Gauti Eggertsson on the Zero-Lower Bound and Liquidity Traps

Gauti Eggertsson is a professor of economics at Brown University. Previously, he worked at the research departments at the International Monetary Fund and the Federal Reserve Bank of New York. He joins the show to discuss his work on the history of liquidity traps and extremely low and even negative interest rates. He and David discuss examples from the Great Depression to Japan in the 1990s to today. Gauti also shares his thoughts on the Fed’s quantitative easing (QE) program and why it failed to return the economy back to normal.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Guati, welcome to the show.

Gauti Eggertsson: Oh, thank you. Thanks for having me.

Beckworth: Oh it's a real treat to have you on board. Let's begin, as I do with all my guests, and ask, how did you get in to macroeconomics?

Eggertsson: Well I think sort of coincidentally when I was in high school I started reading about Adam Smith and thought economics just seemed like an interesting approach to... I guess it was a scientific approach to study human interaction. It was sort of a new thing to me. And that sort of led me then gradually to macro. But that's sort of, the first time I realized what economics was or something. It excited me.

Beckworth: Interesting, so Adam Smith opened your eyes to the field of economics?

Eggertsson: Well, it was just some booklet that a professor at the University of Iceland put together and we had sort of dummied it down for somebody like me at that age to be able to read.

Beckworth: You didn't crack through the entire Wealth of Nations as a teenager.

Eggertsson: No, that I did not do.

Beckworth: Okay. Nonetheless, it's still interesting that Adam Smith put you down this path. Now you went on to graduate school and I was reading your recent articles on Ben Bernanke's argument, and we can come back to this paper later, but in that paper you mentioned that he was your advisor on your thesis, is that right?

Eggertsson: He was one of the advisors, yes. So he was, and Mike Woodford, Chris Sims, and Paul Krugman.

Beckworth: Oh wow. You had-

Eggertsson: So it was quite a collection there.

Beckworth: Yeah, fantastic. It was interesting because in the paper you mention that Ben Bernanke tells you, "Look I don't believe in liquidity traps. You can do this but I don't believe in liquidity traps." So really interesting story, it sounds like.

Eggertsson: Yeah so this was his first reaction and I think it reflected a little bit how people understood the word or the concept liquidity trap to mean at the time. The interpretation a lot of people took was that saying that you were studying the liquidity trap meant that you were saying you didn't think monetary policy could do anything. And I think that was sort of what Bernanke was objecting to. He did not believe that was the case.

Eggertsson: While I think there's sort of more modern nuance, the notion of the liquidity trap is just there's a bound on how much you can cut interest rates.

Beckworth: Yeah.

Eggertsson: And I don't think you would say he doesn't believe that.

Beckworth: Yeah. He's learned the hard way as the Chairman of the Fed.

Beckworth: Now when you wrote your dissertation, and early on when you were doing a lot of your work with Michael Woodford, which again we'll get to in a bit, it was on this issue, the Zero Lower Bound liquidity trap and at the time there really weren't a lot of countries going through that. Japan was the obvious one. So I'm wondering, when you were writing this in the early 2000s, you had several important papers, what were you thinking? Did you think at some point we'd have a whole world filled with Zero Lower Bound countries, or were you thinking, "Man this is really just for one country now." What was your thoughts at the time?

Eggertsson: Well, it's interesting. People nowadays often ask me that, "Why were you working on this, that seemed like a strange thing to work on." But at the time at Princeton, Krugman had written on the Zero Lower Bound in '98 and he was very interested in it. So was Mike. That seemed like the issue in macroeconomics that hadn't really been explored to its fullest. So to me it seemed obvious that that was a first order. It was an issue of first order importance given that Japan was still going through it, and we had this huge experience during the Great Depression. So I was always puzzled why attention was not, why there was not more attention paid to it outside of Princeton.

Beckworth: Yeah, that's interesting. Paul Krugman has often mentioned in his writing how there's a core group of researchers there looking at Japan at the time.

Eggertsson: Right. Yeah, and I even forgot to mention Lars Svensson.

Beckworth: Yeah, yeah.

Eggertsson: He was very interested in these things.

Beckworth: So you had great influences around you helping, maybe shaped some of your thoughts on that.

Beckworth: Now, you worked a lot with Michael Woodford after you got out of grad school as well with some important papers. I'm just curious, what was it like to work with him?

Eggertsson: Oh, he's fantastic to work with. He sort of got me really excited on this research path. I became his research assistant and then sort of gradually, that turned in to co-authorship. But he was a amazing person to be listened to as a grad student because what it was talking about at the time was really things that was nowhere written and he was just about to write, and Interest and Prices that became a very famous book. So in fact, I recall as a grad student we used to tape him because he would want to have the orational source for what he was talking about.

Beckworth: Interesting.

Eggertsson: He couldn't find it anywhere else.

Beckworth: You were the guinea pigs he tried the book out on.

Eggertsson: Yeah.

Beckworth: All right. Now from grad school you went to the IMF and then to the New York Fed, is that the right order?

Eggertsson: Yeah.

Beckworth: All right. And what was it like working at those institutions at the research department?

Eggertsson: It was... the IMF and both I had a good time, great time, both at the IMF and the New York Fed. They're very different institutions in the sense that IMF is for the United Nations so it's very sort of hierarchical while you get to the New York Fed and the next week you may be briefing the president of New York Fed, which was very different from the IMF, where you would go through many different layers and not really ever have contact with the people make the executive decisions.

