How the Original Sin of Borrowing in a Foreign Currency Can Reduce the Effectiveness of Monetary Policy for Both the Borrowing and Lending Country

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Link to Wikipedia article for “Original sin (economics)”

When a central bank cuts interest rates, each type of borrower-lender relationship generates more aggregate demand because (a) the shift in of the budget constraint of the lender is matched by an equal and opposite shift out in the budget constraints of the borrower, (b) borrowers generally have higher marginal propensities to consume out of changes in effective wealth and © beyond the sum of wealth effects from (a) and (b), there is also a substitution effect leading to more spending now simply because lower interest rates make spending now cheaper relative to spending later than it was before the interest rate cut. (a) is the “principle of countervailing wealth effects” I discuss in these three posts:

  1. Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates
  2. Responding to Joseph Stiglitz on Negative Interest Rates. 
  3. Negative Rates and the Fiscal Theory of the Price Level

The Open Economy

I laid out the principle of countervailing wealth effects in “Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates” in order to dispute the idea that causing one’s currency to depreciate was almost the sole transmission mechanism for interest rate cuts into the negative range, so I concentrated on the case where every central bank in the world simultaneously cut its target rate by 100 basis points. But it is interesting considering the open economy case with only one central bank cutting its target rate.

First, it is important to realize that thinking about wealth and substitution effects in the way I describe above is only telling about consumption and investment. The extra net exports from the outward capital flow as funds flee the low domestic interests by going abroad is an addition to aggregate demand that goes beyond the wealth and substitution effect logic above.

See “International Finance: A Primer” for why funds going outward drive net exports up. That post also explains how the outward capital flow puts more of the domestic currency in the hands of foreigners and thereby drives down the foreign-exchange value of the domestic currency.

Small Open Economy, Net Creditor in Foreign-Denominated Assets. To see if there is any chance that the wealth and substitution effect logic can overturn the effect of increased capital outflow on aggregate demand, let’s begin by considering a small open economy that is a net creditor. To the extent that anyone in the country is investing domestically both before an interest rate cut, the usual principle of countervailing wealth effects holds since both borrower and lender are domestic. Because it is a small open economy, the rate of return on foreign assets should be affected by this monetary policy move only to the extent it induces expected exchange rate movements. If people expect any mean reversion of the exchange rate, the usual depreciation of the local currency accompanying a domestic interest rate cut might make people expect a bit of mean reversion and therefore a bit lower returns on foreign assets than before the interest rate cut. But overwhelming this effect, depreciation of the domestic currency makes any foreign assets already owned look bigger in value when totaled up in the depreciate domestic currency. Overall, there is very little room for any ambiguity about the stimulative effect of interest rates cuts for a small open economy that is a net creditor: there is the stimulus to net exports from increased capital outflow, plus a higher return on foreign assets when viewed in the domestic currency, plus the higher value of foreign assets when viewed from the perspective of the domestic currency.  

Large Open Economy, Net Creditor in Foreign Denominated Assets. Now, consider a large open economy that is a net creditor. As with any monopolist that drives down prices by producing more and selling it, a net creditor country that increases its lending abroad could theoretically reduce the rates of return it gets abroad and so make itself effectively poorer. If this were the case, one would expect to have at least some people in that country suggest that it have policies to reduce its foreign lending in order to jack up its returns on foreign assets. In the absence of any such suggestion, it seems unlikely that a country in fact would make itself significantly poorer by increasing its foreign lending from its current level.

Net Creditor in Own Currency. If a country does significant lending in its own currency, such lending is still driven by interest rates abroad relative to interest rates at home, and like the purchase of foreign-denominated assets, puts the domestic currency in the hands of foreigners, who are likely to turn around and spend those funds in increasing net exports from the domestic economy. However, with the lending in the domestic currency, exchange rate changes no longer change wealth as viewed in the domestic currency. It now becomes logically possible for a cut in interest rates to reduce spending simply because of the reduced interest income from foreigners when rates are cut.

Germany. There are three ways of thinking of the situation for Germany. One is that seeing Germany as a set of creditors within the eurozone, where the entire eurozone is seen as domestic. When taking the eurozone as the main unit of analysis, and Germany as only a part, German lending to others in the eurozone is all internal and the principle of countervailing wealth effects still applies in its main form to the eurozone as a whole. 

Second, Germany can be seen as a net creditor in its own currency. 

Third, one can view the situation as the other countries in the eurozone automatically loosening their monetary policy when Germany does. The other countries loosening their monetary policy cancels out the exchange rate effects that would otherwise make the foreign assets Germans hold in other eurozone countries look like more wealth when Germany loosens its monetary policy.

Net Debtor in Own Currency. If a country owes money on net, primarily in its own currency, then in this borrower-lender relationship, a cut in interest rates will have a positive wealth on consumption by this debtor country, enhancing the positive effects on aggregate demand from borrower-lender relationships within the country, and from the capital outflow and consequent increase in net exports induced by a rate cut.  

Small Open Economy, Net Debtor in Foreign-Denominated Obligations. This case is sometimes called “original sin.” Depreciation now makes debts look larger, which should overwhelm the effect of expected mean reversion in the exchange rate in lower the rate of return on those debts. If foreign-denominated obligations are large enough, it might even become impossible to stimulate the economy with an interest rate cut. Thus, getting into this situation is quite dangerous. Countries should put policies into place to avoid owing large amounts of money in foreign-denominated obligations. And the IMF should proactively discourage countries from committing the original sin of borrowing with foreign-denominated obligations.  

