Bill Watkins and Dan Hamilton

Scott Sumner maintains a blog in which he has argued that the FED should not target interest rates, but instead target nominal GDP. When the economy experiences a Liquidity Trap, as it arguably did in late 2008 and 2009, reducing the short-term target interest rate becomes ineffective as interest rates approach zero. Besides the traditional interest rate policy, in this recession the FED has also pursued a program of quantitative easing, including aggressive purchases of long-term debt securities. This new policy tool was Bernanke’s innovation, and we think it helped, especially during the second half of 2009.

While low short-term interest rates helped a bit, we believe the quantitative easing was the more effective policy tool. However, the FED could have done more. They could have targeted nominal GDP. How would they implement this policy? Obviously, they could not implement it via interest rate targeting.

They would buy things.

In this recession the best thing they could have bought would have been homes. Purchases of homes in areas hard-hit by foreclosures would have been especially helpful. Foreclosures kill a neighborhood like little else. They have and are causing continuing losses at Wall Street and at banks across the country. In turn, bank failures and weak banks are a continuing drag on the economy.

How might the Fed administer a real estate purchase program? They could use local housing authorities and agencies. The local housing authorities understand the communities they work in. They are already in existence in virtually every community, even small ones, and they know how to purchase and administer residential real estate. It is already the case that, in many areas, local area housing authorities have become the only active residential real estate developers, since the incentive for the private sector to provide new housing is very low.

Purchasing homes in hard-hit neighborhoods would restore the neighborhoods, provide a floor of support for residential real estate market activity, help with the growing demand for affordable housing, and help banks resurrect their balance sheets. It would foster a recovery.