Zero Matters Because Rules Matter

Ezra Klein recently revived my article on how a cashless economy could end recessions by allowing the Federal Reserve to set short-term nominal interest rates to negative figures, thus eliminating the zero lower bound problem. Some people have not been persuaded by this analysis, including Ryan Avent with whom I usually agree about everything, with a lot of folks arguing that it can’t be so simple as a technical problem. After all, even with the zero bound in place there are things the Federal Reserve could do to revive the economy and they’re not doing them. So whatever reasons are blocking them today would block them even in a world with negative interest rates.

I think this is mistaken for reasons I haven’t been able to properly explain until I read Evan Soltas’ brilliant post on Y2K as a natural experiment in monetary policy. To summarize, there were a lot of hazy worries about a Y2K computer bug that might temporarily compromise the world financial system. Consequently, there was a surge in demand for cash. The Fed responding by printing a lot of money and increasing the monetary base in the leadup to Y2K. But everyone understood exactly what we were waiting for and understood exactly what the Fed was doing. When Y2K turned out to be a non-issue, the extra money was withdrawn. And—and here comes Soltas’ point—if you try to find evidence of any of this in price or interest rate data, you don’t see anything. You don’t see anything because expectations were anchored. People knew what they were worried about (Y2K) and knew what the policy responses were going to be.

This, I think, is why zero matters. It is true that there are lots of different ways the Fed can do. But during the Great Moderation the thing the Fed did do was stabilize the macroeconomy by cutting interest rates. Everyone anticipated the Fed’s behavior to follow a Taylor-type rule in which inflation and unemployment data determined interest rates. You would read paradoxical-sounding stories about the stock market jumping on disappointing jobs data, precisely because everyone felt they understood how everything worked. The problem with the zero lower bound then becomes that as rates got closer and closer to zero nobody knew what was going to happen. People in the know knew that students of monetary theory had proposed a variety of possible central bank measures at zero. But Ben Bernanke didn’t explicitly write down “this is the Federal Reserve’s plan of action if unemployment is high and interest rates hit zero” and then display it for all to see behind some “in case of emergency, break glass” windowpane. In other words, it was the reverse of Y2K. We knew something would happen but nobody knew what. So when rates did hit zero, expectations became unmoored.

But if there were no logistical barrier to going negative, people could just assume that the Fed would keep using its tool of choice and its rule of choice and do what the rule said. No muss, no fuss. It would feel a bit funny the first time it happened, but since the economy would have recovered faster the Fed would have gone back to raising rates faster and ultimately there’d be less discontent than there is with the status quo.

I say all this, I note, not to argue that we need to scrap paper money. The point is that it’s very bad for the Fed to have a policy rule that breaks down in moments of severe crisis. It’s like having an umbrella that dissolves in water. We either need to run a background level of inflation that’s high enough to avoid zero bound episodes, or else shift the policy lever to something that’s not effected by these issues.