Large Open Economy, Net Debtor in Foreign-Denominated Obligations. This does not literally mean a large economy, but only one that must pay higher interest rates when it owes more and can pay lower rates when it owes less. Assuming a depreciation of the currency from a monetary loosening that reduces the rate on own-currency debt raises net exports enough that a bit of the debt begins to be paid off and the rate paid on all of the foreign-denominated debt goes down when it is rolled over, that provides a bit of an extra wealth effect in the positive direction.  

Summary

Overall, the main potential loopholes to the argument that interest rate cuts should stimulate the economy come from a country’s being a large net creditor in its own currency, or a country’s being a large net debtor in foreign-denominated obligations. In both cases, someone is borrowing in a foreign currency. Overall, having countries borrow primarily in their own currency if they do borrow is an important measure for maintaining the effectiveness of monetary policy.

Note: I am worried about the chance that I might have missed some important element of the analysis I pursue in this post. Send me a tweet (@mileskimball) if you think I got something wrong or missed something. 

Update: Olivier Wang’s reply to this post generated the follow-up post “More on Original Sin and the Aggregate Demand Effects of Interest Rate Cuts: Olivier Wang and Miles Kimball.” 

The Bank of Japan Renews Its Commitment to Do Whatever It Takes

Link to Wikipedia article on Haruhiko Kuroda

I am not impressed by a target of zero for 10-year Japanese government bonds as stimulative measure, when they have been trading at negative rates. Fortunately, I think this is simply a sign that the Bank of Japan is continuing to search for new tools. And, as you can see from “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide,” there are tools available that are much more powerful than anything the Bank of Japan has used so far. 

In particular, one of the most powerful tools the Bank of Japan has not yet tried is a negative paper currency interest rate through a gradually increasing discount on paper currency obtained from the cash window of the Bank of Japan (and a corresponding gradually increasing discount in what is credited to a bank’s reserve account when paper currency is deposited). A negative paper currency interest rate in turn makes it possible to cut other short-term interest rates much further.

Watching the Bank of Japan’s actions over the last few years and talking to its chief, Governor Haruhiko Kuroda, at Jackson Hole, left me confident about the Bank of Japan’s willingness to try new tools. What I wondered is whether the Bank of Japan would declare that it was already close to the natural rate of unemployment, and so didn’t need to do much more. My view is that after 20 years of slump, the Bank of Japan needed to risk overshooting its inflation target in order to find out both what its natural level of output really is, and to find out what it takes to permanently raise inflation to 2%, as it has decided it wants to do. In its September 21, 2016 statement, the Bank of Japan declares that it has come around to that point of view–better to risk overshooting than to undershoot:

The Bank will continue expanding the monetary base until the year-on-year rate of increase in the observed CPI (all items less fresh food) exceeds the price stability target of 2 percent and stays above the target in a stable manner. Meanwhile, the pace of increase in the monetary base may fluctuate in the short run under market operations which aim at controlling the yield curve. With the Bank maintaining this stance, the ratio of the monetary base to nominal GDP in Japan is expected to exceed 100 percent (about 500 trillion yen) in slightly over one year (at present, about 80 percent in Japan compared with about 20 percent in the United States and the euro area). 

The Bank will make policy adjustments as appropriate, taking account of developments in economic activity and prices as well as financial conditions, with a view to maintaining the momentum toward achieving the price stability target of 2 percent.

I think it is this stated willingness to overshoot, not the introduction of an explicit yield-curve targeting, is what caused the yen to depreciate on the Bank of Japan’s September 21 announcement. 

The other key section of the the September 21, 2016 statement is the section labelled “Possible options for additional easing”: 

With regard to possible options for additional easing, the Bank can cut the short-term policy interest rate and the target level of a long-term interest rate, which are two key benchmark rates for yield curve control. It is also possible for the Bank to expand asset 5 purchases as has been the case since the introduction of QQE. Moreover, if the situation warrants it, an acceleration of expansion of the monetary base may also be an option.  

Note the specific mention of lower short-term rates as an option. 

Beyond the policy of a gradually increasing discount on paper currency obtained from the cash window of the Bank of Japan to make it possible to lower short-term rates without inducing massive paper currency storage, the most important complementary policy is one to make negative rates more acceptable politically: a shift in the details of the interest on reserves formula to explicitly link the amount of funds on which banks can earn an above-market interest rate to their provision of zero rates to small household accounts. The government retail bank represented by Postal Savings should also be part of this program, just as if it were a private bank (although its subsidy could come from another arm of the government rather than from the interest-on-reserves formula). Here is how it works, as I detailed in my post “Ben Bernanke: Negative Interest Rates are Better than a Higher Inflation Target”: 

I have advocated arranging part of the multi-tier interest on reserves formula to kill two birds with one stone: not only support bank profits but also subsidize zero interest rates in small household accounts at the same time–the provision of which is an important part of the drag on bank profits as it is now. I think being able to tell the public that no one with a modest household account would face negative rates in their checking or saving account would help nip in the bud some of the political cost to central banks.

To avoid misunderstanding, it is worth spelling out a little more this idea of using a tiered interest on reserves formula to subsidize provision of zero interest in small household checking and savings accounts. To make it manageable, I would make the reporting by banks entirely voluntary. The banks need to get their customers to sign a form (maybe online) designating that bank as their primary bank and giving an ID number (like a social security number) to avoid double-dipping. In addition to shielding most people from negative rates in their checking and savings accounts, this policy also has the advantage of setting down a marker so that it is easier for banks to explain, say, that amounts above $1500 average monthly balance in an individual checking+saving accounts or a $3000 average monthly balance in joint couple checking+saving accounts would be subject to negative interest rates. That is, the policy is designed to avoid pass-through of negative rates to small household accounts but encourage pass-through to large household accounts, in a way that reduces the strain on bank profits.

