Editors' Summary

The Brookings Panel on Economic Activity held its eighty-eighth conference in Washington, D.C., on September 10 and 11, 2009. All of the papers were related in some way to the remarkable macroeconomic developments of the past two years: the papers considered the zero lower bound on nominal interest rates, consumer financial regulation, unconventional monetary policy, the macroeconomic consequences of fiscal stimulus, and monetary and fiscal policy in the Great Depression. This issue of the Brookings Papers on Economic Activity presents the papers from the conference, comments by the formal discussants, and summaries of the discussions of the papers by conference participants.

In the first paper, John Williams investigates the implications of the fact that monetary policy cannot push nominal interest rates below zero. An earlier literature studied this issue in light of the Bank of Japan's experience with near-zero rates beginning in the mid-1990s and the Federal Reserve's experience with very low rates in 2003 and 2004. That literature concluded that although the zero lower bound was likely to be a binding constraint relatively frequently, its average economic cost was likely to be small. Williams reexamines this conclusion in light of the recent crisis, during which most major central banks pushed interest rates close to zero.

Williams's first finding is that the zero lower bound is imposing very large costs in the current episode. He reports that although the downturn would have been almost as severe in the absence of the zero bound, the recovery would have been much faster. He estimates that an unconstrained Federal Reserve would have cut its federal funds rate target by about an additional 400 basis points, and that those cuts would have raised output over the next four years by a cumulative $1.8 trillion. Moreover, this increased output would have come with little or no cost in terms of the Federal Reserve's inflation objective.

Looking forward, Williams considers the possibility that the recent sharp recession might signal a return to the greater macroeconomic volatility experienced in the 1960s and 1970s. Such a change would greatly increase the probability that the zero bound would become a binding constraint with a low target rate of inflation, fundamentally altering the case for a low target. For instance, Williams finds that a 1 percent annual inflation target would very likely be associated with frequent and costly encounters with the zero bound. A 2 percent target would also likely involve large costs if policymakers follow a conventional interest rate rule; however, these costs could be mitigated substantially if policymakers followed alternative monetary policy rules or used countercyclical fiscal policy more aggressively. Only when the inflation target is set as high as 4 percent can policymakers be confident that the zero lower bound will not prevent them from forcefully countering recessions. This is an important and provocative finding in light of the current debate around the optimal inflation target for the United States.

In the second paper, Sumit Agarwal, John Driscoll, Xavier Gabaix, and David Laibson mount a compelling case that many individuals, particularly older ones, often make poor financial choices. The authors investigate patterns of errors in personal financial decisionmaking across several large-scale databases. A particular strength of these datasets is that they allow the authors to demonstrate quite convincingly that errors in financial decisionmaking are both widespread and quite costly. The financial mistakes they consider include suboptimal use of offers of low interest rates on transfers of credit card balances, misestimation of housing values, and tolerance of excessive interest rates and fee payments. Across a wide range of financial decisions, the authors find that the tendency to make these errors initially declines with age, then flattens during the middle years, and finally rises increasingly steeply during old age. The "age of reason"—the trough of this U-shaped pattern—occurs when people are in their early fifties. This nonlinear pattern likely reflects the offsetting influences of financial experience (which rises with age) and cognitive ability (which generally declines with age). Financial errors by older persons are a particular source of concern because the stakes are often large—personal net worth is...