There is considerable discussion about the possibility that the Federal Reserve could and possibly should create a monetary environment in which interest rates are negative.
First, why should it do this?
Second, is this even possible?
Third, if it is possible, under what conditions could/should the FED do this?
I am not speaking here of real interest rates, i.e., the cost of borrowing discounted by the rate of price inflation. That environment existed in the late 1970s when Federal Reserve policy under the pipe-smoking Arthur Burns and then the long-forgotten G. William Miller produced negative real interest rates. Prices were rising at rates higher than T-bill rates or T-bond rates. Investors lost wealth by investing in these assets rather than gold or silver.
To call a halt to this, the cigar-smoking Paul Volcker instituted a new policy in the fall of 1979. The FED dramatically reduced the rate of monetary inflation. As a result, there was a credit crisis. Short-term T-bill rates in 1980 went to 15.5% in March, fell back to 7% in the recession, and then soared to 15.7% in December.
This policy created back-to-back recessions: one for Carter and one for Reagan. But it sharply reduced the rate of price inflation over the next few years. The Dow Jones Industrial Average bottomed at 777 on August 13, 1982.
Negative real rates are the product of monetary inflation, which produces price inflation, which is followed by rising interest rates. For a time, interest rates — especially short-term rates — pay less than the depreciation of the currency unit. This is common in a boom phase of the economy. To escape price inflation, the central bank must do what the FED did in the first half of Volcker's chairmanship, 1979—1982.
The economists who talk about negative interest rates today mean an actual negative rate. We already have negative real rates for T-bills, with 90-day T-bills at 0.1% or thereabouts these days, and price inflation rising faster than this, as reported by both the CPI (0.4% for August) and the Median CPI (0.1% for August).
Check Treasury rates on my site: the department on "Yield Curve."
Check the Median CPI and CPI on my site's department, "Federal Reserve Charts." Or just type "Federal Reserve Charts" on Google. My department is the top link.
WHY SHOULD THE FED DO THIS?
There is a make-believe monster in the closet called a liquidity trap. Keynesian economists fear the liquidity trap almost as much as they fear not getting tenure. The liquidity trap takes place when prices fall. Yes, fall! You know, like the price of computer disk storage falls, which will destroy civilization if lots of other things are mass-produced and get cheaper. The horror!
Keynesianism's logic is that falling prices will reduce investment opportunities. You know, the way Henry Ford lowered the price of Fords, and then nobody wanted to buy Ford Motor Company shares, which is why he paid fortunes to his former investors to buy their shares back, i.e., to help them out in a terrifying situation for them. He was a generous man, as you have no doubt read.
The liquidity trap produces something called the zero-bound interest rate condition. That is where we are today. It was described by Nobel—Prize winning Keynesian economist Paul Krugman in March, 2008. In an article called "Liquidity Trap Watch," he warned:
And as I've pointed out before, we're quite close to liquidity trap territory: the point at which open-market purchases of Treasury bills, the normal way monetary policy operates, don't have any effect because the T-bill rate is near zero.
We are a lot closer to this now than we were in 2008.
But why does this terrify Keynesian economists? If the Federal Reserve really can jump-start the economy by lowering interest rates close to zero, under what he called "normal monetary policy," then why will a zero interest rate — free money — not get the economy rolling?
There is only one logical answer: people will not borrow at zero interest. Does this make sense? Maybe you won't. Maybe I won't. But I know someone who will. Uncle Sam.
Keynesians believe that a large government deficit is good in a recession. This deficit must be funded. The FED can fund all or part of it. The Federal government will then send this borrowed money to millions of people. These people will then spend this money.
So, why won't this familiar Keynesian prescription to fight recession work with rates at zero? The Keynesians never say. Krugman offered no additional insights in his short column.
Why must rates go below zero for the FED to buy more T-bills? No good reason. It can buy all the T-bills it wants. There are $11.8 trillion out there, with lots more in the budget pipeline. So, what's the problem, other than mass inflation — never anything that a Keynesian worries about?
Keynesian economists have only two policy recommendations for recession: (1) have the Federal government borrow money from investors, which the government then spends; (2) have the FED create the money to buy T-bills, which lets the T-bill sellers spend. For a Keynesian, "recession" means "insufficient consumer spending," not "insufficient saving and therefore reduced output."
In theory, I see a problem. If, at zero interest rate, the Federal government is unwilling to sell the FED more debt, this will create a crisis. This assumes one of two conditions:
1. The Federal government does not have any more debt to sell.
2. The Federal government will not spend any money that it borrows from the FED.
Keynesian economists live in a strange intellectual world in which threats that the rest of us regard as inherently preposterous are very real threats to the nation's prosperity. Any economist who refuses to live in this world risks not getting tenure. That, for Keynesian economists, is a terrifying world indeed.
So, on the assumption that a rate of zero interest — free money — will keep the economy from recovering, the Keynesian looks for ways for the Federal Reserve to stimulate the economy. How can it get the interest rate below zero, thereby encouraging the Federal government to borrow even more money?
Answer: it can't.
ARE NEGATIVE RATES POSSIBLE?
Harvard University economist Greg Mankiw has written the most popular introductory textbook on economics. He assures us that it is possible to have negative interest rates. "How?" you may ask. After all, would you lend someone money with a promise to be given back less money? He explains how this is possible.
