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Larry Summers explains why we’re even more screwed than you thought

“I’m pretty annoyed with Larry Summers right now,” wrote Paul Krugman. “His presentation at the IMF Research Conference is, justifiably, getting a lot of attention. And here’s the thing: I’ve been thinking along the same lines, and have, I think, hinted at this analysis in various writings. But Larry’s formulation is much clearer and more forceful, and altogether better, than anything I’ve done.”

Here’s what Summers said: The Fed’s job, most of the time, is pretty simple. Its main job is to set the federal funds interest rate, which ripples out and raises or lowers other rates on everything from mortgages to credit cards to business loans; economists and journalists tend to refer to the Fed as raising or lowering “the interest rate” rather than just the funds rate to reflect its wider influence on the whole economy.

If the Fed wants to know what interest rate we should have at a given time, it can just plug the unemployment rate and the inflation rate* into an equation, which will spit out what the fed funds rate should be. Couldn’t be easier.

The problem is that when inflation is low and unemployment is high, the interest rate that equation spits out is sometimes negative. And the Fed can’t have negative interest rates; that’d mean peoples’ bank accounts would start losing dollars over time. If that were to happen, everyone would just start doing transactions in cash, which doesn’t decay like that over time. So what the Fed can do — and does do — is promise to keep interest rates at 0 for a very long time. The hope is that doing that has similar effects to having negative rates, and will get the economy back to normal, where we can have positive rates again.

But that approach only works if, when times are good, the interest rate we want is positive. For most of history to date, that’s been true. But Summers argues that it could be that the rate we want is negative. If that’s true, then keeping rates at zero indefinitely won’t get us where we need to be. We need to take much more drastic action.

Click “Know More” to read Danny Vinik on what form that action could take. Also, read Miles Kimball on electronic money, one promising way around this problem.

* Or the output gap and the inflation rate, or just nominal income, but let’s not get hung up on details of various policy rules.

Dylan Matthews | November 19, 2013 at 9:10 am
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