ZIRP!

That’s zero interest rate policy. And it has arrived. America has turned Japanese.

This is the thing I’ve been afraid of ever since I realized that Japan really was in the dreaded, possibly mythical liquidity trap. You can read my 1998 Brookings Paper on the issue here.

Incidentally, there were a bunch of us at Princeton worrying about the Japan problem in the early years of this decade. I was one; Lars Svensson, currently at Sweden’s Riksbank, was another; a third was a guy named Ben Bernanke. I wonder whatever happened to him?

Seriously, we are in very deep trouble. Getting out of this will require a lot of creativity, and maybe some luck too.

Comments are no longer being accepted.

Dr. Krugman,

I’ve read few papers by Dr. Bernanke on the Japanese problem and I disticnlty remember that at least in one of his papers he has argued that a country which can print paper money CANNOT fall into liquidity trap. I can email you the paper or if I find a weblink I’ll post it on this forum.

I’m thinking of Charlton Heston’s final scene in the original Planet of the Apes.

I understand the dreaded dangers of deflation. But having been a econ major back in college and a history buff since, I am even more concerned about the risk of very high inflation–not just high inflation, such as the 30% annual inflation I experienced as a grad student in England in the mid-1970s, but hyperinflation like that of Germany in the 1920s. Our government in increasing the money supply at an astounding rate. What will prevent inflation on a scale the U.S. has never seen? If inflation gets going, what stands between us and catastrophic capital flight?

Well, I guess that’s it. The Fed has now made themselves irrelevant.

Given that we can no longer advantageously manipulate rates, given that a major increase in expenditures probably isn’t tenable, besides altering the money supply, what options does the federal government really have?

Can you explain how cutting the interest rare encourages lending? I see how it could encourage borrowing, and I suppose a lower interest rate means less chance of a default, and that could make banks slightly more willing to hand over money I suppose. But how does this encourage Bank A to lend money to Bank B, or to a small buisness, or whatever, if there’s any significant risk? With rates ranging from ~0% to 4% for the common folks, doesn’t the bank better serve its investors by sitting on the money and making sure they stay liquid, rather than risking those funds for marginal gains?

> Seriously, we are in very deep trouble. Getting out of this will require a lot of creativity, and maybe some luck too.

The Fed buying a lot of US bonds is a good start. This should take care of the deflationary spirale. After the economy has bottomed, the governement should reintroduce reserve requirements, of at least 50%, to avoid inflation from all the newly created money – voila, we would be on the way to full reserve fiat money where we should have been all along. The banks, of course, would make less profit with over 50% reserves, but who cares about the banks that brought us this mess?

someone should calculate the rate of progressive collapse in the economic sense. How long will it take Wal-Mart , and its business model to grind up the American economy. Bailouts alone will help for awhile, like diluting your blood. But if jobs are continued to be exported, there will be no income to pay for those houses or cars yet to be unloaded. Giving the guy in Ohio a job at Wal-Mart after he lost his at a car company or a TV making factory will not save our cash flow. How would China look if it gave away its industrial base to India?

Anytime you have to rely on luck to get yourself out of a rut is an indication that you are in a really, really bad situation.

Do you have any prediction for when creative lucky people might see the end of this?

Dear Paul,
there are many differences to Japanese … What are chances of ending up in a non-Japanese outcome of stag-flation? Just assume sinking dollar, jumping commodities … and the growth still may be close to zero.

The economists’ four-letter word: Z!@#.

I’m about to graduate with a BA in economics… and I remember reading in my intro econ textbook just a few years ago about the Japanese liquidity trap, thinking “I’m so glad we manage our economy better.” Oops.

This will be less effective even than the Japanese ZIRP, which did at least boost their exports by suppressing the yen-dollar exchange rate enough to give their exporters a 20-25% cost advantage over US competitors.

By reducing to zero the interest income of those retirees and soon-to-be-retirees who actually have savings, this will dramatically reduce the propensity to consume of the only market segment not already in deep financial doo-doo.

It won’t raise home prices, because the supply glut is now obvious to all, and the “real estate can only go up” psychology has been destroyed. And there’s no pent-up first-time buyer demand because the bubble pulled it all forward. Not only does everyone who wants and can afford to own a home already own one, millions who can’t afford one “own” one, too (often three or four). In Japan, mortgage rates fell to 2.38% (governemnt-subsiidy), but home sales and prices just kept on falling.

Millions of baby boomers fast approaching retirement — many about to be forced into it by layoff into a hopeless job market — have seen their stock holdings slashed 40% in value, and their bond funds fallen, too. Since the Fed intends to force them to lend their savings to the banks at zero percent interest, they are going to realize they need to save even more. If they’re still employed, that is; if they’re not, they’re going to tie their purse strings into super-Gordian knots proof against even an Alexander.

Cute name for a bad problem. How much does Japan’s demographics play into their problem? They have a shrinking population, and not much immigration. The US has a huge advantage in these areas. Will this give us a boost in alleviating problems similar to them?

Ben may have had the know-how, and he sure is in a place to help out, but it seems to me tlike he isn’t really taking action. Am I reading him right? Does Ben have the will to step up and order what we need in this time of crisis?