Beckworth: So one thing I was dying to ask you, and I think I already know, is what you were thinking when you were at the New York Fed given what we know about you and your work. Your calls for breaking the Zero Lower Bound through the different number of policies we'll talk about in a bit. And I've often wondered, man it must've been frustrating for Gauti sitting in New York Fed because the Fed persistently undershot its inflation target. It never really did anything... I mean it did QE's but even those things may have been limited.

Beckworth: So it was interesting, just recently a Bloomberg article came out that showed what you were thinking and suggesting in a 2010 memo that went out to your president at the New York Fed. And in it you see the work that you did and you have this memo called Inflation Budget Accounting. And I like that because part of the difficulty, I think, with the Zero Lower Bound is just communicating this idea across, the idea of level targeting I think is sometimes difficult to communicate. People think you would never repeat the 1970s inflation. No, no, no. It's rules based approach where you make up for past misses. But you had a nice way of framing this. I just want to read a paragraph from that memo you wrote to your boss.

Beckworth: It said, "We suggest the FOMC keeps track of the extent to which inflation has missed its target. Let us call these accumulated misses inflation debt, hence if inflation target is 2%, inflation is at 1% for two years in a row, then the accumulated inflation debt is 2%."

Beckworth: I like that. An accounting framework where you, I guess the opposite would be like a credit if it goes the other direction. So it looks like that was, you pushed that through. So what was Dudley's reception to that?

The Fed Undershooting Inflation

Eggertsson: Well I think he was interested. And I think there were of course a lot of different approaches discussed at the time, both at the board and at the New York Fed. I guess the inflation accounting framework never really took off. So I don't recall it going much beyond this initial idea. But as you may recall, the way the Fed then moves further, which was I thought a little bit a misdirection, was basically to state explicit thresholds when they would lift rate and try to move out expectations about the lift off by making explicit that we were not going to raise until X, Y, Z.

Beckworth: The Evans Rule and-

Eggertsson: Yeah.

Beckworth: QE3.

Eggertsson: Yeah so that sort of, I think, pushed in that direction. Because the original idea that I had with Mike Woodford in that 2003 paper was in fact to specify a trigger for when you would start raising rate. We specified that trigger in terms of a price level target or I guess output gap. And just price level target but it was sort of a similar idea as you saw in the triggers.

Beckworth: Yeah, again I think communication's a big issue here because I've been a fan and an advocate of a nominal GDP level target, very similar to this idea of the output gap but just at price level target. But it's a sale, it's a marketing issue.

Beckworth: In 2011, as you probably know well, the Fed FOMC discussed it and Bernanke in his book talks about that period. That was right after, right around the time that Michael Woodford had his big paper at the Wyoming, at the Jackson Hole meeting. Christina Romer had a op ed in the New York Times asking Bernanke to have his Volcker moment. They were all calling for a nominal GDP level target. But as Bernanke mentions in the book, it's kind of hard to communicate this, to get it across. You don't want to change horses midstream. It's a difficult thing to do.

Beckworth: But that's why I found your little note to your boss interesting because you famed it in a very, I think, accessible way. That's part of the challenge, nominal GPD targeting. Do we sell that as the total spending target or nominal income target? So it's, part of this is just the messaging so as need to see that.

Beckworth: Well let's move in to the-

Eggertsson: I supposed you can call it the Nominal GDP Debt.

Beckworth: Oh, there you go. Yes.

Eggertsson: But you want to pay off that debt.

Beckworth: There you go. That's a nice way, maybe that's what we've been missing then is the proper framing.

Beckworth: Well let's get into the basics of these issues that you spend so much time in. So what is a liquidity trap and how does it relate to the Zero Lower Bound and why is this such a problem?

Liquidity Trap and the Zero Lower Bound

Eggertsson: So the origin of the word comes really back to the '30s and I think the meaning people often then took for it mean, was that it would have no effect to increase the money supply. I think nowadays when I talk about the liquidity trap, it's just this idea that there's limit on how much you can cut the Federal funds, right. In particular it's hard to go much below zero simply because then people will want the whole currency as an asset. And then the question becomes what can you do when this standard tool is not available? And what are the... and that's sort of the question that a lot of my work has been grappling.

Beckworth: So the idea, for many of listeners they understand this well, some of our listeners may not. But the idea is central banks use interest rates to adjust the stance of monetary policy. And sometimes, and ideally in a theoretical sense, they always want to adjust it to where the natural interest rate would be. And that, right, is the rate that's driven by the fundamentals of the economy.

Eggertsson: Mm-hmm (affirmative)-

Beckworth: And so what you're saying and the concern is that sometimes if you're in such a deep recession that natural interest rate or the market clearing rate might go negative, way negative. And the central bank simply can't get down to it. So its tool becomes constrained by this, almost like a floor. And so what do you do? And one thing I really want to stress to our listeners is when we talk about negative rates we're really talking about making market work, making capitalism work. And I think that often gets another miscommunication in that people think the Fed's artificially lowering rates when in fact it's trying to track down and get to where the rate would naturally be.

Eggertsson: Right. It's this presence of money as an asset that makes it difficult. And it's just like the Fed always tries to do when you have a recession. It tries to get people to spend more by lowering interest rates that leads into the mortgages and their credit cards and that should goose up spending. And yeah you hit this constraint. So that's sort of what this whole liquidity trap is about.

Beckworth: And I guess, so what are the big historical cases where we would say we've hit the Zero Lower Bound? What are some good… what are the historical ones?

