So Much for the Zero Lower Bound

The Zero Lower Bound (ZLB) is a bullshit concept in economics whereby it's argued that nominal interest rates cannot go below zero. That’s why the Great Recession has been as bad as it is: the Fed reduced its target interest rate “as much as it could”, eventually down to near zero[1]. But economic conditions were / are so bad that it wasn’t enough, and we’ve been experiencing low growth ever since. One way to get around it while still keeping interest rates from going negative in nominal terms (they’ve been negative in real terms for years) is through expansion of the money supply, or QE. An expansion of the money supply leads to higher inflation, which is a good thing in current conditions because it causes wages and prices to adjust faster, real debt burdens to be lower, and even lower negative real interest rates.

Another way to do it is to just not subscribe to the idea that there even is a lower bound. Why does there have to be? Idk, I guess it’s not how things normally work in finance. But that’s a stupid reason to suffer through a recession that's worse than it has to be. Thankfully the European Central Bank (ECB), the central bank for the Euro zone, has finally gotten around to breaking the ZLB, and has set interest rates for banks holding reserves at the ECB to -0.1%. This is a very timid decrease, and probably isn’t nearly enough, but hopefully it’s just a start. Charging banks for holding reserves at the central bank will make banks more likely to lend out the reserves as they attempt to profit maximize. This means the effective money supply is larger, and it could increase the velocity of money, or the amount that is transacted per unit of time. Both these effects will increase inflation, which in these conditions will lead to a faster recovery.

I think I still like old fashioned adjustment of the money supply better; you don’t need to mess around with financial indicators. A doubling of the money supply will double prices (which are nominal, so it will not cause everything to have twice the real cost to acquire) in the long run per se. And because humans can conceptualize the future, an expected increase in the price level in the long run has an effect today. Interest rates? Who cares? Just keep the growth path of nominal GDP or prices stable. But negative interest on reserves would make QE more effective in the short run because less of the new money will be kept sitting in vaults or on a spreadsheet entry[2]. The ECB has mostly been too little too late, but this latest move is progress. A little less too little, a little less too late.

1. But even for this the response time of the Fed, and other central banks, was pretty bad. The Fed didn't bring rates close to zero until December 2008, after a year of recession. The ECB didn't bring rates down to near zero, despite a worse crisis, until mid 2012, and that was after raising rates in 2011.

2. For example, in the U.S. the Fed buys bonds from banks with newly created money, and then pays the banks 0.25% (risk free) to keep them as reserves, which reduces QE's effectiveness. This also imposes an opportunity cost of lending for anything lower than 0.25%.