So what can policy do?
1. It can try to achieve negative real interest rates by creating expectations of inflation. That’s actually the more or less free-market solution. Many years ago I tried to explain this by considering a hypothetical world of perfectly flexible prices and a fixed money supply. How would such a world deal with the situation shown above? The answer is, prices would plunge far enough that people would expect them to rise again in the future, generating the expected inflation we need. Since prices aren’t perfectly flexible, and anyway the existence of nominal debt makes massive deflation a really bad idea, the preferred alternative is simply to create expectations of inflation looking forward.
2. Alternatively, governments can step in and spend while the private sector won’t.
3. Finally, central banks can try to circumvent the zero lower bound by buying long-term debt. The point here is that we only have zero rates at the short end, and it’s possible, though not certain, that you can get at least some traction by buying those longer-term bonds.
But now that we’re in this situation, VSPs around the world are objecting to all of these possible actions. Inflation targets are horrible because we must have price stability. Fiscal policy is unacceptable because we must have balanced budgets. QE is outrageous because that’s not what central banks are supposed to do.
Notice that in each case the objection is based on a shibboleth. Price stability is treated as an absolute virtue, without any model to explain why. The same with budget balance. And those who are horrified at the idea of expansionary monetary policy have been inventing concepts on the fly to justify their position.
The simple fact is that we have a global excess supply of savings, which is doing terrible things to workers.
The reasonable thing is to do something about it; it’s deeply unreasonable, and deeply irresponsible, to invent reasons not to act because you’re clinging to simplistic slogans.
I'm a Keynesian, but I think this is bad Keynesian policy. It's certainly not the best way to stimulate the economy. It is the best way for the banks to make a hell of a lot more money to sit on and not invest in workers and capital, and unless the banks loosen credit, there's not going to be anything useful out of this. It's trying to water your crops by blowing up the reservoir dam. You will get water to the crops, it just might take your farm with it.
The problem is the more useful ways to stimulate the economy have been summarily rejected, blocked, and killed by the GOP. That will not improve in the next two years, so the Fed has to step in.
However this has got to be the most painful way of doing it...short of you know, doing nothing at all. And we've got nothing else to try.