A Visual Representation of the Zero Bound

I’ve been trying to understand the relationship between savings and interest rates in the economy. There are many theoretical models and constructs that purport to represent the relationship between savings and interest rates, but it is interesting to look at it from an empirical standpoint. This graph shows savings at depository institutions as a percentage of GDP against the Federal Funds Rate:

Mises

The actual cause of the desire to save rather than consume or invest is uncertain. Perhaps this is a demographic trend — with more people closing in on the retirement age, they seek to save more of their income for retirement. Perhaps it is a psychological trend — fear of investment in stock markets and bond markets, due to fear of corruption, or market crashes or a general distrust of corporations. Perhaps it is a shortage of “safe” assets — by engaging in quantitative easing, central banks are removing assets from markets and replacing them with base money, and deleveraging corporations are paying down rather than issuing new debt. Perhaps it is anticipation of deflation — people expecting that saved money will increase its purchasing power in future. Perhaps it is a combination of all these things and more. But whatever it is, we know that there is an extraordinary savings glut.

There have been a lot of assertions that interest rates at present are unnaturally or artificially low. Well, what can we expect in the context of such a glut of savings? Higher interest rates? Based on what?

There was a clear negative association between savings and interest rates up until interest rates fell to zero, while the savings rate continued to soar. Theoretically, lower interest rates ceteris paribus should inhibit the desire to save, by lowering the reward for doing so. But interest rates cannot fall below zero at least not within our current monetary system — there exist some theoretical proposals to break the zero bound using negative nominal interest rates, but these remain untested and controversial. Even tripling the monetary base — an act that Bernanke at least believes simulates an interest rate cut at the zero bound — has not discouraged the saving of greater and greater levels of the national income.

In the long run, the desire to save increasingly massive percentages of the national income will cool down. Sooner or later some externality will jolt the idle resources in the economy into action. But that is the long run. In the short run saving keeps soaring. Investors are not finding better investment opportunities for their savings and the structure of production does not appear to be adjusting very fast to open up new opportunities for all of that idle cash.

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Negative Nominal Interest Rates?

A number of economists and economics writers have considered the possibility of allowing the Federal Reserve to drop interest rates below zero in order to make holding onto money costlier and encouraging individuals and firms to spend, spend, spend.

Miles Kimball details one such plan:

The US Federal Reserve’s new determination to keep buying mortgage-backed securities until the economy gets better, better known as quantitative easing, is controversial. Although a few commentators don’t think the economy needs any more stimulus, many others are unnerved because the Fed is using untested tools. (For example, see Michael Snyder’s collection of “10 Shocking Quotes About What QE3 Is Going To Do To America.”) Normally the Fed simply lowers short-term interest rates (and in particular the federal funds rate at which banks lend to each other overnight) by purchasing three-month Treasury bills. But it has basically hit the floor on the federal funds rate. If the Fed could lower the federal funds rate as far as chairman Ben Bernanke and his colleagues wanted, it would be much less controversial. The monetary policy cognoscenti would be comfortable with a tool they know well, and those who don’t understand monetary policy as well would be more likely to trust that the Fed knew what it was doing. By contrast, buying large quantities of long-term government bonds or mortgage-backed securities is seen as exotic and threatening by monetary policy outsiders; and it gives monetary policy insiders the uneasy feeling that they don’t know their footing and could fall into some unexpected crevasse at any time.

So why can’t the Fed just lower the federal funds rate further? The problem may surprise you: it is those green pieces of paper in your wallet. Because they earn an interest rate of zero, no one is willing to lend at an interest rate more than a hair below zero. In Denmark, the central bank actually set the interest rate to negative -.2 % per year toward the end of August this year, which people might be willing to accept for the convenience of a certificate of deposit instead of a pile of currency, but it would be hard to go much lower before people did prefer a pile of currency. Let me make this concrete. In an economic situation like the one we are now in, we would like to encourage a company thinking about building a factory in a couple of years to build that factory now instead. If someone would lend to them at an interest rate of -3.33% per year, the company could borrow $1 million to build the factory now, and pay back something like $900,000 on the loan three years later. (Despite the negative interest rate, compounding makes the amount to be paid back a bit bigger, but not by much.) That would be a good enough deal that the company might move up its schedule for building the factory.  But everything runs aground on the fact that any potential lender, just by putting $1 million worth of green pieces of paper in a vault could get back $1 million three years later, which is a lot better than getting back a little over $900,000 three years later.  The fact that people could store paper money and get an interest rate of zero, minus storage costs, has deterred the Fed from bothering to lower the interest rate a bit more and forcing them to store paper money to get the best rate (as Denmark’s central bank may cause people to do).

