With nominal interest rates in many western countries at or approaching the zero lower bound, economists are calling for more quantitative easing or greater fiscal expansions to generate inflation, reduce real interest rates, and rejuvenate the economy. But what if these policies fail? Or are no longer possible? This column outlines a third way: supply-side policies.
The US and the Eurozone are stuck in a situation in which the short-run nominal interest rates cannot fall, either because they are against the zero lower bound (the US) or sufficiently close to it that the monetary authority refuses to allow further reductions (in the Eurozone). When this situation is combined with nominal rigidities in prices and wages, the interest rate cannot play its role of efficiently directing the intertemporal allocation of consumption and investment. Households want to save too much and the economy may get trapped in a “black hole” of contraction (Krugman 2002). The recent experience of the US and Europe can be read as an example of this “black hole.”
Economists’ traditional answer to this problem has been to recommend the use of monetary and fiscal policy. Monetary policy, either through a commitment to temporarily higher inflation (Krugman 1998, Eggertsson and Woodford 2003) or through lump-sum transfers of cash (Auberbach and Obstfeld 2005), can generate a rise in prices that lowers the real interest rate even if the nominal interest rate is still zero or positive. Similarly, as shown by Correia et al (2010), fiscal policy can neutralise the effects of the zero lower bound and achieve first best by using taxes to replicate the optimal path for the price level.
A third way: Supply-side policies
In a recent paper (Fernández-Villaverde et al 2010), we argue that supply-side policies can also play a role in fighting the perils of the zero lower bound. The argument is straightforward – any supply-side policy that raises future output (for instance, by improving productivity or by reducing markups) generates a wealth effect that increases the desire to consume today and decreases the excessive desire to save. Thus, supply-side measures address the core of the problem of the zero lower bound – the weakness of current aggregate demand. Supply-side policies are helpful precisely because there is a shortfall in aggregate demand.
We illustrate this mechanism with a simple two-period New Keynesian model. Prices are fixed in the first period but can be changed, at a cost, in the second period. This nominal rigidity makes output partially demand-determined. The representative household consumes, supplies labour, holds money, and saves. When the nominal interest rate is above zero, the household holds money to diminish transaction costs and saves in nominal bonds. When the nominal interest rate is zero (the nominal rate of return of money net of the marginal reduction of transaction costs), the household is indifferent between holding money or bonds. Because of price rigidity, prices cannot adjust as fast as they should and the real interest rate is not low enough to induce a sufficient level of consumption in the first period.
But if we suddenly increase productivity in the second period (or, alternatively, we lower the market power of firms), future output and consumption will rise. Because of the Euler equation of consumption, higher future consumption is followed by either higher interest rates and/or higher consumption today. This wealth effect of higher future output is translated into higher consumption, hours worked, and output today.
One of the few tools left
The possibility of using supply-side policies to cure the maladies of the zero lower bound should not be read as an argument for inaction along other fronts. Fiscal and monetary policy can and should be used in a coordinated fashion. For instance, fiscal policy can be directed toward expenditures, such as investments in infrastructure or R&D, which, beyond pulling aggregate demand today, may raise future productivity. Our position is, more modestly, that supply-side policies should not be forgotten and that, in many economies, they may be one of the few tools left.
Think, for instance, about the cases of countries such as Portugal or Spain that are members of the Eurozone. Without their own currency, these countries cannot rely on monetary policy. Similarly, policies such as exchange-rate depreciation or tariffs, which may induce an increase in aggregate demand, are out of the question, at least while the currency union is maintained. At the same time, perhaps in an unfair fashion, fiscal policy is severely limited by a growing level of sovereign debt and the ever-increasing cost of servicing it. Financial markets are forcing peripheral countries to undertake a contractionary fiscal consolidation. With both monetary and fiscal policy off the table, supply-side policies are among the last men standing.
Two questions remain open. First, why do we emphasise the importance of increases on future output when we are at the zero lower bound? Should not a government want to increase future output regardless of whether we are at the zero lower bound? Yes, it should if the increases are free. However, these increases are usually costly, either in pure economic terms (we need to build a new bridge or learn a new technology, or more competition may reduce incentives to carry out R&D in a model of endogenous growth) or politically (the reforms that yield higher productivity decrease the rents of some groups). But when we are at the zero lower bound, these structural reforms have a higher-than-normal rate of return. Not only do we obtain more consumption tomorrow, we also fight the demand problems today. Outside the zero lower bound, increases in future productivity are undone, in terms of consumption today, by an increase in the interest rate that ensures market clearing in the first period. At the zero lower bound, that effect disappears and hence consumption today also rises. Thus, reforms that would be too expensive either economically or politically in normal times can become desirable when the interest rates are zero.
Second, would the wealth effect be important enough? Unfortunately, we do not have a firm answer to this question simply because we have not been in this situation in recent decades. Our prior is that countries such as Spain also have a sufficient number of “low-hanging fruits” in terms of supply-side reforms that can be easily snatched. Anyone familiar with the deep inadequacies of the Spanish labour market or with the surrealistic regulations in many sectors of its economy cannot but forecast considerable gains out of structural reforms (as occurred in the past, such as in 1959, 1985 or 1993–95, when previous structural reform packages were passed). One interesting aspect of our argument is that it does not depend on a permanent change in the growth trend of the economy, something that after 25 years of endogenous growth theory is still a chimaera, but only on the possibility of increases in the level of output. Thus, we are much more sanguine about the role of supply-side policies in Eurozone countries than in the US or the United Kingdom where, arguably, there are fewer productivity gains to be had.
In summary, the zero lower bound is a serious challenge to economic policy. Supply-side policies can be an important additional tool to pull economies away from the low output–high unemployment problems that the bound generates.
Disclaimer: Beyond the usual disclaimer, we must note that any views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Philadelphia, the Federal Reserve System, or the National Bureau of Economic Research.
Auerbach, AJ, and M Obstfeld (2005), “The Case for Open-Market Purchases in a Liquidity Trap”, American Economic Review, 95:110-137.
Correia, I, E Farhi, JP Nicolini, and P Teles (2010), “Unconventional Fiscal Policy at the Zero Bound.” Mimeo, Harvard University.
Eggertsson, GB, and M Woodford (2003), “The Zero Bound on Interest Rates and Optimal Monetary Policy”, Brookings Papers on Economic Activity, 34:139-235.
Fernández-Villaverde, J, P Guerrón-Quintana, and JF Rubio-Ramírez (2011). “Supply-Side Policies and the Zero Lower Bound“, CEPR Discussion Paper 8642, November.
Krugman, PK (2002), “Crisis in Prices?”, New York Times, 31 December, A19.
Krugman, PK (1998), “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap”, Brookings Papers on Economic Activity, 29(2):137-206.