Eggertsson: Well the Great Depression of course was the big one where we saw that happen in the US. And then Japan post '96 or so, and then basically the rest of the world after 2008. Well not the entire world, but most industrialized countries found themselves very close to the, or at the Zero Lower Bound, some even experimenting with negative rate.

Beckworth: Yeah it's been amazing to watch these past few years. To see 10 year treasury yields go as low as they have, go negative in some countries even. This has been an amazing time to live through.

Beckworth: Well let's go to your work. And I want to start with your 2003 paper, your Brookings paper on Economic Activity with Michael Woodford. And specifically I want to jump to this great conclusion or this, one of the great insights from your paper. And you call it The Irrelevance Results. What are The Irrelevance Results and what does it tell us about QE?

The Irrelevance Results and QE

Eggertsson: So it's interesting how that result end up to have actually more predictive power than even I had anticipated. The basic point was that a lot of people at the time were saying, "Well, even if the short term nominal interest rate is zero, there are these long term interest rates that are positive. So then we can just try to affect them, for example by buying long term government bonds." And what we pointed out in this paper based on also original insight by Neil Wallace is that in these modern macro models these two things are not really independent, the long rates are just going to depend on current and expected future short rates. So those expectations are what tie the long rates now. And so just buying long term debt by itself is not going to have any effect if it does not change the expectations of a future short rates.

Eggertsson: And that was sort of the genesis of our Irrelevance Result. And we showed that it actually didn't matter even what kind of assets you were buying within a fairly idealized environment. But that was the gist of it.

Beckworth: And one of the other implications to come out of that is forward guidance is very important.

Eggertsson: Yeah. So this is a statement that these operations have no effect if they don't change expectations. Now one of the key results of that paper, however, was that even if you're constrained by the Zero Lower Bound today, you can have an effect by affecting people's expectations about what you're going to do in the future when this constraint may no longer be binding.

Beckworth: Yeah so you want to change expectations about the future path of interest rates, right? That's of the key. And going back to the natural interest rate idea, the natural rate has fallen negative and somehow you've got to get it down there so you want to change the expectation in such a manner that the rates actually match or get close to that match rate level.

Beckworth: Now how to actually get there, and this is where I find it really interesting, because there's a money guy in me who likes to think about money. And one of the implications from this and also from the Paul Krugman paper that was in 1998, very similar, but you guys had a more sophisticated and built upon, is that you've got to have a permanent increase in the monetary base in order to change those expectations about rates in the future. Is that right?

Eggertsson: Right. So Krugman, so our Irrelevance Result, you're right, is really an extension of his original insight. And basically what Krugman '98 showed was, if people's expectation about the money supply are fixed, once the nominal interest rate becomes positive again, then increasing the money supply today is not going to do anything because you're just exchanging money for government bonds, both is like exchanging blue M&M's for yellow M&M's. And if people then, the money supply's only going to matter once the interest rate will become positive. And if people expect it to contract at that time to the original level, nothing's going to happen.

Eggertsson: And I guess what he assumed was that this future money supply level was fixed. What Mike and I did was say, well actually you only need for people to form, hold their expectations about future interest rates, fixed. For example, with assuming the government will follow a... the central bank will follow a Taylor rule and the same insight applies. Moreover, it doesn't even matter how you increase the money supply when you buy long term loans or this or that. So that is sort of the... that was how these two thing connected together.

Beckworth: Yeah I see a few quotes from that paper, page 147 you guys say, "Open market operations should be largely ineffective to the extent they fail to change expectations regarding future policy." And then later on you say, "An injection of base money that is expected to be removed once the zero bound ceases to bind should have little effect on spending and pricing behavior."

Beckworth: So I guess the way I think about this is, if a central bank is not going to allow a temporary surge in inflation... so if you inject the monetary base, if it's going to be permanent, then looking forward there's going to be a one time increase in the price level which implies a temporary increase in inflation. And if that inflation goes up it drives the real interest rate down, drives them down far enough if it's calibrated right to get out of the Zero Lower Bound, markets recover and you have that escape.

Beckworth: But the issue is, the central bank won't allow that to happen, right? They won't allow that temporary overshoot of inflation, is that the idea?

Eggertsson: Yeah they won't contract the money supply back to its original level again. Which is indeed what we saw, for example, in the case of Japan in 2006 when they thought they were out of the woods. They contracted in very short the money supply in the Spring of 2006, quite quickly and without much technical difficulties. So to the extent that people are anticipating that sort of behavior, then just increasing the money supply in itself is not going to do much.

Beckworth: Yes, and you wrote this and you Mike wrote this and then also Michael in his 2011 paper wrote this. You make this point, which I think is very interesting, that because the balance sheet in the Bank of Japan got so large, it almost was a signal that it had to be temporary because if it were permanent it would've made some incredibly large increase in the price level that wouldn't have been tolerated.

Beckworth: So I've got a quote and I believe this is from, there's a working paper version of your Brookings paper that had some extra stuff in it, I believe. And they have this great quote which I don't think made it into the Brookings paper but it says, "The very size of the increase in the Japanese base money that has occurred as such to make it implausible that they are intended to be permanent. After all that would imply that once it has become possible to ban it in the zero lower rate policy, the general level of prices probably would have to rise by nearly 50%, something that one could not imagine being accepted even by a central bank firmly committed to Krugman-ess irresponsibility."

