Negative nominal interest rates

Here is a post by Matt Yglesias, my version goes like this:

1. If there is something akin to a liquidity trap, one can expect that a broader aggregate such as M2 has collapsed.  Accelerating the velocity of currency (say through a negative nominal interest rate, enforced through money stamping) may be a highly imperfect substitute for all the lost credit.  (Not all AD is created equal.)  Currency is usually small relative to M2, it is sector-specific, and the demand for currency can be slow to respond to relative prices.

2. If currency disappeared, how might negative nominal interest rates come about? The market won’t do it automatically.  Let’s say we start with zero price inflation and the real rate of return goes negative.  Competitive banks won’t impose negative nominal rates, rather the equilibrium is that they stop further real investments and pay zero on the balances.  One constraint is that some form of withdrawals may always be possible, the more important constraint is simply that “storing balances” costs almost nothing at the margin and so competition will bring a zero rather than negative nominal return, adjusting for costs of transacting of course.

3. There is another way to get negative nominal interest.  We could imagine a government-engineered reserve requirement, the shutting down of competing networks for trading reserves, and then the government raises the tax on those reserves to bring about negative nominal interest rates.  This can be done with or without the existence of zero-interest-bearing currency.  (Converting large quantities of reserves to currency, by the way, might be quite costly, given costs of transport and storage.)

4. Conclusion: getting rid of zero-interest-bearing currency doesn’t provide a new weapon against a liquidity trap.  Tsiang (JMCB, 1974), by the way, went to an extreme and argued that getting rid of zero-interest-currency meant you were in a liquidity trap all the time, because arguably the money-bonds distinction disappears.   I don’t agree, but the presumption lies in that direction.

5. Most generally, the problem in liquidity trap scenarios is that the economy is making an attempt to move from riskier assets to safer assets, and in the face of that attempted adjustment economic expansion is unlikely, no matter what the policy response.  Changing one of the properties of one of the safest assets (i.e., allowing currency to bear interest) probably won’t make the reequilibration process much easier if at all.  In broad outlines it will be pretty much the same.

Comments

Tyler, I have only one question. Who do you think is laughing in his grave while reading your post, Milton Friedman or Hayek or perhaps James Tobin or Franco Modigliani, or Knut Wicksell, or JMK?

I put more faith in the sayings of Bill Gross (PIMCO bond manager) than any economist: "Unless entitlements are substantially reformed, the U.S. will likely default on its debt,” Gross said in an April report. “Not in conventional ways, but via inflation, currency devaluation and low-to-negative real interest rates.” Anyone running a fund with $ billions at stake is more credible than an ivory tower economist (or a blogger such as Yglesias)

Bill Gross is talking his book. He was dead wrong about the end of QE I, and he will likely be very wrong about the end of QE II as well.

For many years, Bill Gross used the words "default" even through he knew this was impossible for the United States. Basically, the greatest bond trader in history lied about the potential for a U.S. default to benefit himself. Excessive spending may debase their currency through inflation, but "Default" sounds much worse. Now he has changed his language because people are now realizing that the U.S. cannot default, and he seems like an idiot for using the word "default".

We never have to worry about a buyers strike in the bond market, because we cannot default. This must scare the hell out of Bill Gross.

Of course, we can have inflation. The good thing about this, is that we can observe inflation. We can see it and measure it, however imperfectly. Right now, inflation is about 3% or so. Somehow, this 3% inflation doesn't seem as scary as default.

Let’s say we start with zero price inflation and the real rate of return goes negative. Competitive banks won’t impose negative nominal rates, rather the equilibrium is that they stop further real investments and pay zero on the balances...the more important constraint is simply that “storing balances” costs almost nothing at the margin and so competition will bring a zero rather than negative nominal return, adjusting for costs of transacting of course.

Can you describe this argument more fully or provide a citation?

Indeed. The costs of transacting are part of the return.

Look at it in terms of the costs. Absent any physical cash and any lending activity, an account just consists of a line in a database, regardless of the size of the account, so the cost of maintaining a balance is fixed and determined by the cost of IT resources. If this cost is passed directly to the account holder as a fixed fee as would be expected in a competitive market, the interest rate on the average dollar is -1*fee/balance, but the interest rate on the marginal dollar is still zero. Since the cost of maintaining a database isn't huge enough to deter people from saving entirely, it's that marginal rate that's going to matter, and it will still stubbornly sit at zero.

That handles holding money in an account, but what about moving money in and out of one? Once again, if we assume that costs are passed on directly to the account holder, then we'll have a fixed transaction cost for a transfer, and since all movement of money is handled through transfers between these accounts, it will create a friction on all economic activity, so velocity of money is going to decrease, as the chains of transfers that would occur when these costs are simply paid by taking a chunk of the interest that might otherwise be returned to account holders will occaisionaly be short-circuited by transactions that don't deliver enough surplus value to get over the transaction cost. That's going to drive prices, and thus nominal interest rates, down, pushing the economy further into very trap that this measure is supposed to get it out of.

"Here is a post by Matt Yglesias". Nothing like that to make my heart flutter! And the reason you think his opinion is worth noting is?

MY's opinion IS worth nothing: comprehensive ignorance backed up by unadulterated arrogance. If there is such a 'thing' as negative real insight: there it is.

Tyler, I'm not sure you have thought through your understanding of what it means to have no currency. A bank can't store a balance for free any more than an individual can. If there is no currency and central banks pay negative interest on reserves then holding a balance costs something!

