Paul Krugman has just made me much more pessimistic about the likely success of "unconventional monetary policy" measures to fight deflation and liquidity traps. It's not that I hadn't heard the argument before--this is the third time I've read Paul's stuff on liquidity traps, after all.
But when you are teaching something, you focus on it in a way that you almost never do otherwise...
Posted by DeLong at May 14, 2003 02:15 PM | TrackBackThinking about the liquidity trap: Unconventional open-market operations: A second argument on monetary policy is that while conventional open-market operations are ineffective, the central bank can still gain traction by engaging in unconventional operations ? with the most obvious ones being either currency-market interventions or purchases of longer-term securities. The argument of proponents of such moves, for example Alan Meltzer, is that in reality foreign bonds and long-term domestic bonds are not perfect substitutes for short-term assets, and hence open-market operations in these assets can expand the economy by driving the currency and the long-term interest rate down....
Clearly there is something to this argument: perfect substitutability is a helpful modeling simplification, but the real world is more complicated. And in the absence of perfect substitution, these interventions will clearly have some effect. The question is how much.... A rigorous model of monetary policy in the face of imperfect substitution is difficult to construct (if only because one must derive that imperfection somehow). But a shortcut may be useful. Consider, then, the case of foreign exchange intervention ? purchasing foreign bonds in an effort to bid down the currency.... What would the central bank be doing if it engages in exchange-market intervention in such a situation? The answer is that in effect it would be trying to do through its own operations the capital export that the private sector is unwilling to do. So a minimum estimate of the size of intervention needed per year is "enough to close the gap" ? that is, the central bank would have to buy enough foreign exchange , i.e. export enough capital, to close the ex ante gap between S-I and NX at a zero interest rate. In practice, the intervention would have to be substantially larger... would induce private flows in the opposite direction. (An intervention that weakens the yen reinforces the incentive for private investors to bet on its future appreciation)... could involve the Bank of Japan acquiring foreign assets at the rate of 10, 15 or more percent of GDP, over an extended period....
Purchases of long-term bonds would work similarly. In this case the central bank would in effect be competing with private investors as a source of investment finance (this would be true even if the intervention itself were in government bonds). Again, there would be an offset ? with lower yields, private investors would divert some of their savings from bonds into short term assets or, what is equivalent under liquidity trap conditions, cash. So again the central bank would have to sustain purchases at a rate several times the ex ante savings-investment gap; in this case the BOJ might find itself purchasing long-term bonds at a rate of 10-15 or more percent of GDP.
There are obvious political economy problems with such actions. The prospect of having a quasi-governmental institution owning a trillion dollars of overseas assets, or most of the Japanese government?s debt, is a bit daunting. Of course this would not happen if a relatively brief period of unconventional monetary policy led to a self-sustaining recovery. But to believe in this prospect you must, as in the case of fiscal policy, believe that the economy is currently in a low-level equilibrium and can be jolted back to prosperity with temporary actions ? a fairly exotic, though not necessarily wrong, view on which to base policy.
The same remarks applied to fiscal policy also apply here: while unconventional open-market operations are less certain a cure than their proponents seem to think, they could help, and might well be part of a realistic strategy...
Isn't the implication of this analysis that we are always in a liquidity trap? I mean, in a world where the private sector is huge and tends to make offsetting shifts in its portfolio, the central bank is helpless regardless of the level of interest rates or inflation.
I think it's possible that we live in such a world and refuse to admit it. That is, all of our praise (or condemnation) of Greenspan is just the Fundamental Attribution Error--treating him as responsible for something that is out of his control.
I mean, he can control the Fed Funds rate (as long as he stays close to where the private market thinks the rate ought to be), but in all the markets that matter--foreign exchange, mortgages, etc--large private sector flows may be the major factors.
Posted by: Arnold Kling on May 14, 2003 02:53 PMThis is a good opportunity to ask a question which has been puzzling me. Way back, when I was a schoolboy, I remember being told that the Government Broker (the guy who ran around the old London Stock Exchange in a top hat) dealt in all levels of gilts. In fact, the Treasury intentionally priced each issue of the long bond so that the bulk of the issue would not sell immediately so that, therefore, it constituted much of the Government Broker's inventory. Thus the latest long bond was known as the "long tap."
But I read in this post (and have seen implied elsewhere) that long bond dealings by a Central bank are "unconventional open market operations."
Did I misunderstand what they tried to teach me 40 years ago? Or has practice changed? Or was that a purely Bank of England practice even then?
Posted by: jam on May 14, 2003 03:00 PMWell, that's what Fischer Black thought all his life...
I think the answer is "No." There is just too much evidence that central bankers decide that they need to change things, and that things change. As long as nominal interest rates are relatively high and excess reserves are low, central bank actual and expected open market operations matter for financial-sector behavior.
The question is what can a central bank do when nominal interest rates are very low, excess reserves are mounting up, and an open market operation looks a lot like the exchange of one nearly-identical asset for another...
Posted by: Brad DeLong on May 14, 2003 03:01 PMA B of E thing. The U.S. Treasury sells all (or almost all) of every issue at a real auction...
Posted by: Brad DeLong on May 14, 2003 03:15 PMThanks. Is there any (theoretical) reason the UK does long bond open market ops and the US doesn't?
Posted by: jam on May 14, 2003 03:29 PMCan someone explain what Paul Krugman is trying to say, to non-economists.
Thanks a ton to the person who does
Cheers
Posted by: Vivek on May 14, 2003 09:36 PMOn second thoughts, thanks a ton to the person who explains Paul Krugman's musings on liquidity trap to not-yet-economists, as I prefer to be called.
Cheers
Vivek.
Arnold: welcome to the Post-Keynesian dark side, good to have you aboard. Perhaps an intermediate position would be that the Fed can contract the money supply but not grow it; that's my view and (I think) also Keynes's.
Jam: The BoE did deal in the gilts market, but it didn't act as a central bank in so doing (this is the distinction between the Banking Department and the Issue Department which makes chunks of Bagehot so difficult to understand). It was selling these bonds on behalf of the Treasury, and they were financed with "real" outside money, not money created for open market operations.
Posted by: dsquared on May 15, 2003 02:58 AMWell, Paul, as I understand him, is saying 'push this button'. Now if we're all agreed that such 'unconventional monetary policy' may not work, where exactly does that leave us?
Posted by: Edward Hugh on May 15, 2003 01:00 PM"Isn't the implication of this analysis that we are always in a liquidity trap?"
In one sense Arnold is right, but doesn't this lose the specificity of the Krugman/Keynes trap. Perhaps, after all the thing is a misnomer: maybe 'viscosity trap' would be more to the point.
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