Finally, in Japan, I would tie the ability of banks to get an above-market rate on a portion of their reserves to their passing along the discount on paper currency to their customers when their customers withdraw paper currency, so that regular people would get the benefit of that discount, too.

With the combination of a negative paper currency interest rate induced by a gradually increasing discount on paper currency obtained from the cash window of the central bank, and effective subsidies to support zero rates on small household accounts to make negative rates in general more acceptable, the Bank of Japan would have as much firepower it needs to achieve its goals. 

Given how little we understand about economies that have been in a 20-year slump, I applaud the objective the Bank of Japan has now announced of continuing to stimulate the Japanese economy until the signs of the Japanese economy being above the natural level of output become absolutely unmistakable by inflation going above 2%. In the case of Japan, the economic risk from doing too little is much greater than the risk from doing too much. 

Note: I will be going to the Bank of Japan to deliver this message personally in a few days. I have seminars scheduled at the Bank of Japan on September 27 and October 7. You can see the regularly updated itinerary for all of my travels to promote the inclusion of full-bore negative interest rate policies in the monetary policy toolkit in my post Electronic Money: The Powerpoint File. 

Negative Rates and the Fiscal Theory of the Price Level

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I was very pleased to be invited to the Jackson Hole monetary policy conference this past August. One of the highlights of the conference was Chris Sims’s lunchtime talk on the first main day of the conference, “Fiscal Policy, Monetary Policy and Central Bank Independence.” The fiscal theory of the price level is something I have been confused about for a long time. Chris Sims interpreted it from a remarkable simple point of view–a point of view very close in its logic to the way I analyze the transmission mechanism for interest rates cuts–including going to a negative interest rate or a deeper negative rate–in my posts  

I confirmed my interpretation of what Chris was saying in a question I posed in the Q&A right after his talk. I still may have it wrong, but here is what I understood. 

Why Lower Rates Increase Aggregate Demand and Higher Rates Reduce Aggregate Demand

Suppose real interest rates go down. Adding up spending from both sides of almost every borrower-lender relationship in which rates go down, aggregate demand should increase because:

  1. The negative shock to effective wealth of the lender is matched by an equal and opposite shock to the effective wealth of the borrower. This is the “Principle of Countervailing Wealth Effects” I discuss in the posts listed above. Long-term fixed rates can mute the shock to the effective wealth of both sides, but absent a big change in the inflation rate will still typically lead the borrower to feel better off with the change in rates and the lender to feel worse off in terms of annuity equivalents (whatever the asset values on paper). 
  2. In almost all cases, the marginal propensity to consume is higher for the borrower than for the lender, so that adding up the effects on borrower and lender, the wealth effects add up to an increase in spending. The particular marginal propensity to consume (MPC) that matters is the marginal propensity to consume of the borrower out of reductions in interest expenses and the marginal propensity to consume of the lender out of interest earnings.
  3. In addition to the wealth effects on the non-interest spending of the borrower and lender, there is a substitution effect on both borrower and lender toward spending more now simply because spending now is relatively cheaper compared to spending later when the interest rate is lower. (For the lender alone, the wealth effect may easily overwhelm the substitution effect, so that the lender may spend less when interest rates go down, but for the borrower and lender combined the wealth effect and substitution effect both go in the same direction given 1 and 2: toward more non-interest spending when the rate goes down.)

What if interest rates go up? Then, adding up spending from both sides of almost every borrower-lender relationship in which rates go up, aggregate demand should decrease because:

  1. The positive shock to the effective wealth of the lender is matched by an equal and opposite shock to the effective wealth of the borrower–the “Principle of Countervailing Wealth Effects.” Long-term fixed rates can mute the shock to the effective wealth of both sides, but absent a big change in the inflation rate will still typically lead the lender to feel better off with the change in rates and the borrower to feel worse off in terms of annuity equivalents (whatever the asset values on paper). 
  2. In almost all cases, the marginal propensity to consume is higher for the borrower than for the lender, so that adding up the effects on borrower and lender, the wealth effects add up to a reduction in spending. The particular MPC that matters is the marginal propensity to consume of the borrower out of reductions in interest expenses and the MPC of the lender out of interest earnings.
  3. In addition to the wealth effects on the non-interest spending of the borrower and lender, there is a substitution effect on both borrower and lender toward spending less now simply because spending now is relatively more expensive compared to spending later when the interest rate is higher. (For the lender alone, the wealth effect may easily overwhelm the substitution effect, so that the lender may spend more when interest rates go up, but for the borrower and lender combined the wealth effect and substitution effect both go in the same direction given 1 and 2: toward less non-interest spending when the rate goes up.)

The Fiscal Theory of the Price Level Points to the Exception

The Fiscal Theory of the Price Level comes into play when there is an exception to the rule that the borrower has a higher marginal propensity to consume than the lender. This has happened historically along the path to hyperinflations. The key borrower-lender relationship for understanding hyperinflations is the one in which the government is the borrower and bond-holders are the lenders. If inflation and interest rates are changing rapidly the wealth effects on both sides of the borrower-lender relationship in which the government is the borrower can have extra complexities, but the Principle of Countervailing Wealth Effects still applies: any effective gain in wealth to the government is an effective loss in wealth to the bond-holders and any effective loss in wealth to the government is an effective gain in wealth to the bond-holders.  

