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Monday, 23 March 2009

Negative interest rates as an economic tool?

Economic textbook author Greg Mankiw discusses an idea put forward by a student at a recent Harvard seminar.

Reloading the Weapons of Monetary Policy

Some people are concerned that in the the fight against recession, the weapons of monetary policy are nearly out of ammunition. That is certainly the case for the standard monetary weapon--cuts in short-term interest rates. After all, short-term interest rates are already about zero, and the Fed cannot cut interest rates below zero.

Or can it? In a discussion at a Harvard seminar recently, a clever grad student proposed a solution to the zero-lower-bound problem.

Let's begin with the basics: Why can't the Fed cut interest rates to below zero? Why can't the Fed announce, for example, an interest rate of negative 2 percent? You borrow $100 today and repay $98 a year from now. A negative interest rate would certainly encourage people to borrow and spend, thereby expanding aggregate demand. And if negative 2 percent wasn't enough to get the economy going, we could try negative 3 percent. And so on.

The problem, you might reply, is that no one would lend money on those terms. Rather than lending at a negative interest rate, you could hold onto cash by, for example, stuffing it in your mattress. In other words, the interest rate on loanable funds cannot fall below zero because holding cash guarantees a rate of return of zero. If the Fed tried to cut interest rates below zero, money would dominate debt instruments as a portfolio investment.

With this background, I can now state the proposed solution: Reduce the return to holding money below zero. Imagine that the Fed were to announce that, one year from today, it would pick a digit from 0 to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 2 percent. Losing 2 percent is better than losing 10. Of course, some people might decide that at those rates, they would rather spend the money by, for example, buying new car. But since expanding aggregate demand is precisely the goal of the interest rate cut, that incentive is not a bug but a feature!

Okay, I understand that this plan is not entirely practical. But you have to give the student credit for thinking out of the box. And his plan does address a fundamental problem facing the economy right now: Given the fall in wealth, increases in risk premiums, and problems in the banking system, the interest rate consistent with full employment might well be negative.

Update: Alan Taylor of UC Davis (and coauthor, incidentally, of an excellent international economics textbook) reminds me of earlier versions of this kind of idea:

The idea of using scrip to stimulate spending dates back to the 1890s, when Silvio Gesell wrote a series of books related to monetary system reform. He claimed that since money held its nominal value over time, there was little reason to be in a hurry to spend it. This encouraged people to hoard money during periods of financial stress. Gesell, following a suggestion made by Swiss merchant George Nordman, argued that a “carrying tax” on money could prevent hoarding.

Gesell suggested that a periodic tax placed on money could do the trick. By making it costly to hold money, he believed people would be encouraged to spend it. In a severe depression, the idea that spending could be stimulated by making money costly to hold seemed appealing. In fact, Gesell’s views received the stamp of approval of the renowned economist John Maynard Keynes in his General Theory. Keynes viewed stamp scrip as a possible solution to what has been referred to as a “liquidity trap”—a situation where interest rates are so low in an economy, that no one cares to hold interest-bearing assets. By establishing a carrying tax on money, the nominal rate of return on money could be lowered, creating an incentive for people to hold interest-bearing assets, which might stimulate greater production across the economy.


peteremcc said...

So basically your suggesting reducing the money supply?

Which is pretty much the opposite of what governments around the world are doing at the moment in printing more money.

Steve Baron said...

I would have thought he was suggesting quite the opposite of what peteremcc suggests. By having a negative interest rate it encourages people to borrow more and use that money which stimulates the economy. It would be offering an incentive for people to borrow because they would only have to pay back less than they borowed. People certainly respond to incentives.

murray12 said...

A creative idea, and we need as many creative ideas as we can get.

But I think a more fundamental change is needed, from the present system (in the USA) where the Federal Reserve creates money as debt. Better to create money in exchange for real value given, as in the American Monetary Institute's finely worked-out plan for doing this in America, It's tried and true historically, too.

The principles would adapt to many other countries.

Alternative currencies can free up a stuck economy, and people are gradually waking up to them. There's a big list of info sites on them at Alternative currencies apparently helped to pull the world out of the Great Depression in the 1930s. They let people get on with their lives when the main money system is broken and, in these days of computer communication, are easier to run.

There's a list of such Community Exchange systems in New Zealand at . One of them, the HANDS system at Golden Bay, I know is growing apace.