The bottom line is that all we have to do to give the Fed (and other central banks) unlimited power to lower short-term interest rates is to demote paper currency from its role as a yardstick for prices and other economic values—what economists call the “unit of account” function of money. Paper currency could still continue to exist, but prices would be set in terms of electronic dollars (or abroad, electronic euros or yen), with paper dollars potentially being exchanged at a discount compared to electronic dollars. More and more, people use some form of electronic payment already, with debit cards and credit cards, so this wouldn’t be such a big change. It would be a little less convenient for those who insisted on continuing to use currency, but even there, it would just be a matter of figuring out with a pocket calculator how many extra paper dollars it would take to make up for the fact that each one was worth less than an electronic dollar. That’s it, and we wouldn’t have to worry about the Fed or any other central bank ever again seeming relatively powerless in the face of a long slump.

First of all, I question the feasibility of even producing a negative rate of interest, even via electronic currency. Electronic currency has practically zero storage costs. What is to stop offshore or black market banking entities offering a non-negative interest rate? After all, it is not hard to offer a higher-than-negative rate of interest for the privilege of holding (and leveraging) currency. A true negative interest rate environment may prove as unattainable as division by zero.

But assuming that such a thing is achievable, I think that a negative rate of interest will completely undermine the entire economic system in clear and visible ways that I shall discuss below (“white swans”), and probably also — because such a system has never been tried, and it is a radical departure from the present norms — in unpredictable and emergent ways (“black swans”).

Money has historically had multiple functions; a medium of exchange, a unit of account, a store of purchasing power. To institute a zero interest rate policy is to disable money’s role as a store of purchasing power. But to institute a negative interest rate policy is to reverse money’s role as a store of purchasing power, and turn money into a drain on purchasing power.

Money evolved organically to possess all three of these characteristics, because all three characteristics have been economically important and useful. To try to strip currency of one of its essential functions is to risk the rejection of that currency.

How would I react in the case of negative nominal interest rates? I’d convert into a liquid medium that was not subject to a negative rate of interest. That could be a nonmonetary asset, a foreign currency, a digital currency or a precious metal. I would actively seek ways to opt out of using the negative-yielding currency at all — if I could get by using alternative currencies, digital currencies, barter, then I would.  I would only ever possess a negative-yielding currency for transactions (e.g. taxes) in which the other party insisted upon the negative-yielding currency, and would then only hold it for a minimal period of time. It seems only reasonable that other individuals — seeking to avoid a draining asset — would maximise their utility by rejecting the draining currency whenever and wherever possible.

In Kimball’s theory, this unwillingness to hold currency is supposed to stimulate the economy by encouraging productive economic activity and investment. But is that necessarily true? I don’t think so. So long as there are alternative stores of purchasing power, there is no guarantee that this policy would result in a higher rate of  economic activity.

And it will drive economic activity underground. While governments may relish the prospect of higher tax revenues (due to more economic activity becoming electronic, and therefore trackable and traceable), in the present depressionary environment recorded and taxable economic activity could even fall as more economic activity goes underground to avoid negative rates. Increasingly authoritarian measures might be taken — probably at great cost — to encourage citizens into using the negative-yielding legal tender.

Banking would be turned upside down. Lending at a negative rate of interest — and suffering from the likely reality that negative rates discourages deposits — banks would be forced to look to riskier or offshore or black market activities to achieve profits. Even if banks continued to lend at low positive rates, the negative rates of interest offered to depositors would surely lead to a mass depositor exodus (perhaps to offshore or black market banks offering higher rates), probably leading to liquidity crises and banking panics.

As Izabella Kaminska wrote in July:

The simple fact of the matter is that in a negative carry world – or a flat yield environment for that matter  there is no role or purpose for banks because banks are forced into economically destructive practices in order to stay profitable.

Additionally, a negative-yielding environment will result in reduced income for those on a fixed income. One interesting effect of the present zero-interest rate environment is that more elderly people — presumably starved of sufficient retirement income — are returning to the labour force, which is in turn crowding out younger inexperienced workers, who are suffering from very high rates of unemployment and underemployment. A negative-yielding environment would probably exacerbate this effect.

So on the surface, the possibility of negative nominal rates seems deeply problematic.

Japan has spent almost twenty years at the zero bound, in spite of multiple rounds of quantitative easing and stimulus. Yet Japan remains mired in depression. The fact remains that both conventional and unconventional monetary policy has proven ineffective in resuscitating Japanese growth. My hypothesis remains that the real issue is the weight of excessive total debt (Japan’s total debt load remains as precipitously high as ever) and that no amount of rate cuts, quantitative easing or unconventional monetary intervention will prove effective. I hypothesise that a return to growth for a depressionary post-bubble economy requires a substantial chunk of the debt load (and thus future debt service costs) being either liquidated, forgiven or (often very difficult and slow) paid down.