One possible issue is if there is an unexpected increase in inflation that reduces even the annuity equivalent of long-term government bonds, so that the higher inflation increases aggregate demand through a higher government propensity to consume out of that inflation windfall than the reduction in spending to those who have had the annuity equivalent of their bonds eroded by inflation.  

Another possible issue is related to the one envisioned in Thomas Sargent and Neil Wallace’s “Some Unpleasant Monetarist Arithmetic.” Suppose government borrowing is short-term and that the markets demand inflation compensation according to the Fisher equation, and that the central bank pushes up the real interest rate as inflation goes up. If the government reduces non-interest spending more than the bond-holders raise their spending as its real interest costs go up, then the situation is stable. But if the government keeps its non-interest spending roughly the same (financing the rising deficit out of additional borrowing), then any increase in bond-holder spending will result in an increase in aggregate demand. Unless aggregate demand goes down as a result of the effect of rising real rates on other borrower-lender relationships, the situation will be unstable. That instability can easily lead to hyperinflation.    

Failure of Stabilization with a Lower Bound on Rates

Now consider the opposite situation from a hyperinflation. Suppose the economy starts with aggregate demand below what would keep the economy at the natural level of output. Interest rate cuts should raise aggregate demand according to the logic his post begins with. But if interest rate cuts are stopped short by a lower bound on rates, there may still be a deficiency in aggregate demand. And the markets, knowing that balance may not be reachable given the lower bound on rates, will not have future expectations that are as stabilizing as one would hope. 

How Eliminating the Zero Lower Bound Leads to Stability

As long as rates can go as far down as needed, the logic of countervailing wealth effects–with borrowers having a higher MPC than lenders–ensures that aggregate demand will eventually rise to equal the natural level of output. Expectations of this will exert a stabilizing influence. The only potential problem is if important borrowers have lower marginal propensities to consume than the lenders on the other side of that borrower-lender relationship. The most plausible case of such a failure would be the government as borrower. But even a government in the grip of austerity because of a concern about budget deficits and national debt, is likely to have a relatively high marginal propensity to consume out of interest savings because those interest savings are manifested as a lower budget deficit–as conventionally measured–than the government would otherwise face. That is, is it really plausible that even a government in the grip of an austerity policy would spend less on non-interest items than it otherwise would because its interest expenses went down? That doesn’t seem plausible to me. Whatever reduction in non-interest spending the austerity approach lead to in itself, a low enough interest rate should reduce interest expenses enough that the government should begin spending more on non-interest items. I would be surprised if it isn’t close to 1 for 1 (MPC = 100%) in an environment where many people will be pushing the government to spend more, and for austerity proponents, pointing to a high budget deficit is one of the few effective ways of pushing back on that pressure to spend more. 

How, in the Event, the Stabilization Mechanisms Need Not Be So Fiscal After All

The confidence that a low enough interest rate would bring forth enough additional aggregate demand to equal the natural level of output, plus the confidence that the central bank can and will lower the interest rate as much as necessary (having eliminated the zero lower bound) will make the economy stable. And part of that confidence may be knowing that in extremis the interest rate mechanisms described above would lead to more government spending on non-interest items as the central bank cut rates. But that does not mean that (given the initial recessionary situation) equilibrium would, in fact, be restored by a large increase in government spending on non-interest items. Knowing that the economy would return to the natural level of output, investment would be more robust. And even if there is still a big deficiency of aggregate demand, interest rate cuts raise aggregate demand through all the other borrower-lender relationships as well–many of them relationships in which the government is not involved. So it is quite possible for aggregate demand to be restored to equilibrium with the natural level of output with a relatively modest response of government spending on non-interest items as interest rates drop. Indeed, it is quite possible for the direct effect of an austerity policy to exceed the effect of interest rate cuts on government spending on non-interest items, so that government spending on non-interest items remains below normal during the recovery. Aggregate demand doesn’t have to come from the government. Interest rate cuts will guarantee that it comes from somewhere–unless the whole thing is destabilized by implausible expectations of an implausibly low government marginal propensity to consume out of interest rate savings. 

Why There Is an Asymmetry Between Hyperinflation and Stabilization in the Absence of a Lower Bound on Interest Rates

Because cutting non-interest spending can be very difficult, it can and does happen that a government sometimes does have a low marginal propensity to cut non-interest spending as interest expense increases. But in a serious recession when there will be clamoring for more spending from all sides, there is nothing likely to stand in the way of even a quite austere government increasing government spending on non-interest items somewhat relative to what spending on non-interest items would have been had interest expenses been higher. On the other side of the transaction, the typical MPC of government bond-holders is quite low. And there are many, many other borrower-lender relationships in which borrowers unquestionably have a higher MPC than the lenders on the other side of the transaction. Finally, all of that leaves out the substitution effect, which can be quite powerful in raising aggregate demand in response to interest rate cuts, once one is comparing it to the sum of wealth effects for the borrowers and lenders on both sides of a transaction rather than to the wealth effect for only the lenders. 

Conclusion

Anyone who forgets to think about borrowers will never understand the transmission mechanism through which interest rates affect the economy. Thinking about borrowers as well as lenders shows just how powerful cutting rates can be in stabilizing the economy once the lower bound on interest rates has been eliminated. 

