S.C. Tsiang, prophet

by on December 16, 2008 at 4:48 pm in Economics | Permalink

Or should I have called this post "zero nominal rates of interest"?

The JSTOR link is here.  In 1969 Tsiang wrote that if the Fed pays interest on reserves, or nominal interest rates in loan markets approach zero, money (if you can still call it that) dominates all investment assets.  The only equilibrium involves the government holding all of the economy’s real capital.  In other words, Milton Friedman’s old recipe for an optimum quantity of money can never be realized in anything resembling a decentralized economy.

Here is Jeff Hummel’s post on paying interest on reserves.  Here is today’s headline on the Fed and the federal funds rate.  Note that for Chiang, either zero nominal interest rates or interest on reserves was enough to cause the problem; did he imagine we might someday have both?


1 RK Shah December 16, 2008 at 5:17 pm

My understanding is that one of the reasons to lower interest rates is to encourage banks to lend. Is it possible that lowering interest rates is causing the exact opposite of its intended effect? Let me give an example to illustrate my point.

A good friend of mine was trying to decide whether he should “hoard” his cash or start paying off his student loans and credit cards. He decided against paying anything more than the minimum payment on the understanding that the interest rate of 10 or 15% he was paying was somewhat of an insurance policy on his having cash available in case he needs it. At a time when credit card companies are cutting limits, he realized that if he paid off $2,000 worth of debt he would have $2,000 less cash and not necessarily have access to $2,000 in more credit. So he is paying $300 a year in interest for the ability to have access to his $2,000 in cash.

Is it possible that banks, instead of lending, are thinking that with interest rates as low as they are and the risk of defaults as high or higher than before, that they might be better off borrowing money from the government at a low rate and just hoarding it and not lending it out? If interest rates were higher, wouldn’t banks be compensated more adequately for the risks they are taking for lending in a dangerous environment for creditors?

So could low interest rates as set by the fed be actually causing a tightening as opposed to a loosening of the credit supply as banks are being given an additional reason not to lend?

2 David Beckworth December 16, 2008 at 6:10 pm

The Fed’s paying of interest on excess reserves may lead to an outcome like the one that arose in response to the Fed’s 1936-1937 raising of required reserves: a reduction in lending during an economic downturn. See here for more.

3 Mercutio.Mont December 16, 2008 at 7:45 pm

Can anyone explain in a bit more detail why “the only equilibrium involves the government holding all of the economy’s real capital”?

4 xerocky December 17, 2008 at 7:37 am

If you ask me, it seems like the banks are useing the money to buy gov. bonds.


So, they’re borrow from the fed and lend it to the gov?

5 Robbie December 17, 2008 at 4:07 pm


This seems to be saying that interest on excess reserves is paid at 75 basis points below the Fed Fund Rate. With the Fed Fund Rate currently at 25 basis points shouldn’t the interest on excess reserves be 0%?

6 whitebread December 17, 2008 at 5:49 pm

This seems to be saying that interest on excess reserves is paid at 75 basis points below the Fed Fund Rate. With the Fed Fund Rate currently at 25 basis points shouldn’t the interest on excess reserves be 0%?

from one of the articles linked to in tyler’s post:
The irony is that the Fed is now less able to hit its interest rate target than ever before. It first adopted the corridor or channel system of the ECB, setting the interest rate on reserves below its Federal funds target, as a lower bound, with the discount rate above the target as an upper bound. But as the effective Federal funds rate fell not only below target but below the interest rate on reserves, the Fed on November 5 moved to the New Zealand system, where the interest rate on both required and excess reserves is set right at the target Federal funds rate. So far, this hasn’t worked either.

7 albatross December 23, 2008 at 11:33 am

But in that situation, why don’t the banks offer to lend money at higher interest rates? I mean, if you have some notion of the risk you’re facing, it ought to be possible to decide on how much to charge for taking it.

The only ways I can see this making sense (I’m a pretty unsophisticated observer!) are:

a. The banks don’t have confidence in their ability to price risk right now, so they’re reluctant to commit to any interest rate.

b. The banks forsee a plausible future in which any lending they do that isn’t extremely liquid and low-risk could lead to their going under–for example, if their worst-case models involve high probability of having many of their depositors pulling out money over time to cover losses in other places, maybe they fear that they’ll have a kind of slow run, in which it’s impossible to keep borrowing short, even though they’ve lent long and are stuck with it.

c. They would lend at some higher interest rate, but either don’t think they can get that rate on the market, or fear the political backlash of offering loans at 20% when T-bills are paying nothing. (This might also make sense if they’re worried about near-term massive inflation, right? Don’t lend long at 8% when next year, inflation will be at 20% and you won’t be able to borrow short at less than 25%.)

I’m sure I’m missing a lot here. Is there some other reason why banks wouldn’t just offer loans at higher interest rates? Normally, raising the price is supposed to make suppliers want to provide more of something….

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