Our Peril at the Zero Bound

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If you’ve been reading Paul Krugman regularly for the past 18 months, you know what he says about interest rates, and the way traditional monetary measures are unavailable to us during this recession. This is Krugman back in January 2009:

But looking forward, the Taylor rule says that the Fed should cut rates a lot from here — in fact, to negative 6%. That’s not surprising: we’re clearly opening up a huge output gap, inflation is turning into deflation.

The problem, of course, is that you can’t cut interest rates below zero (if you try, lenders will just hoard cash.) So the Fed simply can’t do what the rule says it should.

He’s been beating this drum pretty regularly since that time, writing many posts on the liquidity trap and zero interest rate policy. This one is long (and, as he says, wonkish) while this one gets to the nitty gritty. What it comes down to is this:

The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem.

Of course, that’s the opposite of what we’ve been doing lately, but that’s beyond the scope of this post. What made me want to write about this today was a graph and two paragraphs in Calculated Risk. First, the graph:

Housing Starts vs. Unemployment (Inverted)

And now, the real meat of this post—thanks for sticking around—the two paragraphs that sum up our situation so well:

Usually near the end of a recession, residential investment (RI) picks up as the Fed lowers interest rates. This leads to job creation and also additional household formation – and that leads to even more demand for housing units – and more jobs, and more households – a virtuous cycle that usually helps the economy recover.

However this time, with the huge overhang of existing housing units, this key sector hasn’t been participating. This is what I expected when I first posted the above graph two years ago!

The housing bubble really pooched us, as I’m sure you’re aware by now. But we can’t rely on the housing sector to help bring us out of the unemployment slump this time around either, because we can’t lower interests rates like we normally would.