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.

38 thoughts on “Negative Nominal Interest Rates?

  1. @Aziz: ” 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 (very difficult) paid down.”

    This is a Political question. In Spain, Greece, it will be forgiven (nothing else to do) In the USA, UK, paid down. ZIRP will be here for 10-20 years. We do have deflation with overproduction

    It basically is a reversal of the policies that got everybody into debt in the first place.

    My solution is conversion of the currency to a new note, the seizure of accounts and property above a capital level, new land taxes and death duties and redistribution via a Debit Card, in the new currency.

    Capital needs to be recirculated. It has been captured by the Corporation, dividends have stripped capital from the Middle Class. Basically we have atrophy of the economy.

    • I wouldn’t bet on a successful deleveraging of the UK and USA, even over a period of 20 years. Japan has done no such thing, and their debt is overwhelmingly domestic. In the UK and USA there is the problem of owing money to the producers of our consumption.

      • Who does the USA consumer owe it to? The producers of the goods, or the Government of the Producers who lend to the Government of the Consumers.

        If it is found that China has deliberately kept currency rates low, to take advantage of WTO membership (Selling trinkets to Wallmart, the biggest billionaire owners) and Wallmart also took advantage of this system, then wouldn’t the Debt be waived, as it was found to be predatory lending?

        • USA might try to “waive” the debt itself. Good luck with trying to keep the American economy functioning without all the necessary ingredients that would be lost from a trade shutdown. China controls global supply chains in so many components and resources. They have all the leverage. Very few thinkers understand this point.

      • Whilst I agree China does have critical supply chain status, the USA still has an ability to tool up.

        I am sure new goods will be hard to source while they tool up, but there is plenty of “old” stuff to keep them going. It might be an inconvenience, but they would get through it.

      • Remember the USA is ready to be an net energy exporter (Shale Gas), they will have lower energy inputs, therefore inflation due to a trade shock would not be catastrophic.

  2. “It is legitimate to ask whether a government pressed for money should be forgoing $40 billion a year in tax breaks mostly pocketed by the rich for their charitable donations”

    Really? What if the rich could do a leveraged buyout of the welfare State because the charitable tax deduction was adjusted so every dollar given to charity could cancel out an equal amount in the taxes a person was expected to pay? The welfare State may be bankrupt, but something still needs to play to the welfare of unfortunate people

  3. Pingback: Negative Nominal Interest Rates? | My Blog

  4. How is Bernanke’s negative real interest rates working out?

    He pushed retirees into equities and the markets are tanking!

    Wealth effect!

    • Negative nominal rates are far more problematic than negative real rates at the zero bound. Negative nominal rates would mean deeper negative real rates.

  5. If the Baby Boomers, who had equity which qualified them for loans to purchase multiple homes with leverage, that we now know was not a good idea, then seizing or taxing property that is not the family home and subsidising first home owners, new couples or homeless with the proceeds, put the situation back to normal.

    The Cantillion effect is what put everything out of whack. Cheap money fueled the stock market, which allowed Mutinationals to canibalise small business; the wealthy to purchase multiple properties causing land/housing inflation and other distortions to the economy.

    Lets recognise the mistakes and right the wrongs.

  6. Actual negative interests is what hyper-inflation is. Giving out more money than its worth is the same as printing [counterfeiting]. What people forget is that money is an abstraction, not an actual thing, in and of itself.

    I know that I would be first in line for my loan of $1,000,000,000,000,000., that after three years @ -3.33%would net me a cool $33,000,000,000,000.

    Nice self contained carry-trade.

    The negative real interest rates that the Swiss had on their t-notes was to stop the entire continent of Europe from using their banks as a safety depository, as they could not loan-out such large amounts of the deposits [no demand].

    • Hyperinflation is not a negative nominal rate (in fact, nominal rates tend to go up during hyperinflation). Hyperinflation is an ultra-negative real rate.

  7. Negative interest money is the same as Gesellian stamp money. It is maintained at current value by affixing a stamp every month. The stamp is a tax which raises revenue for the treasury which it uses to retire pre-existing debt.

    The government sPends the money into circulation- for example, it could simply mail $1 trillion to student loan debtors who would ASAP unload the money on the banks. The banks, in turn would make available extremely short term loans. The more the treasury gives this money away, the faster it retires the public debt. The purchase power of the dollar increases as the price level falls. once the public debt is paid, the need for negative interest money will self- terminate.

    • johanraft, I am going to attempt to make sense out of what you wrote.

      So you are going to tax the private sector in order to retire public debt in addition to spending money into circulation [QE]. Then the banks will [I would assume are recipients of this re-circulated money] would make available short term loans [to whom?, for what demand?].

      You say the more the treasury gives away, the faster the public debt is retired?

