A late epiphany

Paul Krugman writes a lot about the Liquidity Trap. I’ve always struggled with the concept – on one hand, he’s right – you can’t have interest rates below zero. But on the other hand, being in a liquidity trap (i.e. Monetary policy doesn’t work, so we have to perform Fiscal policy) is a justification for lots of arbitrary Keynesian stimulus, which I find loathsome because of the extremely high probability of abuse, corruption, waste and fraud.

But thanks to a podcast by Scott Sumner and Russ Roberts, I think I finally understand now why the Liquidity Trap doesn’t exist – or at least, doesn’t have to exist.

First – here’s my understanding of the Liquidity Trap:

1) The Fed can reduce interest rates, which helps incent businesses to borrow money, because the interest rates are low.
2) But once interest rates get close to zero, they can’t lower them any more, because people can hold cash – people would just withdraw their money from the bank altogether if the interest rate went negative.

And nominally, that is true. The nominal interest rate can’t get below zero. But because of inflation, the real interest rate absolutely can get below zero. This is obviously true, and bipartisan – liberals have been talking excitedly about the fact that the US government can borrow money from the world at a rate lower than inflation – “the world is paying us to borrow money!” they say.

But the same is true of businesses – if the inflation rate is, 3%, and the interest rate on borrowing is 1%, a business is essentially being paid to borrow money and turn it into a profitable work. And that is even more true if the inflation rate is 5% or 10% or whatever.

And as Prof. Sumner has said – no central bank has ever failed to credibly commit to causing inflation.

So there we are – when a large, diverse country hits the lower bound on nominal interest rates, the next monetary option is to increase inflation, making the real interest rate negative. Real interest rates can go below zero, which means that the Fed is never truly out of options, and we don’t need fiscal stimulus after all. Businesses (and individuals, and municipalities, etc) will essentially be paid to borrow money, and that will cause them to start new projects that were previously unattractive.

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