Ben Bernanke: Negative Interest Rates are Better than a Higher Inflation Target

Link to “Modifying the Fed’s policy framework: Does a higher inflation target beat negative interest rates?” on Ben Bernanke’s blog

It is clear from Ben Bernanke’s September 13, 2016 blog post, that his answer to his title, “Does a higher inflation target beat negative interest rates?” is “No.” This is not a ringing endorsement of negative rates by Ben, but it is a recognition of the importance of negative rates as part of the monetary policy toolkit. And Ben is quite forthright in naming names of other central bankers he thinks have too negative a view of negative rates. 

Ben links to my paper with Ruchir Agarwal, “Breaking Through the Zero Lower Bound” in this passage:

… it is not clear that an inflation target as high as 4 percent would be politically tenable and hence credible in the U.S. or other advanced economies, whereas arguably feasible institutional changes, some as simple as eliminating or restricting the issuance of large-denomination currency, could expand the scope for negative rates.

Ben also says this in a footnote:

[3] The Fed could also encourage banks (or provide incentives for them) to pass on the negative rates to market-sensitive investors rather than retail depositors, as described here by Miles Kimball, a negative-rates proponent. For more on Miles’ overall argument, see here.

Let me expand on that footnote. I have advocated arranging part of the multi-tier interest on reserves formula to kill two birds with one stone: not only support bank profits but also subsidize zero interest rates in small household accounts at the same time–the provision of which is an important part of the drag on bank profits as it is now. I think being able to tell the public that no one with a modest household account would face negative rates in their checking or saving account would help nip in the bud some of the political cost to central banks.

To avoid misunderstanding, it is worth spelling out a little more this idea of using a tiered interest on reserves formula to subsidize provision of zero interest in small household checking and savings accounts. To make it manageable, I would make the reporting by banks entirely voluntary. The banks need to get their customers to sign a form (maybe online) designating that bank as their primary bank and giving an ID number (like a social security number) to avoid double-dipping. In addition to shielding most people from negative rates in their checking and savings accounts, this policy also has the advantage of setting down a marker so that it is easier for banks to explain, say, that amounts above $1500 average monthly balance in an individual checking+saving accounts or a $3000 average monthly balance in joint couple checking+saving accounts would be subject to negative interest rates. That is, the policy is designed to avoid pass-through of negative rates to small household accounts but encourage pass-through to large household accounts, in a way that reduces the strain on bank profits.

Comparison to Ben’s March 2016 Post and a December 2015 Interview of Ben by Ezra Klein

Ben also had an earlier March 18, 2016 post about negative interest rates: “What tools does the Fed have left? Part 1: Negative interest rates.”  Reading the two posts back to back, it is clear that Ben has warmed up to negative interest rates in the six months from March 2016 to September 2016. Nevertheless, even back in March, Ben leavened his skepticism about negative rates with these two passages:

1. The idea of negative interest rates strikes many people as odd. Economists are less put off by it, perhaps because they are used to dealing with “real” (or inflation-adjusted) interest rates, which are often negative. Since the real interest rate is the sticker-price (nominal) interest rate minus inflation, it’s negative whenever inflation exceeds the nominal rate. Figure 1 shows the real fed funds rate from 1954 to the present, with gray bars marking recessions.[3] As you can see, the real fed funds rate has been negative fairly often, including most of the period since 2009. (It reached a low of -3.8 percent in September 2011.) Many of these negative spells occurred during periods of recession; this is no accident, since during recessions the Fed typically lowers interest rates, both real and nominal, in an effort to spur recovery.

2. The anxiety about negative interest rates seen recently in the media and in markets seems to me to be overdone. Logically, when short-term rates have been cut to zero, modestly negative rates seem a natural continuation; there is no clear discontinuity in the economic and financial effects of, say, a 0.1 percent interest rate and a -0.1 percent rate. Moreover, a negative interest rate on bank reserves does not imply that the most economically relevant rates, like mortgage rates or corporate borrowing rates, would be negative; in the US, they almost certainly would not be.

It is also clear that Ben Bernanke has warmed up to my proposals specifically, if you compare what he wrote in his most recent September 13, 2016 blog post to what he said in part of a December 15, 2015 interview I transcribed in my post “Ezra Klein Interviews Ben Bernanke about Miles Kimball’s Proposal to Eliminate the Zero Lower Bound.”

Though Ben Bernanke is quite cautious about negative rates, I count him now as an ally in the effort to bring them fully into the monetary policy toolkit, with the actual use of negative interest rate tools remaining a very weighty decision. 

David Beckworth—The Balance Sheet Recession That Never Happened: Australia

I am grateful for permission from David Beckworth to mirror his post as a guest post here. Here is what David wrote:

Probably the most common explanation for the Great Recession is the “balance-sheet” recession view. It says households took on took on too much debt during the boom years and were forced to deleverage once home prices began to tank. The resulting drop in aggregate spending from this deleveraging ushered in the Great Recession. The sharp contraction was therefore inevitable. But is this right? Readers of this blog know that I am skeptical of this view. I think it is incomplete and misses a deeper, more important story. Before getting into it, let’s visit a place that according to the balance sheet view of recessions should have had a recession in 2008 but did not.

That place is Australia. It too had a housing boom and debt “bubble”. It too had a housing correction in 2008 that affected household balance sheets. This can be seen in the figures at the top of this post. 

Despite the balance sheet pains of 2008, Australia never had a Great Recession. In fact, it sailed through this period as one the few countries to experience solid growth. And, as Scott Sumner notes, it was also buffeted by a collapse in commodity exports during this time. If any country should have experienced a sharp recession in 2008 it should have been Australia.