Beckworth: I love that last line there. So, that's Paul Krugman's committing to be irresponsible. And that's a great point. And I think kind of jumping ahead of our discussion to the questions I'm going to ask later, if you look all around the world we've got these huge balance sheets at central banks: the ECB, the Fed, Japan, Abenomics is incredibly large. And were those to become permanent, were they allowed to eventually come out, maybe become currency, you'd see a fantastic several hundred percent rise in price levels that just simply would not be tolerated politically.

Eggertsson: Right.

Beckworth: So I guess, let me just jump to the question I really want to ask. So is the world... have the QE programs throughout the world been plagued? Are they falling prey to your irrelevance results from that paper?

Eggertsson: I think to a large extent they did and frankly, to be honest, to a larger extent than even I anticipated at the time. It's sort of easy to, well it's not that easy for me to forget, but for everybody else to forget how out of consensus at the time the Krugman point was. You can even just see it in the discussion of this paper by Ken Rogoff where he says something to the effect, nobody should seriously believe that they increase the base by 30% and nothing would happen. They went way, way beyond that. And I think that was sort of the general notion of people that if you would just increase the base, stuff would happen. And then we saw banks like the Bank of Switzerland that didn't just increase it by 20% or 30% but by 700%, by largely buying foreign exchange. And yet, inflation there barely budged.

Eggertsson: So, yes, I think it has had a stronger predictive power than I would have expected. Yet on the other end there's always the counter factual. I do think the QE that was done in the US did have some with that.

Beckworth: Sure.

Eggertsson: And especially during the first phase when there was this severe in credit markets. And I think even the buying the long term debt had some effect on chance of signaling commitment to lower future rates. Which is consistent with the Irrelevance proposition. But I do think most of the effect then came because it was signaled to people that the Fed was more committed to keep moving rates low for longer than otherwise would have.

Beckworth: Yeah and I don't want to claim that QE had no results either. It's just that the hopes and the claims the Fed official just never materialized. It definitely is better than it may otherwise have been. But the fact is we've had an incredibly sluggish recover in the US. I've done a little experiment. Go back, take historical output gap data for the US, plug that into a simple auto regressive model, and let it forecast back to the zero, the mean, zero percent, and it's a much quicker recovery than would otherwise would have... any kind of, look at employment, any kind of metric that by historic standards has been a slow recovery. And in my mind it seems to me like man all these policy makers forgot the literature. Let me take that back, they know the literature but there's got to be political economy reasons why they can't do maybe what they want to do or should do.

Beckworth: Let me ask this: do you think the commitment to inflation targeting plays a role in that? In the sense that inflation targeting emerged as the nominal anchor that worked. It starts in New Zealand then spreads around the world. The US didn't officially adopt one until 2012 but implicitly have been doing it for a longer time. But this idea that inflation targeting has created this expectation both among the buddy politic, among policy makers, and in order to do what you guys prescribe and Krugman prescribes, you have to truly have flexible inflation target. You've got to allow some overshoot. And I'm wondering, do you think if the commitment to inflation targeting is one reason that policy makers couldn't allow that?

Eggertsson: To be honest it is one aspect of the policy response during this crisis that I have found somewhat puzzling, is that the central banks were willing to take on quite a bit of risk in terms of their own balance sheet, being quite adventurous and buying a variety of assets that could turn into capital losses. But they have been very reluctant to experiment at all with their inflation targets. And my view before the crisis and during the crisis was that that would be an obvious thing to try and probably less costly than, or should at the very least be done in conjunction with all these balance sheet actions. But nobody really went down that path. And yeah there's a political economy reason for that that I have not quite yet, perhaps it's just as simple as, people are still so burned by the '70s that just the mere mention of that you want to allow some inflation is just going to be beyond the pale.

Eggertsson: Which is almost strange in the sense that that's how the US recovered in 1933 by committing to reflation. But it seems like, yes, the last big crisis is a very strong effect on the side of the policy makers. And I think that perhaps that's one reason. I would say it's more the '70s than say that people were so wedded to a formal framework of inflation targeting and they just so happened to name a number that was rather low a few years back.

Beckworth: Yeah. Now it's... I originally wrote a paper on behavioral economics and wanted to write policy and it speaks to I think what you were just saying. Maybe many central bankers were fighting the last war. They're still stuck and they're worried about overshooting. In fact, Janet Yellen in a recent FOMC press conference, she mentioned we don't want to make that same mistake they made in the 1970s. So there's this kind of aversion, and in fact-

Eggertsson: So let's instead make the mistake we did in 1929 and '37.

Beckworth: Right, right. Well you have a paper, actually, I'll come in a minute, the one about the deflation bias but what's interesting... so I mentioned earlier at the start of this show this Bloomberg article and I'm going to give the title in case our listeners want to get it and maybe we'll link it on the web page as well. But it says, "Private 2010 records showed Dudley's staff urging bold Fed action." So were you called for exactly that, again just a temporary overshoot, so you hit your target on average but you allow the overshoot. Interestingly enough, in the article, it says one of the key people who pushed back against your suggestion was Janet Yellen. Now she wasn't Chair back then but she was still obviously influential.

Beckworth: And again I'm reading into this but I'm looking at, man is she fighting the last war still? And maybe not just her but a number of members on the board of governors on the FOMC. So maybe it's a generational thing, maybe-

Eggertsson: I think there was also in general when these issues were being discussed in public was, there was a concern which has never really been stipulated that well formally in my view, that taking a bold or different action like this would somehow increase risk premia. And though increases in risk premia would somehow work in a contractionary fashion. That was a very common argument at the time and I wouldn't be surprised if she had...

