Let me just flag this post as something to think about that will play a role in questions I’ll be arguing further. The present economic dilemma in which setting short-term nominal interest rates to zero has failed to revive the economy looks exceptional from our present perspective but will in fact be typical of future recessions.
That’s because of factors related to population aging, slowing population growth, and eventual population decline. If your country has some huge stock of five year-olds in it, then the reasonable inference is that twenty years in the future there will be much more demand for houses, refrigerators, and automobiles than currently exists. That means that patient and far-sighted people will be happy to “hire money” at relatively expensive interest rates in order to build the houses and factories of the future. At times the economy will fall into recession and you’ll need a policy of “low interest rates” to induce an adequate level of effective demand. But these rates will be low relative to a background condition of relatively high rates. By contrast if you can see that the stock of toddlers is actually quite modest then low interest rates becomes an all-the-time kind of situation. At first you’ll congratulate yourself that this reflects the efficiency of your capital markets and should serve as a huge spur to investment. But eventually you’ll notice that despite the low background rates investment is only happening at a usual level. What’s more, the first recession you hit leads to a brief deflation scare and a flirtation with the zero bound. Then you recover, but then your second recession leads to actual deflation and a prolonged vacation at the zero bound. Then perhaps you notice that this same thing already happened in Japan. Meanwhile, even though the aging of the population was a long-known long-understood phenomenon you suddenly find yourself reading stories about how there’s no net migration from Mexico anymore either.
Long story short, unless you want to be in a permanent depression you either need to find a way to put nominal interest rates below zero or else to permanently increase the background level of inflation to 4 or 5 percent a year to give yourself headroom.
