tyler cowen

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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.

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Euro Psychoanalysis

Joe Wiesenthal does some interesting analysis on Greece:

In a post last night, economist Tyler Cowen asked: “Is the goal simply to irritate the Greeks so much that they leave the Eurozone on their own?”

Here’s what might be going on.

Sometimes in life you give someone a “shot” at something that maybe they don’t deserve. You hire them, despite the fact that their qualifications were marginal. Or something like that. Bottom line is, you think you’re doing them a favor, and you’re also putting your reputation on the line a little bit. But you expect that they’ll step up and really appreciate the opportunity they have. And you expect they’ll kill it.

And when they fail — which is likely, because they might not have deserved the opportunity — you’re furious at them, because you gave them this great opportunity and they totally blew it, and they made you look like an idiot at the same time. And you just hate them for it.

And that’s what’s going on now. Europe feels like it gave Greece a “shot” with Euro membership, and multiple bailouts. And now it looks to Greece, and sees people rioting, and the reforms not happening, and they’re furious like never before. Merkel, Schaeuble, and the rest just can’t fathom that Greece was given this great shot to be a rich, wealthy European nation and it’s totally blowing it.

Well, if that’s so, Europe never really understood the creature it was creating. For all the talk of the supposed various benefits of the Euro — lower inflation, integrated markets, and so forth— its one huge dilemma — that nations were now budgeting in a currency they didn’t control, and so could not just monetise debt — was always brushed aside. Of course, policymakers were aware of some of the problems, at least in an abstract sense.

As Romano Prodi put it in 2001:

I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.

I suppose what was never understood was that the problems might grow and multiply to the extent that they would pose a threat to global economic stability before such “policy instruments” were created.

I suppose the moral of the story is that it is dangerous to create systems with inherent problems, and assume that the solutions to these problems will naturally emerge later at a time of “crisis”.

And certainly, there does seem to be a sense of punishing Greece for their fiscal misdeeds (even though Germany themselves were the first nation to violate the Eurozone’s deficit rules).

From the BBC:

Some eurozone countries no longer want Greece in the bloc, Finance Minister Evangelos Venizelos has said.

He accused the states of “playing with fire”, as Greece scrambled to finalise an austerity plan demanded by the EU and IMF in return for a huge bailout.

Simply, if Europe wants to maintain the global status quo, the ECB needs to crank up the printing press, and fast, to pump huge liquidity into the system. Of course, this creates huge problems down the road, as exemplified by Japan.

If not, they had better be ready for huge changes to the global financial order. Personally, I believe that the global financial system is fundamentally broken, and that printing more money, kicking the can down the road and hoping for the best will just lead to a worse and bigger breakdown down the line. I favour liquidation. But policymakers can be very reactionary.

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Ron Paul & Austerity

Regular readers will be aware that on the topic of austerity, I generally agree with John Maynard Keynes:

The boom, not the slump, is the right time for austerity at the Treasury.

Regular readers will also know that I like Ron Paul — a Presidential candidate who promises a $1 trillion spending cut in his first year in office.

Is that a contradiction? I don’t think so.

Why?

In comparison to most austerity-stricken nations, the United States under Ron Paul would be a special case, for one key reason.

Ron Paul’s cuts — rather than destroying productive output like Brüning in the 1930s, or Papandreou today — are aimed at cutting the two greatest wastes of productive output: financial sector corporate welfare, and imperial military spending.

This topic cuts to the heart of the Keynesian and Rothbardian views on recessions in general, and depressions in particular.

Essentially, the Keynesian position (and its later monetarist adaptation) is that a slump in aggregate demand (i.e. GDP) is — for whatever reason — the problem, and that this can be remedied by the government doing whatever it can to raise aggregate demand (Keynesian stimulus, quantitative easing, nominal GDP targeting).

The Rothbardian position is that the problem is caused by government-led malinvestment, and that the junk must be allowed to liquidate before an organic recovery can ever take hold (zombification).

Both views have something to them, but both views overcomplicate the problem. The real issue is the drop in productive output.

As I have shown before, it is perfectly possible (and actually quite common) for monetary and fiscal policy to raise or stabilise aggregate demand without actually addressing the underlying productivity issue — leading to superficial (and hollow) recovery, like Japan in the 90s and (probably) America today.

Austerity policies during a recession can often totally choke off productivity (Brüning, Papandreou, etc). This is particularly true in nations that are very centralised, and where government has become a very important economic actor.

Now Austrian economists may say that government spending is always a misallocation of capital. Well, I agree that central planners lack the information of the free market. But government is useful in supporting underlying productivity (as Adam Smith noted) through infrastructure creation, the rule of law, etc, and withdrawing that support during a slump for the purpose of paying down debt is detrimental.

So the key here is that government should do what it can to support productivity. What the Keynesians (and monetarists) got wrong is the idea that aggregate demand was somehow a good reflection of underlying productivity, and that underlying productivity can be effectively supported with money pumping, or by digging holes. My model is that the best means to sustain and increase underlying productivity is that government should let failing economic systems completely fail, end wasteful and capital-destroying activities like imperial adventurism, and recapitalise the broader people of the nation. Ron Paul’s aim of cutting taxes and simultaneously cutting military adventurism and corporate welfare would do that.  His policies are not the austerity policies of tax hikes and spending cuts which constrict the economy by sucking money out to pay down creditors without putting anything back in.