Eggertsson: In a sense though that kind of argument is almost, you can make it against almost any policy to the extent that … different. Well it could increase risk premia and if that's contraction then well...

Beckworth: Well again this speaks to behavioral economics the kind of aversion, the loss aversion. You want to be very cautious, conservative, don't want to make mistakes. So Narayana Kocherlakota has a recent paper for the Brookings panel as well on economic activity where he argues that one of the reasons the Fed was so timid is that it had, at least implicitly in their minds, following a tailor rule, again not formally but at least implicitly they think a certain way and it's hard to think outside the box, hard to think about being super aggressive in the short run and their kind of constraints. So there may be a number of things that were at work there, the Fed's a conservative institution, small ‘c’ conservative. It's slow to change and then also worrying about fighting the last war.

Eggertsson: The only puzzling aspect of that narrative is that, yes, one could take that perspective. But then on the other hand they were extremely adventurous and aggressive on the balance sheet side.

Beckworth: That's a good point.

Eggertsson: And with the QE. So that's the discrepancy that I have always found a little bit puzzling; ready to take so much risk on one side and very little in terms of what would seem not necessarily that costly trying to affect expectations about future inflation or future inflation goals.

Beckworth: That's a great point. So if they spend a lot of political capital right on QE programs, I mean-

Eggertsson: Right.

Beckworth: Poor Bernanke was grilled for QE2. I remember, and I mentioned this many times already but, on other shows on this podcast, but QE2 when it was being implemented, he went before congress, they just railed on him for debasing the currency. And core PCE inflation was like 1% at the time. So he took a big hit even though all the fears didn't materialize. One wonders, had they had a little temporary inflation overshoot instead of drawn out this long QE1, QE2, QE3, now they may have had to have some massive QE up front to make it work, but had they done something initially and used up their political capital then, maybe it would've been a different outcome.

Eggertsson: Right.

Beckworth: So look around the world, Bank of Israel, it's fascinating. They actually did overshoot their inflation targets. They have an inflation target, it's a range, it's 1-3% so on average you hit about 2, but they actually went up about 5% during the great recession period. Israel GDP went down. Interestingly enough, in nominal GDP growth path is relatively stable because of this. But they did. They were more flexible.

Beckworth: Let me ask this question because I often get this pushback. I often argue a true inflation, a true flexible inflation target is one where the inflation target is symmetric, where you'd see as many on average as many overshoots as undershoots. And so the fact that we haven't had that, so the Fed has averaged, its core PC inflation has averaged one and a half percent since the crisis, would indicate to me that it's not truly a flexible inflation target. Or am I reading this wrong? What is your take?

The Fed’s Inflation Target is Not Flexible

Eggertsson: Well, it has turned out that way in practice I think. And in fact the memo that you were referring to was trying to use the fact of the undershoot as justification for what otherwise might seem to have been a hard sell, to allow some excess inflation, because all that was really saying was that we're going to be symmetric. On average we're going to average 2's or if there's undershoot you accumulate that. What we call inflation debt. So I think in effect, yes, the way they have been operating looks awfully a lot like they have an asymmetric inflation target, and it's not clear why. And it does not strike me as a very desirable property.

Beckworth: Yeah, maybe I shouldn't call it a strict inflation target. But that's what Lars Svensson calls one that's more rigid. I guess they could argue well we've got a flexible one between 1 and 2%. But still, it's-

Eggertsson: Yeah, they said 2 and why is it between 1 and 2 as opposed to 2 and 3?

Beckworth: Right. Exactly. I think that's what's called for. And I did a little, I have a paper where I calculated kind of counter factual estimate. And what it would have required, and again this is just my exercise there's many other versions you could do this, I'm sure different models. But in order to, and I did this from a baseline keeping nominal income on a stable path, what would that have required? And I estimate inflation would have overshot 3, maybe 4%. Year, year and a half. Come down and gone back to 2%. And it's striking that something so, it seems in my mind, so modest couldn't have been tried. But there was a political calculation against it.

Beckworth: In that same paper I looked at some-

Eggertsson: Or-

Beckworth: Go ahead, I'm sorry.

Eggertsson: Or a overestimate of the effectiveness of this balance sheet action and that they would work independently of any expectation channel. So maybe that was at the end of the day the calculation people made they thought that would be enough and therefore it would not be worth experimenting with this. And I suppose that's just, that was a different, I came down with a different view prior to the crisis and I guess I still have that same view. If I were to guess, my guess is that somebody like Bernanke might say, "Well I think the price was not too bad." Because we had these effective tools.

Beckworth: Maybe so. If you look at the summary of economic projections, and again this is, Kocherlakota kind of directed me down this path, if you look at those it's interesting. Those consistently show at most 2% inflation, let me state this, not a forecast, the summary of economic projections, the definition if you look them online at the Fed's website, it shows what each FOMC member things would be the optimal path given optimal monetary policy; and so in other words the inflation path that they show, that they forecast, is one conditioned upon an optimal monetary policy.

Beckworth: And the central tendency measure has almost always been, at most 2%, oftentimes below 2%. Two years out, three years out. Which, it's like, blows my mind. You're telling me over a two, three year horizon you've got to have some influence over inflation. You're telling me your best case scenario you just touch 2% and worse case scenario you're below that.

Beckworth: So they're saying the optimal monetary policy path is one where we keep inflation low, you slowly get to full employment. No tolerance whatsoever for an overshoot.