Matt, that is my case #3.

No it's not. With no currency there are only 3 options to hold a positive balance:

1) real investment
2) lend money to somebody else (whether to a bank or to another type of actor doesn't matter)
3) lend money to the central bank (hold reserves)

2 just kicks the can down the road. Your counterparty faces the same problem you did. Balances are a hot potato with no currency, no inflation and negative real rates. Nobody wants to hold them, so they attract negative interest.

About your point 3, this is just reaction on "engineering reserves" as I think this is not our case. Let's just slightly shift our starting condition. We are starting with zero inflation, zero interest rates and with already existing huge bank reserves with insatiable appetite for more while remaining reluctant to lend. So what will happen if we introduce sweden-like fee on these reserves?

Also do not forget that it is not QE money sitting idly on bank ballance. It is also huge corporate profits held on hold to be invested during the time when the fog od sluggish economy and high unemployment is past. Negative interests would incentivize these players to do something with their mony now.

Another reason for the Fed should to revalue gold in the northern neighborhood of $5000, assuming entitlements are reformed. If people want to move to safe assets, do it fast. Also, have Bernanke recite these lines to Ron Paul during Congressional testimony.

The best way to think of the liquidity trap is not as a credit market phenomenon, but as a high demand for the medium of account. A few comments:

1. M2 is endogenous. If a tax on the medium of account raises NGDP growth, M2 will usually rise as well.

2. If currency disappears then a tax on bank reserves allows for a negative nominal rate. (Bank reserves are the medium of account in a cash-less economy.) This reduces the demand for bank reserves and thus reduces their value. NGDP rises.

3. I agree on point 3. The cost of holding cash is not all that high, but it's high enough where a negative IOR may be somewhat effective.

4. The money/bonds distinction doesn't matter; if you reduce the demand for the medium of account, then you raise expected NGDP growth.

5. Or you could say that the economy is trying to drive the risk-free rate below zero, but isn't able to. Negative IOR in a cashless economy will raise the equilibrium risk free rate by boosting expected NGDP growth, and hence solve the problem of the economy bumping up against the zero lower bound on nominal rates.

For instance, Japan has averaged zero percent NGDP growth for 17 years. Suppose they use negative IOR to raise NGDP growth to 3%. In that case risky assets become much more desirable for any given nominal interest rate.

It's also important to clearly separate the questions of whether negative IOR can produce higher NGDP growth, from the very different question of whether higher NGDP growth will raise real GDP growth. In the long run more NGDP won't raise real growth. In the short run it will. Marcus Nunes has an excellent post that shows that distinction:

http://thefaintofheart.wordpress.com/2011/04/04/delong%C2%B4s-%E2%80%9Canatomy-of-a-slow-recovery%E2%80%9D/

Getting to negative nominal interest rates merely requires putting our currency on the Roentgen Standard.

Tyler, I don't see how 3. supports 4. Your answer to Matt suggests that 3. specify a situation with a negative nominal rate of interest on central bank deposits. Now, if the central bank also withdraws all of its currency, why shouldn't this negative interest rate be passed on in the wider credit market? If it does, then, for given expected inflation, short term real rates of interest decline, allowing the economy to escape the liquidity trap. What am I missing here?

I agree that #2 is wrong. With no 0% nominal currency and given very low risk-free rates in the asset markets, "storing balances" over time will be costly, no matter what. Nothing stops the central bank from setting a negative IOR on excess reserves.

"Most generally, the problem in liquidity trap scenarios is that the economy is making an attempt to move from riskier assets to safer assets, and in the face of that attempted adjustment economic expansion is unlikely, no matter what the policy response. Changing one of the properties of one of the safest assets (i.e., allowing currency to bear interest) probably won’t make the reequilibration process much easier if at all. In broad outlines it will be pretty much the same."

Seems like a pretty good case for aggressive fiscal expansion to me, no?

As I'm reading this, the guest on Charlie Rose says something like "if more people work and by innovation produce more you have growth".

Looks to me you are debating which policy string to push and how rather than simply adopting a policy of hiring firms to hire more people to produce more and hire people to invent and innovate to produce even more.

And the US has a two trillion dollar deficit in offsetting the physical depreciation in infrastructure, not to mention the trillion in investment in upgrading the infrastructure to the latest technology that is being built today in places like the BRICs.

China has been investing very heavily in rail and ports in recent decades while the US rail network was built more than a hundred years ago and then major parts abandoned with the rest forced to operate at lower speeds as cities built up around the high traffic regions where roads and trains intersect at ground level.

I suppose you can argue the US is a dying nation so building infrastructure for the next 50 to 100 years is all waste.

Or is the problem that the private firms aren't going to pay to repair the roads and bridges with their tax cut savings because their competitor will be free riders,so all the firms are waiting for the unemployed workers who have saved trillions on taxes to pay higher taxes to pay for fixing the roads for the for profit firms? Of course, they can move to China where the taxpaying workers there are paying for new modern roads....

The easiest way to get an effective negative nominal interest rate is by letting banks (and money-market funds) go bust. If 9 banks pay 1% interest and 1 bank goes bust, the effective nominal interest rate is close to -9%. But oh no, can't do that, because economists want to pretend they've saved, and are saving, the world.

The person should not think negative because negative thought is very devastating for any one person should have positive on their life always.

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