So why did Australia’s balance sheet recession never happen? The answer is that the Reserve  Bank of Australia (RBA), unlike the Fed, got out in front of the 2008 crisis. It cut rates early and signaled an expansionary future path for monetary policy. It also helped that the policy rate in Australia was at 7.25 percent when it began to cut interest rates. This meant the central bank could do a lot of interest rate cutting before hitting the zero lower bound (ZLB). So between being more aggressive than the Fed and having more room to work,  the RBA staved off the Great Recession.

This experience in Australia speaks to why the balance sheet recession view miss the deeper, more important problem behind depressions: the ZLB. Unlike the RBA, the Fed was slow to act in 2008 and that allowed the market-clearing or “natural” interest rate to fall below the ZLB. Had the Fed acted sooner or had it been able to keep up with the decline in the natural interest rate once it passed the ZLB, the Great Recession may not have been so great (See Peter Ireland’s paper for more on this point).

Here is how I made this point in my review of Atif Mian and Amir Sufi’s book, House of Debt, in the National Review:

Why should the decline in debtors’ spending necessarily cause a recession?
Recall that for every debtor there is a creditor. That is, for every debtor who is cutting back on spending to pay down his debt, there is a creditor receiving more funds. The creditors could in principle provide an increase in spending to offset the decrease in debtors’ spending. But in the recent crisis, they did not. Instead, households and non-financial firms that were creditors increased their holdings of safe, liquid assets. This increased the demand for money. This problem was exacerbated by the actions of banks and other financial firms. When a debtor paid down a loan owed to a bank, both loans and deposits fell. Since there were fewer new loans being made during this time, there was a net decline in deposits [and thus] in the money supply. This decline can be seen in broad money measures such as the Divisia M4 measure. These developments—increase in money demand and a decrease in money supply—imply that an excess money-demand problem was at work during the crisis.
The problem, then, is as much about the excess demand for money by creditors as it is about the deleveraging of debtors. Why did creditors increase their money holdings rather than provide more spending to offset the debtors? …Mian and Sufi do briefly bring up a potential answer: the zero percent lower bound (ZLB) on nominal interest rates.
The ZLB is a floor beneath which interest rates cannot go. This is because creditors would rather hold money at zero percent than lend it out at a negative interest rate. This creates a big problem, because market clearing depends on interest rates’ adjusting to reflect changes in the economy. In a depressed economy, firms sitting on cash would start investing their funds in tools, machines, and factories if interest rates fell low enough to make the expected return on such investments exceed the expected return to holding money. Even if the weak economy means the expected return to holding capital is low, falling interest rates at some point would still make it more profitable to invest in capital than to hold money. Similarly, households holding large amounts of money assets would start spending more if the return on holding money fell low enough to make household spending worthwhile. This is a natural market-healing process that occurs all the time. It breaks down when there is an increase in precautionary saving and a decrease in credit demand large enough to push interest rates to zero percent. If interest rates need to adjust below zero percent to spur creditors into providing the offsetting spending, this process will be thwarted by the ZLB.
It is the ZLB problem, then, rather than the debt deleveraging, that is the deeper reason for the Great Recession.

Australia never hit the ZLB. That is why it avoided the Great Recession. If we want to avoid future Great Recessions we need to find better ways to avoid or work around the ZLB.

Narayana Kocherlakota: Want a Free Market? Abolish Cash

Link to Narayana Kocherlakota’s column “Want a Free Market? Abolish Cash” on Bloomberg View

Narayana Kocherlakota has now joined me in advocating the complete elimination of the zero lower bound, and done it with a nice free-market argument. You can see the whole article at the link above. Let me quote my favorite passage and the bit about me:

… governments – by issuing cash and managing inflation – put a floor on how low interest rates can go and how high asset prices can rise. That’s hardly a free market.

Like any government interference, this causes inefficiencies. By preventing the future prices of goods and services from rising too far above the current prices, it constrains demand for current goods and services. The weak demand, in turn, leads companies to hire less and invest less in the development of new technologies, leaving the work force underutilized and productivity low. Sound familiar? …

The right answer is to abolish currency and move completely to electronic cash, an idea suggested at various times by Marvin Goodfriend of Carnegie-Mellon University, Miles Kimball of the University of Colorado and Andrew Haldane of the Bank of England. Because electronic cash can have any yield, interest rates would be able go as far into negative territory as the market required.

To clarify my own position, I have no objection to a cashless economy, but I think some nations may need to eliminate the zero lower bound in the near future, and a nonpar exchange rate between paper currency and electronic money (with electronic money as the unit of account) can be implemented on much shorter notice than arranging things so that the economy can easily do without paper currency entirely. So my own emphasis–as you can see from my bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide”–has been on what might be seen as the transitional system of a taking paper off par to eliminate the zero lower bound rather than the total elimination of paper currency itself. 

Tim Sablik: Subzero Interest

Link to the article on the Federal Reserve Bank of Richmond Econ Focus website

Tim Sablik interviewed me for a well-researched and well-written article “Subzero Interest” that he wrote for the Richmond Fed’s Econ Focus website. The entire article is a great piece for getting background on negative interest rates. As teasers, let me quote just the passages quoting me and a couple of very interesting passages quoting Marvin Goodfriend: 

Miles 1: “Cutting interest rates into negative territory stimulates the economy in exactly the ways that cutting interest rates stimulates the economy in positive territory, with very few difference,” says Miles Kimball, an economics professor at the University of Michigan who has advocated in favor of negative rate policy.