Eggertsson: Right.

Beckworth: Okay, well I'll get off that soapbox. Let's go to your paper you did with the IMF, the IMF working paper 2003: How to Fight Deflation in the Liquidity Trap Committing to Be Irresponsible. And I think you had a paper that was similar. But what are the actual, let's talk through kind of the actual concrete steps. So we've got to somehow have a permanent increase in the monetary base, somehow overshooting, at least temporarily overshooting inflation, get the price level path back up.

Beckworth: So you mentioned several approaches. You mentioned cutting taxes, buying real assets, purchasing foreign exchange. So walk us through. What would be the concrete steps that a central bank would have to take or a government, maybe a combination of fiscal and monetary policy would take to get us to that price level path?

Returning to the Optimal Price Level Path

Eggertsson: Maybe it's clearest to just explain it via an example because later I studied on the Great Depression and found out that in some respects this was the problem that they faced as they wanted to reflate. There was a drop in the price level from, by 30% or so from '29 to '33. And Roosevelt comes in to office and said we're going to inflate the price level back to pre Depression levels. And he basically did three things: he went off the gold standard, bu then he said we're going to issue credit in as much quantity as needed until we reach that target. And we're going to do government spending and run deficits.

Eggertsson: So, that was sort of one straightforward way of putting the whole powers of the government behind a commitment to reflation. So why would something like that have the effect of making people believe that they were permanently going to increase the money supply? Well, if you make, in conjunction with that announcement you start issuing a lot of debt, you have every incentive to make sure that the real value of that debt is not too high because if you don't deliver on your inflation then the real value of what you have to collect, the real value of the debt the government that has issued goes up. And then we'll have to raise taxes by more.

Beckworth: And so back then it was, I guess it's fairly easy to be credible if you go off the gold standard. That's a pretty significant-

Eggertsson: Well that was one important element but I think it's sometimes a little bit overrated as the linch pin because first of all the US was holding gold in excess of what it needed according to the rules of the game. But secondly, now I do think it was important but I don't think it was the only thing, because the second this is that, then during the crisis of '37 and reversal of '38, they abandoned basically the commitment to inflate. You see a recession in '37 and '38. And there's nothing going on with the gold standard there. Or no banking crisis with them but you see exactly the same pattern in inflation as a result of these swings in policy.

Beckworth: Okay, so it takes a coordinated effort, I think is what you're saying, right? Between monetary and fiscal-

Eggertsson: Yeah, that's at least one approach that we have seen in history has worked pretty well when it was very explicit at the time yet more the treasury secretary and at least head of the Federal Reserve. It was clear this was a coordinated effort.

Beckworth: And it requires, and correct me if I'm wrong here, it requires a coordinated effort tied to a price level or some kind of explicit reflation. So the reason I ask this is because prior to Trump getting elected there were many calls for helicopter drops. People were convinced oh we've tried everything else we've got to go to helicopter drops. And my only problem with the helicopter drop is that even if it was implemented, you still have all these central banks around the world who might get worked up once the helicopter drop's effect kick in.

Beckworth: So you do the helicopter drops... I guess it's hard for me to imagine a helicopter drop being meaningfully effective if you're maintaining the same low inflation target. They kind of run against each other. So you would have to have a helicopter drop in conjunction with a higher inflation target, or a price level target, or a nominal GDP level target. Is that right?

Eggertsson: I would subscribe exactly to that because what's the difference between dropping money from a helicopter versus dropping government bonds? They're both government issued piece of paper with zero interest rate in an environment where the Zero Lower Bound is binding. So what's the difference between dropping money from helicopters to frankly what Japan has been doing all the past 20 years, accumulated a large amount of debt. If that debt was in forms of notes that were not government debt instead of money, it's unclear why that should make such a large difference.

Beckworth: And Japan-

Eggertsson: Unless, of course, I think what people have in mind, which is more useful, is that it implies some sort of, it forces the hand in some way of the central bank for the future. But that's a different argument and then I think people should make that argument and as opposed to mixing up the metaphor with helicopters and those sorts of things.

Beckworth: Right. The key is some reflation.

Eggertsson: Yes, exactly.

Beckworth: Above normal reflation. And again, I want to be very clear, we're not arguing for reckless 1970s, we're arguing, and you can do this in a rules based, you can have a price level target where on average you're hitting that growth path but you still tolerate deviations in the short run to get to where you need to be. So I think there's just a lot of confusion and then maybe opposition. If you want to have inflation, what are you?

Beckworth: That's kind of the feedback thing. But I think there's a way to do it, and in fact the whole point of level targeting, and I know you guys have written about this. If you have a level target, it makes it expected. People come to expect that there'll be this reflation and thus the velocity in money picks up on its own to some extent. It kind of, market kind of does the heavy lifting if it's a credible commitment to a level target.

Beckworth: Okay. Let's move on then to another related field you worked on, and that's secular stagnation. So is there a link between being stuck at a Zero Lower Bound liquidity trap and secular stagnation?

Secular Stagnation and the ZLB liquidity trap

Eggertsson: Yeah so the term secular stagnation, at least the way I have used it, is basically on a speech Larry Summers gave at the IMF at 2014. So he suggested formalizing, so the secular stagnation dates back to this idea of Alvin Hanson. He gave a speech in 1938 at the Economic Association, suggest we already had the second phase of the Great Depression. Suggesting that you may have demand weakness for the indefinite future.

