Less Than Zero

Paul Krugman discusses the zero-bound, and what we do (like we're doing now) when we prevent the government from generating the demand needed to pull the economy out of recession:

[T]here’s a definite change in the character of recessions after the mid-1980s. Before then, recessions were basically brought on by the Fed, which raised interest rates sharply to curb inflation, causing a slump in housing. When the Fed decided that we had suffered enough, it let rates fall again, and there was a surge from pent-up housing demand. Morning in America!

Since then, however, inflation has been well under control, and booms have died of old age — or more precisely, they have died because of overbuilding and an excessive level of debt. The Fed is then in the position of trying to goose housing (which is the principal channel for monetary policy) even though housing may already be overbuilt (which was the point I was making, sarcastically, when I said long ago that the Fed has to create a housing bubble), and it is cutting rates from an initial level which isn’t that high. So the odds of running up against the zero lower bound are high, and recovery can be a long time in coming.

You can see what I’m talking about here:



The early-80s slump was brought on by a huge rise in the Fed funds rate, which left lots of room for cuts, and was driven by a deep slump in housing, which meant that there was lots of pent-up demand when rates fell again. The 2007-? slump was brought on by the bursting of a housing and debt bubble, and left the Fed largely pushing on a string.