Douglas Clement - Editor, The Region
Published November 5, 2012 | September 2012 issue
In a liquidity trap, the nominal interest rate is at zero and can go no lower—it is at a limit referred to bleakly as the “zero bound.” And this, precisely, is the current state of monetary affairs in the United States and much of Europe—one of the most pernicious outcomes of the Great Recession of 2007-09.
In the United States, where inflation remains low but unemployment stubbornly high, policymakers eagerly seek to boost economic activity. To that end, Congress and the Obama administration have wrestled over numerous expansionary fiscal policies. Several have been implemented, but with limited success.
The Fed, for its part, has nudged the fed funds rate toward zero—since December 2008 and counting—until it can go no further. The goal is to encourage business investing and consumer spending by minimizing the cost of borrowing.
Since hitting the zero bound, the Fed has tried nontraditional policy tools to stimulate the economy. The three major tools are the large-scale asset purchase programs, the maturity extension program and the Fed’s new forward guidance policy.1/ All three are designed to bring down long-term interest rates and thereby stimulate household and business spending.
The economics profession (let alone policymakers) has yet to reach a consensus—or concession—on the correct policy avenue to pursue.
A recent paper, “Unconventional Fiscal Policy at the Zero Bound”, by Juan Pablo Nicolini of the Minneapolis Fed, with Isabel Correia, Emmanuel Farhi and Pedro Teles, proposes a novel fiscal strategy. The four economists lay out a series of fiscal policy measures that would relieve the zero bound faced by monetary policymakers caught in the liquidity trap. It’s this constraint, the impossibility of forcing nominal interest rates below zero, that undermines the Fed’s standard policy intervention of lowering borrowing costs by injecting still more liquidity into credit markets.
The economists’ fiscal policy proposal generates negative real interest rates that will stimulate investing and spending. And it will do so, the paper illustrates, effectively and efficiently—avoiding the harmful consequences of the more conventional fiscal policies advocated by some economists and the possibly long-term inflationary pressure that alternative monetary policy steps might create.
It’s a promising scenario, but as the economists acknowledge, their strategy of a tax policy that neutralizes the effects of the zero bound constraint is “unconventional.” Explaining it requires careful technical description—it’s a 50-page paper—but the central idea is fairly intuitive.
To encourage consumers and firms to engage in normal economic activity when the economy is stuck and nominal interest rates are at zero requires negative real interest rates. And “the only way to achieve negative real interest rates,” note the economists, “is to generate inflation.” (Recall Irving Fisher’s eponymous equation: The nominal rate equals the real interest rate plus inflation.) This will make holding on to money costly; the longer cash sits in your wallet, your savings account or under your mattress, the less it will buy. Purchasing power will relentlessly dissipate. To avoid poverty, people will spend and businesses invest.
However, caution the economists, generating inflation for producer prices is inefficient; it would create economywide distortions that reallocate resources wastefully and result in lower economic output than would otherwise be possible. Instead, “the idea is to induce inflation in consumer prices while keeping producer price inflation at zero,” they write (emphasis added). “The result is negative real interest rates, and yet the distortions associated with producer price inflation are altogether avoided. This can be achieved by simultaneously adjusting consumption and labor taxes.”
The strategy, then, is to raise tax rates on consumption and lower them on labor. But what’s critical is that these changes continue over time. So the consumption tax rise isn’t just a one-time hike, but an enduring upward trend. (Indeed, one way to implement this would be to initially reduce consumption taxes and slowly bring them up; the key thing is that consumers face consumption costs that will be more expensive in the future than they are today.)
So, to reiterate, the hike and cut are ongoing: Rates climb over time on consumption and fall steadily on labor. The consumption tax, because it rises over time, effectively increases the price of purchasing something a year from now, making it advantageous to spend now—boosting economic activity.
Why cut labor taxes? Ongoing consumption tax hikes mean that workers have to put in more labor hours to pay for the constantly rising cost of products and services; that would alter labor decisions inefficiently. To prevent that distortion, labor tax rates must decline in mirror image to the rising consumption tax rates and, by effectively increasing take-home pay, balance out the increasing cost of consumer goods.
Changing consumption tax rates also distort investing decisions, generating temporary underinvestment in capital. To avoid this, a temporary investment tax credit or short-term capital income tax cut is also essential.
The economists point out that others have raised similar ideas. In 2002, Harvard’s Martin Feldstein suggested that to escape its own persistent liquidity trap, Japan could raise its consumption tax rate and reduce income tax rates. In 2008, economists Robert Hall and Susan Woodford proposed sales tax holidays at the state level.2/
Both proposals hinged on the same fulcrum: Future consumption taxes must be higher than current taxes. The Hall-Woodford sales tax holiday proposal, for instance, would lower the tax immediately to zero and commit to increase it in the future, thereby encouraging consumers to spend now and thus spur the economy.
But this research paper is the first with a model that formalizes the concept and includes the additional taxes necessary for its efficient implementation. The greater part of the paper is devoted to the model’s mathematical structure and specification, and then its elaboration in alterative economic environments (when lump-sum taxes aren’t possible, for example, or idiosyncratic shocks occur).
The economists go further, measuring outcomes under a variety of tax rate scenarios to see if the necessary tax rate changes would be reasonable in scale, not just a theoretician’s pipe dream. And the plan does, indeed, seem practical.
To implement this plan under one feasible scenario, they calculate, tax rates on consumption that are 5 percent in the midst of the liquidity trap would increase over five quarters (15 months) to 14 percent. Simultaneously, labor income taxes would decline from 28 percent to 21 percent. A 9 percent investment subsidy would be implemented immediately and slowly unwind to zero.
Such policies would yield substantial economic benefits relative to the stagnant status quo. Assuming prices and wages are somewhat rigid or “sticky,” meaning that they don’t change instantly, the unconventional fiscal policy would generate a 1 percent increase in consumption over 10 quarters and a 0.2 percent permanent increase. If some price or wage flexibility exists, increases would be greater still; flexible prices and rigid wages would result in increases of over 4 percent temporarily and nearly 1 percent permanently. In the world of economics, these are substantial gains, especially in the moribund landscape of a liquidity trap.
Other appealing features of this strategy: It’s revenue neutral—though it alters tax rates, it requires no net tax increase to implement. And it’s “time consistent”—an economist’s way of saying that policymakers won’t be tempted to change it later to achieve a better outcome.
In closing, the economists caution that this strategy does crucially hinge on the willingness to implement a policy of flexible taxes. But “after witnessing the policy response to the recent crisis in the United States and elsewhere,” they observe, “it is hard to argue for lack of flexibility of any fiscal policy.” Recent examples in the United Kingdom, the United States and Spain demonstrate that, faced with a recession that seems unending, policymakers will adopt promising policies—no matter how unconventional they may first appear.
1/ For a more complete description, see remarks by Chairman Ben Bernanke, “Monetary Policy since the Onset of the Crisis,” Aug. 31, 2012, at the Federal Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyo. Also see the Board of Governors Maturity Extension Program and Reinvestment Policy page at Monetary Policy since the Onset of the Crisis. The Federal Open Market Committee provides forward guidance in its meeting statements. The Sept. 13, 2012, statement, for example, says, “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.”