Eggertsson: So Larry suggested formalizing this idea by supposing in the context of more modern models, that the natural rate of interest is permanently negative. And in the literature before that I have worked on and many others, we had always sort of worked under the assumption that they were just some temporary shocks that let the COP to be binding and that there would be some future date at which it would be no longer binding and that sort of all of the policies really, to some extent, relied upon that sort of magic exit date. Because that's when monetary policy starts having bite again. And that's when the same price or, well that's the key thing that you're playing off the expectation of when the COP is no longer binding.

Eggertsson: So the secular stagnation is this idea that well let's suppose this lasts for a particularly long time. And it turns out that if you want to think about that, you have to sort of do an open heart surgery of the New Keynesian framework, because those who represented model, we couldn't even think about permanently negative real interest rates. The model just blew up. It would blow up. So that was sort of number one.

Eggertsson: And then number two, if you want to think about a permanent demand contraction, you actually need some sort of a permanent trade of inflation. And … property is another somewhat of open heart surgery of the supply side of the New Keynesian model you need to do in order to characterize it.

Eggertsson: So there is a connection between the liquidity trap and the secular stagnation and it's basically a permanent trap. But in order to get there we actually have to do quite a bit of work to get the models to cooperate.

Beckworth: Let me ask it this way, because that's an interesting... if you're at this Zero Lower Bound and you're stuck there, and how we get stuck there, I guess, is what you're trying to justify or motivate, but if you're stuck there, isn't the argument that this short fall, again for whatever reason, maybe because inflation targeting, no tolerance of overshoot, all those things we talked about. But if you're stuck there... the longer you're stuck in the Zero Lower Bound and it's binding, the more erosion there is of economic potential. So in other words, economic potential itself, which we normally think of purely supply side driven, economic potential itself can begin to atrophy just like your muscles. If you don't exercise your muscles you get muscular atrophy. If you don't exercise potential GDP to its fullest, eventually the supply side itself will begin to contract.

Beckworth: Is one way to look at this, if you stay weak for a long, long time the economy, then its ability to run super fast is also going to deteriorate?

Eggertsson: Yeah I think that's a little bit of a separate point but it's related in that a lot of us have been working on this idea of hysteresis and how that can lead to even further stagnation. But the original idea... so what i tie more to the secular stagnation hypothesis is there are these slow moving forces that you don't have any particular reason to expect revert themselves, such as population growth, slowdown, lower productivity, increase in inequality, that increase savings relative to investment opportunities. And that now in order to balance it too you actually need a permanent reduction in the natural rate of interest. And that is going to be impossible to accommodate the Zero Lower Bound and then you have a recession without any natural pull back to full employment.

Eggertsson: But you're right and a second element of this is that, once you have dynamics like that in motion, it becomes very plausible to think that this arm demand recession start affecting directly the supply side. And I do think there is some evidence of that having happened to raise prices.

Beckworth: Yeah. I think that's a very plausible story. Of course the other side would say no we've just reached the new steady state. But it's an interesting one.

Beckworth: Let's move on though. Let's talk about this secular stagnation from a slightly different angle, and that's the safe asset shortage story. You did a paper on the open economy perspective, kind of an international perspective on secular stagnation. But Caballero, Farhi, and Gourinchas have these papers on the global safe asset shortage problem which I find intriguing because it attracts the decline in safe asset yields around the world. And along with that the slow growth. So is this safe asset shortage problem kind of a flip side or related to the problems we've been talking about?

Safe Asset Shortage

Eggertsson: I think of it as a one additional mechanism that can lead to be sort of persistent decline in the natural rate of interest, or the real interest rate if you would not like the Fed to set the full employment. So I don't view it as inconsistent... so we have emphasized more other slow moving forces like demographics and inequality and things of that sort, partially because we think it's less likely that they will revert themselves, they will be more problematic. While with the safe asset shortage it seems as the initial system recovers that there might be reason to believe that you could go back to where you were prior to the crisis. So in that respect, so that was at least why we emphasized that less. But they're complementary, I don't see them as contradicting one another. And the policy conclusion that in fact they reach in their papers are very similar to what we reached even if the frameworks are completely different. And the sources is different and a very different model in a very different way.

Beckworth: It's fascinating because one of the insights or lessons I learned in the crisis, because I feel like I learned a lot going through this, is how we measure money really, in some ways I think is very dated. If you take a typical undergraduate textbook they talk about M2 or M1. And Gary Gordon's work and others have shown us that there's a much broader measure of money, these institutional money assets. So M2 would just be retail money assets that you and I would use, maybe small businesses. But with institutional money assets, treasuries and other safe assets become important and the institutional money supply crashed during this time. And there's been attempts to measure it. There's an M4 measures put out by the Center for Financial Stability in New York. And they kind of tracked this and it includes M2 plus all these other institutional money assets. And it never has recovered, it never has kind of gone back to this growth path. Kind of reflecting everything else in the economy; it hasn't returned to its previous growth path.

Beckworth: For me I find that fascinating because to the extent these safe assets function as transaction assets for the financial system, for institutional investors, it indicates there's still some deficiency out there. Maybe I need to call, we think of money always being in demand side or nominal problem but to the extent these safe assets are a transaction asset, they make life easier, they produce search costs, it suggests that there's still real problems going on that haven't been resolved.