If r is the real interest rate, then the relative price of consumption tomorrow in terms of consumption today is 1/(1+r). Is there anything in economic theory that requires this relative price to be less than one? Unless consumption goods are costlessly storable, which they aren't, I do not think so. Just as the price of apples can be more or less than the price of pears, the price of consumption tomorrow can be more or less than the price of consumption today. If people are eager to defer consumption, then consumption tomorrow could well be more expensive than consumption today — that is, the equilibrium real interest rate could be negative.
This proves to me, beyond a shadow of a doubt, that getting tenure in Harvard's economics department does not require that you communicate in anything resembling the English language. If anything, coherence is a career path liability. It means that you are trying to assist people to understand something both practical and important. Tenure-track professors should not make that mistake!
The Austrian economist Eugen von Böhm-Bawerk in the 1880s noted that there is always a discount of future goods in comparison to identical present goods. His student, Ludwig von Mises, explained this discount in terms of human action. We act in the present. We satisfy our wants in the present. If we win ten ounces of gold in a contest, but we are given the choice of taking possession now or in a hundred years, we choose to take it now. We also choose now over five years or five hours, other things being equal. (Mises, Human Action, Chapter XIX.)
There is a risk premium in all interest rates: a compensating extra payment demanded by lenders for the risk of not being repaid. Mises was not speaking of this. He was referring to the inescapable discount of future goods as against present goods. He called this time-preference. We prefer goods now, when we can use them, to future goods, which we cannot use now as we please. Our range of actions — our freedom — increases when we have control over resources now rather than later. This is why would-be borrowers who wish to persuade us to give up the use of these goods for a time must offer us a rate of return above zero. They know we will not surrender control over our goods without a promise of a return above zero. We can get zero without surrendering ownership. We don't need them to get nothing. We can get nothing all by ourselves free of charge. Or, quoting Professor Kristofferson, nothing ain't worth nothing, but it's free.
So, should negative rates ever appear in a free market, they will be the result of a single factor. There is a safe-storage fee involved in the transaction. Think of storing a million dollars in gold coins or currency. How can you transfer this cost? You can lend the coins or currency on written promise of repayment that the borrower will repay you at the end of the contract time limit. (Lots of luck in a collapse.)
Under any other circumstances, you would hold your money rather than lend it at zero interest. You would not surrender ownership for no good reason. Well, maybe one good reason. You are trying to get a teaching position in Harvard's economics department, and you think that if you prove that you are wacky enough to lend money at zero interest, Dr. Mankiw will recommend you. "He's one of my disciples."
So, assuming (1) you don't have a million dollars in gold coins or currency to store and (2) you are not trying to get a teaching position at Harvard, you will not lend at zero interest. Neither will anyone else.
So, the goal of zero interest rates is impossible except as a storage fee. That economists are discussing the possibility that the Federal Reserve System can somehow create monetary conditions in which there can be negative interest rates is indicative of the unreality of contemporary economists.
DOING THE IMPOSSIBLE IS NOT NECESSARY
Interest rates today are low because private lenders are buying T-bills. The FED has been slowing its purchase of assets this year. The monetary base has remained close to flat compared to the final quarter of 2008. See "Adjusted Monetary Base: Short Term," in my department, "Federal Reserve Charts."
Interest rates are low because of reduced demand by the private sector. People are afraid to increase their debt. But Uncle Sam isn't. He is on a spending binge like nothing we have seen since World War II.
If Keynesian policies work to restore prosperity — increased Federal debt and low interest rates — then this economy should be booming. Productivity should be rising fast. Unemployment should be coming down.
None of this is happening. Thus, Keynesian economists conclude, there has to be a reason. I mean a reason other than Keynesian economics is nuts, i.e., that increased thrift and production are the basis of wealth, not increased consumption. So, they go looking for liquidity traps and zero-bound interest rates. They go looking for a better FED policy.
They go looking for negative interest rates. "If free money won't get the economy booming, then what about a Christmas gift certificate from the FED?"
They are on the right track. They just don't know where the FED can impose its new policy of negative rates. Let me be the first to tell them.
The FED can get the banks lending and consumers borrowing by imposing negative interest rates in the one sector of the economy that it legally controls. It can offer banks a negative interest rate on their excess reserves.
Banks are holding about $700 billion in excess reserves at the FED these days. They are being paid the federal funds rate, i.e., the rate that banks charge each other for overnight loans. But banks are not borrowing overnight money these days. Why not? Because overnight loans were used to keep banks from falling below their legal reserve requirement limit. These days, banks are not lending. They are not flirting with the legal reserve limit. Instead, they are sending their money to the FED for safekeeping. The FED pays them just above zero.
Sound familiar? Think "storage fee." Bankers are terrified of this economy. They don't want to lose any more money. So, they give it to the FED for safe handling.
The FED can get banks lending again simply by charging banks a storage fee on their excess reserves. Put differently, the FED pays negative rates. At some point — probably around 1% — the banks will pull their money out of their excess reserves account and lend it to the Treasury at 0.1%. That's a better rate than negative 1%.
There is no problem with getting banks to lend — nothing that a 1% negative interest rate would not cure in 24 hours. If I am wrong, then the FED can hike the fee to 2%.
The FED's problem is this: as soon as the banks pull out their money and start lending, the fractional reserve process takes over. The doubling of the FED's monetary base, September to December, 2008, will lead to a doubling of M1 and a move of the M1 money multiplier into positive territory.
We would get mass inflation, then hyper-inflation. The FED has no intention of getting either one. So, it pays banks 0.1% on their excess reserves, leaving Keynesians to get all in a dither over the liquidity trap and zero-bound interest rates.
Keynesian economics is nuts. But you knew that.
September 19, 2009
Copyright © 2009 Gary North