Miles 2: It may not be necessary to eliminate cash completely to achieve negative rates, however. Kimball has argued central banks could establish an exchange rate between physical currency and electronic currency at the cash window. For example, if the Fed wanted to adopt interest rates of negative 4 percent, the exchange rate for physical currency in terms of electronic currency would depreciate at 4 percent per year. Banks and financial markets would then pass along the nega­tive rates on physical currency as well as electronic accounts to the rest of the economy. To alleviate banks’ concerns about losing retail depositors, Kimball has said the Fed could reduce banks’ payments to the Fed of negative interest on reserves in order to subsidize their provision of zero interest rates to small-value bank accounts. This would shield most retail depositors from the effects of negative rates.

Additionally, he argues that the depreciation of paper currency would likely be invisible in most everyday trans­actions, at least to a point. “If you go to the grocery store now where they accept both credit cards and cash, they’re likely to accept both payments at par,” says Kimball. That’s despite the fact that both payment methods are not equal for merchants. They pay a fee to card networks for card transactions but don’t typically pass that charge on to cus­tomers. As a result, Kimball suspects many merchants would be willing to accept the “fee” of a small depreciation of cash without passing it on to customers.

“If merchants are still accepting cash at par at the store and you’re still getting a zero interest rate at your local bank, what do negative interest rates in the financial markets look like to you?” he says. “On things like car loans, they just look like lower positive rates. Most people wouldn’t personally see any negative interest rates.”

Marvin 1: In the long run, the likelihood that most countries move to all-electronic currency is quite high, Goodfriend argues. “If you give me a long time horizon of 150 or 200 years, I’d be absolutely shocked if societies did not move to eliminate the zero lower bound by making currency electronic,” says Goodfriend. “As society gets increasingly digitized, the inconvenience and costs of using paper currency will become glaringly high.”

Goodfriend also notes that while holders of digital cur­rency may lose money in times of negative rates, they could actually earn a positive return when rates are above zero, something paper money currently lacks. “If we expect that interest rates are going to be positive most of the time, then for most of the imaginable future, people are going to bene­fit from earning interest on currency.”

Marvin 2: This is why communication from central banks is criti­cal with these policies, says Goodfriend. “Any unorthodox move is complicated if the public has not been prepared for it. In that case, the central bank cannot be sure that these things will work as intended,” he says. But Goodfriend says most of the costs cited by critics of negative rates do not kick in only once rates fall below zero — they apply to all rate cuts. Cutting rates within positive territory also hurts savers and lessens the burden of public debt.

Still, negative rates represent largely uncharted territory for economists and policymakers, and many unanswered questions remain. The good news for monetary policymak­ers at the Fed and elsewhere is that they can wait and see how the experiments in Europe and Japan play out before making any decisions on negative rates. If it works, Goodfriend says he wouldn’t be surprised to see negative rate policy spread.

“If you’re standing around a pool and you don’t know what the temperature of the water is,” he says, “it’s a whole lot easier to jump in if somebody else goes first and tells you the water’s fine.”

How the Fed Could Use Capped Reserves and a Negative Reverse Repo Rate Instead of Negative Interest on Reserves

Link to the New York Fed’s webpage “FAQs: Reverse Repurchase Agreement Operations”

Charging banks for their reserve balances when the Fed decides someday to go to negative interest rates is probably within the Fed’s legal authority, since the Fed can charge fees related to expenses, and it can be argued that handing funds to the Fed requires the Fed to put those funds into other relative safe assets such as T-bills, which would have negative rates in that situation. But it is worth considering other options that might be even easier legally. 

In that vein, I want to refine what I wrote in “How to Keep a Zero Interest Rate on Reserves from Creating a Zero Lower Bound” by suggesting that after capping the amount of reserves (+ vault cash) banks are allowed to hold to a little above required reserves (plus an extra allowance for small accounts they hold, in line with “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies”), allowing banks (along with other counterparties) to put funds into the Fed’s Reverse Repo Program, with a negative rate, is the natural way to have the same kind of economic effect as a negative interest rate on reserves while leaving the interest rate on reserves themselves at zero.

I suggested this possibility at Jackson Hole last Saturday as one of several reasons that the Fed should keep its Reverse Repo Program in operation. This was my comment after Jeremy Stein’s brilliantly clear presentation of how the Reverse Repo Program can enhance financial stability in  “The Federal Reserve’s Balance Sheet as a Financial-Stability Tool,” along with his coauthors Robin Greenwood and Sam Hanson.   

As you can see in the screenshot at the top of this post from the New York Fed’s website,  

A reverse repurchase agreement conducted by the Desk, also called a “reverse repo” or “RRP,” is a transaction in which the Desk sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the transaction.

While only regulated banks are allowed to put funds into a reserve account, many other financial firms as well as banks are allowed to put funds into the Fed’s Reverse Repo Program. That clearly makes it different from reserves. But I want to argue that other than the more diverse set of participants allowed, the Reverse Repo Program can, in effect, act as if it were the second tier in a two-tier interest on reserves structure, while reserves themselves act as the first tier. As in any two-tiered interest on reserves policy, once the first tier fills up to its cap, it is the lower interest rate on the second tier that serves as the marginal interest rate that matters most for markets.  

There may be institutional and economic subtleties I don’t understand, which I would be glad to be corrected on. But let me write based on my current understanding of the Reverse Repo Program (RRP) until one of you corrects me. The reason funds in the Reverse Repo Program (RRP) can act, economically, as such close substitutes for reserves, is that during the day they become reserves, while at night, for the bank or other financial firm, they become something else that can earn a different interest rate from reserves. That is, with RRP, the Fed is borrowing money overnight using T-bills as collateral, and then repays the money in the morning by crediting the lender with funds that are reserves in some bank’s reserve account at the Fed. 

