Greg Mankiw proposes having the Fed lower interest rate into negative territory:
That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.
Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw — it’s a benefit.
The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynesapprovingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves, Gesell’s concern about cash hoarding suddenly seems very modern.
If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.
Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.
Much like giving an alcoholic a stiff drink to ease his withdrawal symptoms... Why is it that everyone seems to think the best way out of this mess is to re inflate the bubble of consumer spending? Loose monetary policy by the Fed is what helped inflate the real estate bubble in the first place. Maybe solving a debt problem by allowing people time to deleverage is a little too simple minded. A bit of the hair of the dog, anyone?
Update...More on the topic from Mish:
On the other hand, I prefer common sense over economic models any day of the week. And common sense dictates that loose lending practices and a cheaper dollar got us into this mess so loose lending standards and a cheaper dollar cannot possibly get us out of this mess. Logically it is as simple as that.
Moreover, even if the Fed could orchestrate inflation, there is no guarantee jobs would come with it or wages would rise with those jobs even IF the jobs came. Both Mankiw and Krugman are ignoring the macro picture, including but not limited to global wage arbitrage.
Home prices and asset prices in general rose much faster than wages during Greenspan's great experiment. Cash out refinancing, and rising consumer credit supported consumption during this experiment as real wages shrunk. Now consumers are cash strapped and Mankiw proposes a method to force consumers to spend more. Any eighth grader would immediately see that such a policy cannot possibly work.