.  But what I think will be the case is that instead of small amounts of cooperation now, we are setting the stage for large amounts in the future.  Debt reduction via inflation will come; the longer we wait, the more disruptive it will be.

Such thoughtful, careful, technocratic cooperation between monetary and fiscal authorities, however, is no where to be found.  In the US, Europe, and Japan, at best we have is monetary authorities trying to offset real and expected fiscal austerity.  That path, I fear, only leads us deeper into permanent zero bound territory.

Bottom Line:  2015 is too long to wait to emerge from the zero bound.  Policymakers need to make efforts to normalize the economic environment a priority.  That may require a level of fiscal and monetary cooperation that today seems to be unthinkable.  But if gets to the point where central banks are pulled kicking and screaming into such cooperation (the European Central Bank may be the first to explicitly monetize government spending; I suspect it will be the only way to keep Greece in the Euro and live up to Draghi’s pledge that the Euro is permanent), then I think we will all wish we had engaged in such cooperation sooner than later.

This post was originally published at Tim Duy’s Fed Watch and is reproduced here with permission.

2 Responses to "Why I Agonize About The Zero Bound"

  1. Burk   September 25, 2012 at 6:47 pm

    The fears here are a bit hard to understand. The point of all this policy is to maintain employment, and thus services of all kinds to citizens. The problem Japan and we have been having is that too much saving (or financial implosion) takes money out of the system, necessitating continuing pumping of money back into the system by the money issuer- BOJ, along with fiscal deficits and rising state debt, which = personal savings.

    So as long as there is no inflation or other type of boom, this can go on as long as needed. Savings build up and people feel secure and happy. The question is whether the real economy has been sufficiently tended, and whether demographics are stable enough, to support everyone in the future. Once the current savers start to spend down their savings, (though it is not at all clear that in a rich country any net spending will *ever* take place, since being rich means having and keeping your money in reserve, then bequeathing it), then that spending will support economic activity, and the government can naturally withdraw deficit spending and even raise taxes to keep inflation at bay, on the strength of that economic flow, which keeps everyone employed, perhaps tending the elderly.

    So, fear of continued unemployment- yes. Fear of debt? No. If interest rates go up, they will not go up on BOJ bonds much post the inflation rate. This is because they are guaranteed bonds with no solvency risk. So, financially to the government, they are a wash, as long as interest rates and inflation are in rough parity, which will continue to be the case. As you say, some managed higher inflation wouldn't be a bad thing, but 2X GDP is not at all outrageous as a net savings position for a population to have in perpetuity. How much do you have?

  2. DiranM   September 26, 2012 at 2:23 am

    You make some very cogent points. Bill Gross has also written about the abnormal situation for investors and even the future of fractional banking.

    You miss, however, some serious point sabout Draghi, OMT and Greece. OMT is not even addressed to Greece. A precondition for Spain and other eligible countries for OMT is to wear the Eurozone hairshirt of internal devaluation that means in effect Fisher debt deflation: an severe economic depression that destroys tax base, bankrupts large parts of the private sector and creates massive unemployment. That is somehow offset by ECB sovereign bond purchases to lower interest rates…. Here we have typical EU thinking: lower interest rates coupled with mounting default risk that could in the end mean the bankruptcy and capital call for the ECB, which will fall on the remaining Eurozone members who are still standing. Let's face it, the Eurozone is a highly destructive system!!!