      Look, the only way to [sanely] solve a debt crisis is to discharge the debt [one way or another]. If you are going to create money which that is not tied to economic productivity, then you are simply debasing the money.

      The purchasing power of the dollar can only increase if less dollars [or credit-dollars] are in circulation [on the books] and/or productivity increases.

      Perhaps, you can clarify if I am off-base.

      • The sequence is as follows:

        1. The treasury, without borrowing, Prints up $1 T of -12%/year(-1%/month) stamp money which depreciates at 1%/ mOnth unless a stamp worth 1%,of the note face value is affixed at the end of the month (a 10 cent stamp for a $10 bill) by the holder in due course;

        2. On a $1T issue, the treasury would receive a $10 B income that would be applied to retiring the $16 T public debt. After 100 months, the public debt would decline from $16 T to
        $15 T;

        3. The price level would fall from say 25 to say 23. The purchasing power of the dollar would increase frOm 1/25 to 1/23;

        4. The more stamp money that introduced, the more debt that is consumed. The govt could sPend it into circulatiOn via govt wages, contracts, or by simPly giving it away to relive debtors like student or the credit card poor;

        The velocity of stamp money is very high because nO one wants to be stuck with the stamp tax at the end of the month – I would say the velocity would be at least 12. The current velocity Of the pathetic aggregate is less than 1.5 ie. at death’s door;

        The low velocity is due to too much long term debt and too little short term. When the students unload the stamp money on the banks, the banks will have no choice but to reloan at extremely short term. It will be quite easy tO borrow $1000 for30 days for 1.25% Money will flow to the highest velocity segments of the ecOnOmy (whatever that is);

        The issuance of stamp money will continue until the public debt is fully paid. Those wanting to save can simply hoard cash since the price level will be continuously falling.


        • I meant if it works in the context of what are the unintended consequences? How does it distort the price mechanism, and other feedback loops?

          Does it require “Reserve” currency status, and if not a small debt ridden African country could benefit from this experiment.

        • @Aziz – Thanks for your kind words. I’ve been pitching this concept everywhere and was starting to wonder if there was a sensible person anywhere who would consider it. I’m thinking that the garden variety economists are mostly chuckleheads who can’t think their way out of a paper bag.

          I was actually kicked off the New Austrian blog by Keith Weiner for persisting about it.

          It is a timely idea and should be widely considered.

        • Again, you need to find a small debt ridden country and speak to their Finance Minister. Get them to try it. Take the credit.

  8. Pingback: Negative Nominal Interest Rates? « Hawks5999

    • I disagree with Faber. Markets and citizens are hooked on government largesse. Cutting government spending by 50% would lead to a large-scale liquidationary crash. Maybe 1-2 years later once all the junk has cleared out, there would be a real recovery, but it would be a tough road.

  9. Yeah, I guess you’re right…I know my thinking might seem naively optimistic..I just can’t help but try and be positive…with so many smart people communicating so much nowadays, there must be something, someway for people to fairly limit the negative effects…it is not in the interest of anyone for things to just randomly become really bad…

    • I look on government largesse as like an addiction to hard drugs. Ultimately, I want to get us off the drugs, but it’s going to be a difficult road whenever and however we do it. Three places that I think should be cutting back a little are the places not so deeply depressed, where there has been some recovery — USA, Australia, Germany. The places which are depressed the most, however are the ones which are cutting back the most — the UK, the eurozone periphery, etc. This is very frustrating. In my experience, nothing promotes socialism more than austerity in a deep depression.

      • I see that austerity in a deep depression tends to promote socialism, too, and some people even argue that reducing debt meaningfully is now technically impossible:

        It’s a horribly tough thing to reason about

    • It’s not a matter of being positive or negative, instead, it’s all about being able to see the truth. Once you understand what’s going on [as accurately as is possible], you can make the best decisions to help yourself contend with whatever your situation is/becomes.

      After all, what else can one do?

  10. Cartels in action…

    “In an effort to ferret out rogue agents and discourage actors from working with them, several agencies, led by L.A. Direct, banded together to form Licensed Adult Talent Agency Trade Association (LATATA) in 2009. All member agencies — there are seven, including Spiegler Girls — meet once a month, are licensed by the state and adhere to standard practices”

  11. From the FT:

    “Ten ways HMRC checks if you’re cheating”

    I wrote….

    This is the corollary viewpoint to not understanding that markets now finance governments, and not vice versa, because the practice of instituting citizens into (legal) existence for the purpose of taxation is increasingly a redundant business model. Boosting taxes will repel capital, while current subjects cannot stand much more taxation. Consequently, central banks will bankrupt themselves (through inflation) while trying to avoid adaptation to this new environment. Darwin himself said that it is not the fastest, the richest or even the strongest that necessarily survive and prosper; it is, rather, the people who are most willing to adapt.

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