An alternative history of the Fed, from 2008 to present

July 25, 2012

With the Fed potentially taking new action to try to speed up the recovery, it's worth asking what policies it could have adopted that would have prevented the slump from getting this bad to begin with.

Consider, for instance, the Taylor rule. The Fed usually tries to keep unemployment and inflation low by trying to alter the rate that banks with accounts at the Fed charge each other for short loans -- a rate called the "federal funds" rate. The Fed states a target for that rate, a target that usually holds. The Taylor rule is a rule proposed to figure out when the Fed should change that rate, and by how much. Named after Stanford economist John Taylor, it proposes that the Fed set the rate based on a formula that uses the rate of inflation and the growth rate of the economy. There are many variations on the rule. A prominent formula from Harvard professor, and Romney advisor, Greg Mankiw uses only inflation and the unemployment rate. Here's what the Fed's rate would have looked like under both Mankiw's rule and actual policy, from the start of 2008 to today:

 

 

 

 

 

 

 

 

As of last month, the rule recommends a rate of 0.125 percent -- smack dab in the middle of the Fed's actual 0 to 0.25 percent range. But for nearly two years, Mankiw's formula recommended negative interest rates. Traditional Fed policies can't push the interest rate below zero. After all, for an interest rate to be negative, people putting money in banks would have to lose a certain fraction of that money regularly, just as they gain a certain amount when interest rates are above zero. But if that's happening, everyone would just pull their money out of the bank and keep it in cash.

But there are more exotic methods that can push interest rates below zero. Lars Svensson, vice governor of Sweden's Riksbank and a former Princeton colleague of Ben Bernanke, in 2009 implemented a negative interest rate on bank reserves of 0.25 percent. What that means, in plain English, is that banks had to pay 0.25 percent of the principal they parked at the central bank. Because the banks can't keep their reserves in cash, they couldn't just pull them out and avoid the penalty. The result was the strongest recovery in Europe.

There are other ways to achieve negative interest rates. Mankiw has jokingly suggested invalidating all physical currency whose serial number ends with a certain digit. If every $1, $5, $10 etc. bill with a serial number ending in 7 were declared invalid, 10 percent of all paper money would be worthless -- or, in other words, there'd be a negative interest rate on cash of 10 percent. Willem Buiter, formerly of the London School of Economics and currently of Citigroup, has proposed abolishing paper currency altogether. If all the money is in bank accounts, after all, the Fed can just shave off a certain percentage every so often. This is harder to do with paper money, absent a scheme like Mankiw's serial number idea.

Instead of doing this, of course, the Fed used quantitative easing, which rather than targeting short-term interest rates targets long-term interest rates. Normally, the Fed buys and sells bonds to lower or raise short-term interest rates. But quantitative easing involved buying up a lot of assets with the goal of lowering interest rates in the long term. Some studies suggest that effort helped, but perhaps Svensson's method would have been more effective.

Alternatively, the Fed could have targeted nominal GDP -- that is, the real size of the economy multiplied by the rate of inflation. This idea, made famous by Bentley University's Scott Sumner and embraced by the likes of former White House chief economist Christina Romer, would have the Fed allow inflation to rise during an economic downturn, and tamp back on growth if inflation is getting too high during an upswing. Though Bank of Israel governor Stanley Fischer -- coincidentally, Ben Bernanke's dissertation adviser -- hasn't explicitly embraced this idea, economic wunderkind Evan Soltas has mustered some evidence that Fischer has been following this policy. Israel let inflation rise when the recession hit by the same amount as economic growth fell, and as a consequence, the economy quickly rebounded:


Source: Evan Soltas.

 

 

 

 

 

 

 

 

 

In the United States, by contrast, inflation stayed constant while both real and nominal GDP fell considerably:

 

 

 

 

 

 

 

 

Of course, the United States and Israel are very different countries and what worked for them may not have worked here. But the evidence suggests they were doing something right.

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Ezra Klein · July 25, 2012