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How central banks can save the world

The trillion-dollar gap between actual GDP and potential GDP is a gap made up of misery, unemployment, and unfulfilled promise. It's also a gap that can be eradicated — if central banks embrace unconventional monetary policy.

  • That's the message from Eric Lonergan and Megan Greene, two economists who reject the idea that central banks have hit a "lower bound" on interest rates. In fact, they reject the idea that "interest rates" are a singular thing at all, and they fullthroatedly reject the idea — most recently put forward by New York Fed president Bill Dudley — that the Fed is "out of firepower."

Why it matters: If Lonergan and Greene are right, then central banks have effectively unlimited ammunition in their fight to increase inflation and employment. They are limited only by political will.


How it works: Historically, central banks have borrowed and lent at pretty much the same interest rate. But that doesn't have to be the case.

  • In Europe, the central bank, the ECB, is now lending money to banks at a -1% interest rate. That's significantly lower than the rate it pays on those banks' reserves.
  • European banks can't just borrow the money and put it on deposit at the central bank. They only get the loans if they turn around and re-lend them into the real economy — and their regulator, the European Banking Authority, makes sure that they do exactly that.

In the U.S., the Fed could do something similar. It could reduce the discount rate — the rate at which banks borrow money from the central bank — to, say, -3%, while still keeping the Fed Funds rate in positive territory.

  • Savers would still be able to get positive returns on their deposits, but borrowers could effectively be paid to borrow money.
  • The deeply discounted loans to the banks would be contingent on the banks taking that money and re-lending it into targeted areas of the economy, rather than speculating with it or using it to fund things like mortgages.

Be smart: By targeting the loans, a dual interest rate policy could turbocharge government efforts to, say, build a carbon-neutral economy.

My thought bubble: Such a policy looks — and is — very close to fiscal policy, rather than monetary policy. It violates the principle that central banks are politically independent. But the Fed is already working hand-in-glove with Treasury. And given political constraints on extra spending from Congress, it makes sense to find that money at the Fed instead.

Go deeper: Lonergan and Greene explain their proposal in detail in a fantastic episode of the "Macro Musings" podcast.

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