We are continuing with Larry Summers’ talk at the N.A.B.E. in early 2014 entitled: “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound.” As gibberishical as that sounds, it is less so than a lot of academic paper titles. Nevertheless, many of my readers will be seeing familiar words used in a new way here, perhaps wondering, “Zero lower bound of what?” and “Hysteresis sounds Freudian,” and even, “Is the earth’s rotation slowing?” I will give a simple definition of each of these concepts in order of increasing complexity, which puts them in the reverse order from Summers’ title. In future posts we’ll explore them at some depth.
Zero Lower Bound:
This refers to interest rates, which must always be above zero if they are to have any meaning. You loan me $100 at 6% interest, and I pay you back $106. A 0% interest rate would mean I pay you back exactly $100. A negative (-6%) interest rate would be when we agree that I will pay you back only $94. The last one doesn’t make any sense: we never see loans with “negative” interest rates.
But actually–when there is inflation–it is possible for an interest rate to be negative in inflation-adjusted terms. Let’s say the rate of inflation is 2% and you loan me $100 at a rate of 1%. Fast-forwarding a year, when I pay you $101 it is worth slightly less now (when adjusted for inflation) than the $100 dollars was worth when I borrowed it. On the other hand, it is worth slightly more than the $100-dollar bill that you stuffed under your mattress, which is now worth only the equivalent of $98.04 in last year’s dollars. By comparison, the $101 I just gave you is worth $99.02. 2% inflation over the past year means that today’s $102 is worth exactly the same as $100 was worth a year ago. To stay even with inflation, you would have had to charge me a nominal interest rate of 2% to match the expected rate of inflation. In that case, the real interest rate would have been 0%. In the case where inflation was 2% and the loan was at 1%, there was a negative real interest rate of 1% – 2% = -1% (nominal interest rate minus inflation rate equals real interest rate). So sometimes interest rates are negative when inflation is taken into account. (You may have figured out by now that for economists, ‘real’ is shorthand for ‘adjusted for inflation’.)
What professor Summers is talking about is a key interest rate for the economy which is set by the Federal Reserve, the “Fed Funds Rate,” which is what banks charge each other for overnight deposits. The Fed can’t control this rate directly–there is no chalkboard at the main entrance with today’s special rate posted. Instead, they influence the rate by buying and selling securities. When they buy securities from the open market, there is more cash “out there.” When they sell them, they are sucking up cash from the market. This adjustment to the money supply leads to changes in the interest rate according to the forces of supply and demand. They set a “target rate” and buy and sell securities until the going rate is close enough to the target. (As an example of how indirect this control is, the Fed Funds Target Rate has been 0.25% for quite a while, but the effective market rate is only 0.13%–they seem to be having trouble getting it up.)
Because banks always have the option of just sitting on cash rather than lending it, it is impossible to get the rate to go below zero. This is a problem for the Fed when the economy is in recession and they want to cut interest rates to stimulate investment. Once they hit the zero lower bound, there is no place else to go.
OK, I am out of time for today, but tomorrow I will take up hysteresis, and probably get to secular stagnation in the post after that.