Stephen G. Cecchetti is Professor of International Economics, Brandeis International Business School.
Kermit L. Schoenholtz is Professor of Management Practice in the Department of Economics of New York University’s Leonard N. Stern School of Business
What can we do to avoid hitting the zero lower bound in future?
The primary reason countries hit the zero lower bound (ZLB) for nominal interest rates is that their financial systems were not resilient in the face of a large negative shock to their economies. This shock precipitated defaults by borrowers that led to losses sufficient to drive a number of banks into insolvency. The primary solution is more capital in the banking system, combined with more rigorous regulation and supervision of both banks and non-banks. With a sufficiently strong and robust financial system, it will be much less likely that an economy will hit the ZLB.
Some observers advocate a higher inflation target as a complementary solution to this challenge. While this might help, our view is that this would pose a costly threat to central bank credibility (see our discussion here).
Why were conventional monetary policy tools insufficient to tackle the Great Recession? What do we need to do to fix modern macroeconomic models that apparently did not perform well in the last couple years?
The presence of the ZLB meant that real interest rates could not fall sufficiently to offset the shock that came when the financial system nearly collapsed in 2008-09 (see our views on the ZLB here).
In contrast to widespread opinion, we believe that modern macroeconomic models had a significant and constructive influence on a number of central banks that responded to the crisis with aggressive expansionary policies. Their management of balance sheet scale and composition (and the use of other policy tools) was guided by an understanding of the real impact of financial disturbances that came from modern macroeconomic models. This knowledge served us well then, and ongoing efforts to elaborate on the financial sector in macroeconomic models will add to their usefulness.
Are worries about “secular stagnation” justified?
The hypothesis that the equilibrium real interest rate in the advanced world is and will remain below zero for some time to come is plausible and important to consider. But our best judgment is that this equilibrium real rate is modestly positive (see our commentary here).
Thank you very much.
Stephen G. Cecchetti is Professor of International Economics, Brandeis International Business School. Formerly, he was Economic Adviser and Head of the Monetary and Economic Department at the Bank for International Settlements in Basel, Switzerland.
Kermit L. Schoenholtz is Professor of Management Practice in the Department of Economics of New York University’s Leonard N. Stern School of Business, and directs the NYU Stern Center for Global Economy and Business. Formerly, he was the chief global economist for Citigroup.
They are the authors of the textbook Money, Banking and Financial Markets, 2014, Fourth Edition. Their commentary appears at www.moneyandbanking.com.