Liquidity Traps and Low Real Rates

Not much time for blogging these days, but I thought I would contribute to this discussion by David Andolfatto, Tyler Cowen, Paul Krugman, and Brad DeLong.

Here are the facts: (i) The short-term nominal interest rate is essentially at the zero lower bound (ZLB); (ii) real bond yields (of all maturities) are very low relative to history. People have a hard time explaining those facts with Keynesian models. In a typical sticky price New Keynesian model, the problem that the ZLB can present for monetary policy is that the real rate of interest is too high, and there is no way to lower it. But if one thinks that history is a guide to what is right, then it looks like what is wrong is that the real rate is too low, not too high.

How do New Keynesians deal with this? If you read Ivan Werning's paper, for example, you'll see that he sidesteps the question. In Werning's model, the central bank wants to be at the ZLB because there is a negative shock to the natural rate of interest, and he analyzes how policy should deal with that problem. But what's a natural rate shock? I don't think we want to think of the financial crisis as a change in preferences, with everyone becoming contagiously more patient, any more than we would want to think of the Great Depression as a contagious attack of laziness.

If you press New Keynesians on this question, they will say that the natural rate shock - or preference shock - stands in for something that is going on in another type of model. One explanation I have heard appeals to incomplete markets frameworks. In such models, if exogenous debt limits for individuals fall, then the real interest rate will go down. In those models, the real rate is always below the "natural rate," which is the rate of time preference, and the gap between the natural rate and the actual real rate depends on how tight borrowing constraints are. There's something like this going on in Eggertsson and Krugman's paper.

But carry that one step further. Why would borrowing constraints be tighter in the world we're living in now? One explanation could be that collateral has become more scarce. The financial crisis essentially destroyed a large quantity of privately-produced collateral, which took the form of asset-backed securities. Government debt is a substitute for privately-produced collateral, and with a lot of sovereign debt in the world looking very dodgy, the world demand for the debt of the US government is very high. Assets that are used in financial exchange, and which serve the role of collateral in credit transactions carry a liquidity premium. The prices of those assets are higher than their "fundamental," where the fundamental price is what would be justified purely by the future payoffs on the assets and risk. The more scarce the assets are, the higher the liquidity premia, and the higher the prices. Higher asset prices is the same thing as low real interest rates. Simple.

Thus, the explanation is not a drop in "natural" rates of interest. It's the scarcity of safe assets for use as collateral and for exchange in financial markets.

I've been thinking about this a lot lately, and think I have come up with something interesting. I'm presenting some preliminary work on this on Monday at this conference. I'll tell you more later when I have the bugs worked out.