The paper straight forward and compelling. It essentially models the discussion we’ve been having on the blogs and outlines why monetary and fiscal policy are compelling at the zero lower bound.
The core difference from the basic model is of course that some people are forced in the short run to pay down debts. The paper doesn’t say a lot about how or why and at this stage that’s useful since there is more disagreement about how this comes about than that something like that exists.
My forecast at the outset of the crisis was that impatient households were going to be cut-off and that this would produce the liquidity constraints. I would ask for a show hands from the audience as to how many people were saving. Lots of people would raise their hands. Then I would say, “Well how then can the savings rate be zero? Someone must be constantly dis-saving. That person just got their credit card cut up.”
However, from watching the crisis unfold I would say there seems to be a significant amount of repaying going on as well.
In any case the point is that some segment of the populace is liquidity constrained and that’s the driver.
The model shows how something like a money financed payroll tax holiday would be particularly useful. My stance is still to cut taxes as far as possible for as long as possible in as progressive a manner as possible. I argued this before but looking through the model gives me more confidence in it.
Of course, it is the case that targeting debt relief to the individuals who are actually underwater would give more bang for the buck but that has incentive and fairness problems.
Government spending is also more bang for the bucky but has rent seeking problems. Additionally, it still seems to me that more bucks can be moved through the tax system.
My one quibble off the bat is with the statement
It is commonly argued that price and wage flexibility helps minimize the losses from adverse demand shocks. Thus Hamilton (2007), discussing the Great Depression, argues that “What is supposed to help the economy recover is that a substantial pool of unemployed workers should result in a fall in wages and prices that would restore equilibrium in the labor market, as long as the government just keeps the money supply from falling.” The usual criticism of New Deal policies is that they inhibited wage and price flexibility, thus blocking recovery.
Our model suggests, however, that when the economy is faced by a large deleveraging shock, increased price flexibility – which we can represent as a steeper aggregate supply curve – actually makes things worse, not better.
This is not quite right. Debt-deflation produces a countervailing force that means some measure of price-flexibility is worse. However, as prices become more and more flexible the adjustment to consumption will outweigh the debt-deflation effect.
This is clear because a vertical AS curve would result in no recession.