No, Paul, No! You Don't Slaughter the Returning Prodigal Son, You Slaughter the Fatted Calf!!

Paul Krugman writes:

Irving, Maynard, and Me: I’m going to be a bit grouchy right now, and unfairly so. Via Mark Thoma, I see that David Glasner is worried about what appears to be a need for negative real interest rates, and suggests that this may be close to concerns about the liquidity trap. OK, what I should do is welcome Glasner to the club — and I do, I do. But let me vent for a minute: the observation that a liquidity trap arises when the economy “needs” a negative real interest rate is at the heart of modern liquidity trap analysis; it’s where I came in back in 1998, when I started the whole thing (pdf):

To preview the conclusions briefly: in a country with poor long-run growth prospects – for example, because of unfavorable demographic trends – the short-term real interest rate that would be needed to match saving and investment may well be negative; since nominal interest rates cannot be negative, the country therefore “needs” expected inflation.

I suspect that a lot of time and effort has been wasted because smart commentators like Glasner “knew” that Keynesians were crude thinkers using mechanical approaches — I don’t know if that’s actually true for Glasner, but I’ve seen it a lot in others — leading them to spend several years laboriously arriving at the same conclusions people like me, Woodford, Eggertsson, Svensson etc. had already laid out in detail a decade ago.

OK, venting over. Now, what’s the proposal?

One idea I have been playing with is that we need to take the equity return premium seriously, and think about what it means for proper monetary policy.

Because of a combination of short horizons of investors, principal-agent problems on Wall Street, cognitive errors and illusions, and a general failure of financial markets to fully mobilize the risk-bearing capacity of society, there appears to be a wide gap between safe and expected risky rates of return: a gap that averages five percent per year or so in normal times. With an average real rate of profit for publicly-held operating companies of something like seven percent per year, that means an average real safe Treasury interest rate of two percent per year. When something bad happens in finance, this risk gap is going to grow.

All this means that if we push our average inflation target below the Blanchard four percent per year level, we should not be surprised to find liquidity trap recessions becoming not exceptions but rather the rule...