Sigh. In an otherwise useful article about divisions in the Fed, Jon Hilsenrath says this:
The Fed is better equipped to solve some economic problems than others. As Mr. Bernanke noted in a now-famous 2002 speech, the Fed has the power to fight deflation—or falling wages and prices—by printing money.
But the bank’s tools aren’t perfectly suited to reducing unemployment, which is influenced by a range of factors including fiscal policy, regulation and global demand.
Sorry, but that’s totally wrong. The question is whether, at the zero bound, the Fed has the ability to increase aggregate demand — full stop. If it can increase aggregate demand, it can fight both deflation and unemployment; if not, not.
In a way, the problem with Bernanke’s speech was that he made increasing demand and fighting deflation sound too easy. The Fed can print money, if you increase the supply of something its price will fall, end of story.
But as I tried to point out a long time ago, this simple story breaks down when short-term interest rates are near zero.
Here’s one way to think about it: when the Fed conducts an open-market operation, buying short-term debt with newly printed money, this normally affects the short rate because bonds and money are imperfect substitutes: money yields less, but has the advantage of being something you can use directly to make payments, that is, it’s more liquid.
But when you have bought so much debt and created so much money that rates are near zero, the public is saturated with liquidity; from that point on, they’re holding money simply as a store of value, which makes it no different from bonds — and hence a perfect substitute for bonds. And at that point further open-market operations do nothing — they just swap one zero-interest asset for another, with no effect on anything.
So why not forget about open-market operations, and just drop the stuff from helicopters? Well, remember that at this point cash and short-term bonds are equivalent. So a helicopter drop is just like a temporary lump-sum tax cut. And we would expect people to save much or most of such a tax cut — all of it, if you believe in full Ricardian equivalence.
In my simple 1998 model, there’s only one way the Fed can affect things at all: by promising, credibly, to print more money in the future, when the zero lower bound no longer binds.
In practice, things are more complicated, because long-term bonds aren’t perfect substitutes for short-term — so the Fed can get some traction by buying at longer maturities. But I always felt than Ben was overstating the effectiveness of such purchases. It’s worth noting that in his “it” speech Bernanke’s more-or-less specific proposal was to set a ceiling on the yield on two-year securities. How much would that accomplish now, when even the 2-year yield is only 0.67 percent?
Anyway, back to the original point: it’s depressing to realize that two years into liquidity trap economics, the WSJ still doesn’t seem to understand the basic point of why the zero bound is a problem.