Krugman, Mankiw, and the Problem with Zero

It’s not everyday that Greg Mankiw and Paul Krugman agree.  When they do, it’s worth thinking about.  Here are their blog posts: Krugman & Mankiw.

The topic is a Taylor Rule, which is a method, proposed John Taylor, for determining what Fed Policy should be.  That is, what is the interest rate that the Fed should be maintaining?  There are several versions of the Taylor Rule, and the Fed looks at several of them, but they do not use them to set policy.  Why have 300 economists if you could replace them with a rule?

Krugman has been on a bit of a rampage about bond prices, and he uses the Taylor rule to propel his argument that bonds are not overpriced, that is they are not paying too little interest.  Mankiw just notes that Krugman is using a Taylor Rule that he, Mankiw, recommended.

I’m interested in the policy implications.  The Mankiw Taylor rule currently implies that the optimal Fed Fund Rate should be approximately -6.2 percent.   Of course, that’s impossible.  So, the Feds Fund Rate is approximately zero.

The inability to have a negative interest rate is dragging our economy down.  However, policy makers do have a tool available to them, one that would allow them to overcome the zero lower bound on interest rates.  A large investment tax credit would effectively create a negative interest rate for businesses considering investment and expansion, and this is what we need.

Consumers and governments, already overextended, cannot be the source of a robust recovery by continuing debt-fueled consumption.  In the end, only technological advances and investment can drive a long-lasting and vigorous recovery.  To do that, we need to create an effectively negative interest rate.  Without that, Krugman’s forecast of four years of zero interest rates is probably correct, and that implies lots of economic pain.

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