Eggertsson: So I actually, in a paper with Marco Del Negro, Andrea Ferrero, and Nobuhiro Kiyotaki, we sort of took this perspective as well where the assets were, where assets could not be sold instantaneously, they had different degree of liquidity. And our motivation was basically to try to break the kind of irrelevance result Mike Woodford and I had made and understand the effect of the facilities of the Fed and the beginning of the crisis which I think had a big effect due to the dry up and a lot of secondary markets and the fact that... but I suppose there though typically the prediction was that you should expect during the time of this sort of distress that the spread between a safe asset like treasuries and corporate bonds or other should be high. I guess what we saw after then in sort of shortly after 2008 and '09, '10, '11 that those spreads went down. So that's sort of why I always thought it might be interesting to look for alternatives, sort of slower moving alternatives to explain why we didn't see a normalization.

Beckworth: Interesting. Well let's move on in the time we have left to the Trump shock and how it applies. We were just talking about the natural rate or in the press it's been called R-star, a lot of R-star discussion. And even some of the academics, John Williams San Francisco president uses the R-star language a lot. But there's been this discussion over the past year or so, couple years, R-star has just tanked. So you mentioned earlier under secular stagnation that the natural rate of interest itself has declined because of demographic reasons and other things. And there's a huge discussion going on about how to estimate it, is it really down. I remember I was at the Hoover Monetary Policy conference when John Williams was presenting these results and him and John Taylor got into a discussion has it really gone down or not. And now suddenly Trump's elected and many of these conversations have disappeared.

Eggertsson: Mm-hmm (affirmative)-

Beckworth: So it makes me wonder, and I'm maybe reading too much into this, but suddenly I don't hear as many R-star conversations, number one. Number two, we see some non trivial increases in long term treasuries. Before Trump, they were like 1.7, the 10 year treasury in the US was 1.7, 1.8. Now it's 2.4 last I checked, around there.

Eggertsson: Right.

Beckworth: So it's gone up if you look at some decompositions of that. So your former workplace the New York Fed has a neat data set where they model and they provide to the public where you can decompose the 10 year treasury into a term premium, into expected short rates, the safe rate, and then also you can get explicit inflation from other places.

Beckworth: If you look at all those it tells a story of one inflation, especially if you go up, it is expected to go up, and two, growth might be going up. So one can look at this Trump Shock and say man, is the R-star finally changing trajectories? What's your sense of this?

Eggertsson: Well, one of the key prediction of this work that I have done on secular stagnation is that in order to increase R-star as you called it, the most straightforward way of doing that is just to increase government debt. And another thing that is pretty powerful is to do increase infrastructure spending. So I guess I was one of the people that was surprised by the election. So one of the first thing I did the morning after was to actually read the hundred day contract. And then you realize that he was talking about increasing, I mean people had estimate that his tax cut plan would increase the government debt by between 6 and 7 trillion over the next 10 years. And the infrastructure plan was on the order of 1 trillion over the next 10 years.

Eggertsson: So if now... I don't know those plans in any particularly detail, but if it will be increase in deficits and debt and there will be infrastructure spending, now then one should expect that to have an effect on R-star. However I think if you look at, now there has been a recovery in 10 years but it still, in historical context, incredibly low at 2.4. So if you just plot it since the last crisis, yeah it's a little bit higher than last year, this year, but it's not, in the grand scheme of things, if you go before the crisis you'd need to go back to the '50s after the war to find similar rates on long data, on 10 years.

Beckworth: Well, anything to get a recovery.

Eggertsson: Right.

Beckworth: Let me-

Eggertsson: I think the interesting question though is there's just so much uncertainly about. And I think if there's one thing that took a bit of a beating as far as I'm concerned at the Trump election it was this notion that policy uncertainty would be very recessionary because I can't remember more policy uncertainty than after this election because people are just not sure what he's planning to do. And yet-

Beckworth: But I... go ahead, I'm sorry.

Eggertsson: And yet we have been seeing a rally and I think it's based on this particular belief that now we may see tax cuts and infrastructure spending.

Beckworth: Yeah and I also think another part of that story is, with Donald Trump, because he is so risky so there's so much uncertainty about him, that I think there'll be a higher tolerance for inflation with him.

Eggertsson: Right.

Beckworth: It's, like you said, there's a lot of things we don't know who he's going to appoint to the board of governors and so forth. But my sense is there's a political economy vote here. By voting for Trump, there's been an implicit vote to tolerate a little bit more inflation. We've tried the past eight years, didn't work, low inflation did not work, I'm willing to ride with this cowboy called Trump, try whatever he throws at us. If that means a little more inflation, so be it. Because really as we said earlier to make that debt work the Fed would have to tolerate a little bit more inflation. And what would be really fascinating to see 10 years from now or 4 years from now maybe is if the Fed suddenly has a symmetric inflation target. After the Trump election or whatever forces go to work.

Eggertsson: I guess the conundrum or I guess the... so that's one reading of it, but I guess the big concern to me is that those that protested the loudest over QE and all of these actions were in fact the Republicans and it seems like there's a non trivial wing in the Republican party that's sort of talking about gold standard and things of that sort. But I think your reading of it is, though, it's actually the same of mine but there's just this uncertainty that is a problem.

Beckworth: Right. There's tension within his campaign. His transition team has some really hard money people on it. But then at the same time his policies... Time Magazine for his Time of the Year, he profiled it, said he thinks sometimes you just have to prime the pump. It's like well what happened to the standard view?

Beckworth: Well we are out of time and it's been a real treat, Gauti, to have you on the show. Our guest today has been Gauti Eggertsson. Gauti, thank you for coming on.

Eggertsson: Thank you so much.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.