Prof. Krugman – thanks for providing the link to the 1998 paper, it makes for very interesting reading. Are there any other resources you recommend for those of us trying to wrap our heads around this situation?

Could it be that the dismal science is dismal because it has no measurement tool other than money? How can flooding America with dollars change the level of trust in a society poisoned by lies?

Bernanke can print dollars, but he can’t print trust or honesty, and that is why there is no easy remedy to our current distress. Until the culture of lying is driven out of most economically significant organizations, no amount of financial manipulation or economic theory will resolve this crisis.

Re comment #4, on how lowering interest rates can encourage lending:

The Fed doesn’t actually raise or lower the federal funds rate. (We have been misled by over-simplified media coverage.) In fact, the banks set this rate themselves. What the Fed does is set a “target” rate — a rate it hopes the banks will choose. The Fed then does things with an eye toward encouraging the banks to adjust their rate toward the target.

To add in my own simplification: when the Fed wants the banks to lower their rates, it prints up new money & either lends it out or buys things with it. Normally the extra money is directed to banks, and with all that extra money, normally banks say, “Hey, look at this extra money. We don’t need all of it. We can make a profit by lending some of it out.” Since many banks will be doing that at the same time, they start competing for borrowers by lowering their interest rates. So lending increases precisely as interest rates go down.

The current situation is unusual in many ways, and this is a simplification in any case, but this is the basic idea.

Prof.

Would it be an option to kick in interest tax to make it negative interest rate so that we can dodge the bullet of liquidity trap?

Why not actually allow interest rates to dip below zero for loans to banks which promise to use them for extending credit and making loans? I’m no economist but it seems that letting banks make an instant profit on loans might ease their fears of taking on a little risk with people.

I believe that a large part of the current problem has been the low interest rates that we have had for several years. This has caused investors to seek any way to make higher interest rates anywhere they can because the rates available to them from bonds, banks, etc. were so low. I think that this helped lead to the sub prime mortgages (cheap capital seeking higher returns), derivatives, highly leveraged hedge funds (cheap cost of capital), Lehman Brothers leveraged 30:1, etc.

Given that perspective, when I see that rates are now even lower, I wonder if investors will continue to pursue (new) risky strategies in order to continue to try to gain high rates of interest? Might we be better off if the US Gov’t issued bonds at a meaningful rate of interest to attract borrowers from all over the world, including US citizens, and then use the money for the programs that it wants to fund in the stimulus packages. Yes it would cost our government more money over the long term, but it would create interest income for the purchasers, minimize efforts to pursue riskier strategies, and bring some of the money that is sitting on the sidelines into the markets.

My economics training is rusty – which I am sure shows, but it is just a thought.

How can we possibly stand by and let the country and the majority of its people fall by the wayside when there is so much wealth out there to be taxed?

Well how would it work? It has been brought up many times. Let’s try, This April 15th, 19% of all wealth is due and payable to the US Treasury, then each year after, 19% of the amount over that, so of course once taxed, a dollar of wealth will never be taxed again.

Sure there are some wealthy people who read these comments, but I think the vast majority of us won’t get to pay this tax — ever in our lives.

HH: “Bernanke can print dollars, but he can’t print trust or honesty”
Bingo. That’s the nature of a liquidity trap. %M suddenly does not equal %P or %GDP because the multiplier and velocity (people’s willingness to spend and lend and borrow and invest) is destroyed by lack of confidence.

Any economist who works in mathematical models without truly studying the psychological and sociological factors of human behavior in this type of situation is not really an economist… just a high-paid accountant.

Non-Japanese: “there are many differences to Japanese.”
Yes there are. They were net exporters and net savers before their liquidity trap snapped, just like the US was in the leadup to the Great D. I don’t think any research has ever been done about liquidity traps that emerge in countries that pre-trap are net importers and net borrowers with pro-cyclical deficits. We’ve kinda guessing and hopefully learning as we go.

Neil: “They have a shrinking population, and not much immigration. The US has a huge advantage in these areas.”
How do you figure? The percentage of our population older than working age will be seeing the largest surge in history over the next 40 years. Importing workers has some political and sociological issues, not least of which is the willingness of the electorate to support additional labor competition during a period of unemployment.

Keynes’ hypothesis that some time in the future a liquidity trap could happen though to the best of his knowledge this had not happened yet (writing in 1935) had to do with the long rate, not short-term rates. The idea was that due to the speculative demand for money a situation could arise that the long-term rate would reach a floor at some positive value above zero and would not go any lower. Just as that did not happen in the Great Depression, it has not happened now. To argue that we are in a liquidity trap is to redefine the term radically from how Keynes used it.

Early editions of Robert J. Gordon’s Macroeconomics text incuded an interesting case study “Was There a Liquidity Trap in the Great Depression?” which showed that as the ratio of real money balances to real GDP increased, which happened during the partial recovery from the Great Depression before WWII, long term interest rates dropped.

We are far from zero interest in longer term rates. While pegging the federal funds rate has lost its effectiveness, there are other types of monetary policy which have not. Directly aiming open market purchases at 10 year U.S. government notes or even at FHA insured morgages can still bring those interest rates down.