Above, I said that in the policy I envisioned, reserves would be capped, but that is only partly true: the reserves banks can hold are capped at night, but banks are allowed to have what is potentially a much larger amount of reserves during the day. At night, to meet their cap, banks both on their own account and on behalf of depositors have to sweep reserves above the reserve cap into RRP. An individual bank might find another alternative, but that just shuffles reserves around to another bank. So in the aggregate, the funds above the cap have to go into something with the Fed on the other side of the transaction, and RRP is what is available.

“During the day, reserves; during the night another alter ego that earns a different interest rate” sounds structurally a bit like the blurb for a superhero. The Reserve Repo Program may not be a superhero, but it could come in handy. I hope the Fed keeps it in operation, just in case it is more useful in some future situation than is now appreciated. 

Postscript: One reason the Fed is considering discontinuing the Reverse Repo Program in the future is the fear that too many funds might flee to it in a future crisis, allowing some other markets to collapse. The solution to this is already built into the structure of the Reverse Repo Program: over short horizons, there is a level at which the rate in the Reverse Repo Program adjusts by auction rather than the quantity adjusting with the same rate. Then over longer horizons–that is, as soon as the Fed can meet, which might be within a week during a crisis–the regular rate for the Reverse Repo Program should be adjusted downward sharply to avoid that rate becoming an obstructionist lower bound. 

Mark Carney: Central Banks are Being Forced Into Low Interest Rates by the Supply Side Situation

Link to Mark Carney’s August 4, 2016 Press Conference

The Natural Interest Rate. Mark Carney is remarkable in many ways. He was chosen as Governor of the Bank of England despite being a Canadian. He has been a leader in pushing up equity requirements for banks in the real world–a key for financial stability. And in his August 4, 2016 press conference, he has given the most articulate statement for the press and the public that I have heard for the view that central banks must now use a lower range of interest rates for economic stabilization than before because supply-side forces have brought down the natural rate of interest. Central bankers all over the world, including in the United States, would be well-advised to study carefully how Mark Carney handles the questions in this press conference, particularly on the issue of how hard low interest rates are on savers. 

I have no doubt that Mark Carney’s understanding of what is happening with the natural interest rate has been informed by the excellent report on this issue by Bank of England economists Lukasz Rachel and Thomas Smith: 

I highly recommend it. 

Conceptually, I write about the natural interest rate in these two posts:

Mark Carney’s particular point that central banks do not control the medium-run natural interest rate was also made by Mario Draghi. See this post:

Negative Interest Rates and Bank Profits. The one unfortunate note in Mark Carney’s August 4, 2016 press conference was his speaking against negative interest rates. But he did ably undercut his own reason for being against negative interest rates. Mark Carney’s reason for being against negative interest rates is that they are hard on banks, backing up my claim in “What is the Effective Lower Bound on Interest Rates Made Of?” that the effective lower bound is now primarily made of central bank concerns about bank profits. But there are many ways for central banks to support the profits of private banks. One is by reducing the rate at which the central bank lends to private banks. In his press conference, Mark Carney explained in some detail how the Bank of England had closely calculated how to use that kind of mechanism to cancel out the effects of other rate cuts on bank profits. So the Bank of England knows well how to support bank profits when interest rates are cut–and could do so even if rates were cut into the negative region. Another way for obvious way for central banks to support bank profits is to use a multi-tier interest on reserves formula. I write about this in 

A third way to support bank profits when interest rates are lowered is to reduce the paper currency interest rate, as I discuss in 

Banks live on spreads, so a good way to keep from adding stress to banks by central bank policy is to lower all government-controlled interest rates (including the paper currency interest rate) an equal amount. Then the government can avoid the problems that arise when the government effectively competes for funds with banks by having too high a paper currency interest rate. Beyond these three mechanisms, it is quite unlikely that a roomful of competent economists would have all that much trouble in thinking of other ways to throw funds to banks in order to keep them from being stressed out too much by rate cuts, if that is a genuine concern. For governments that have any substantial amount of short-term debt in the hands of the public, the budgetary savings from lower interest rates guarantee that such governments can easily afford such subsidies to banks should they think them necessary (though in many countries the budgetary savings may show up in the balance sheet of the non-central-bank part of the government).

As an aside, I should mention that in an effort to discourage other countries from using negative interest rates too freely, Mark Carney used some faulty analysis, as I discuss in 

The Need for Supply-Side Reform. The fact that unfavorable supply-side forces are pushing the natural interest rate down gives one more reason to pursue supply-side reform. I view stabilization through a vigorous interest rate policy–including use of negative interest rates where needed–as a complement to supply-side reform, not a substitute. Both are needed, and both reinforce each other.

Q&A With Gerard MacDonell on My Presentation “Enabling Deeper Negative Interest Rates by Managing the Side Effects of a Zero Paper Currency Interest Rate”

I am grateful to Gerard MacDonell for permission to share this exchange. I answered some emails full of questions with my own email interleaving my answers about my presentation “Enabling Deeper Negative Rates by Managing the Side Effects of a Zero Paper Currency Interest Rate.” You can see a shorter (20 minute) version of that presentation here. 

Gerard: We have never met, but Noah Smith speaks very highly of you and told me I should read your stuff. I loved the series of tweets where you got talked down from endorsing Cochrane’s work on the cost of regulation. I had the exact same experience.

I really enjoyed your deck on negative interest rates. I used to work at a hedge fund and was close with a guy who traded banks who was absolutely convinced that low interest rates crushed margins. My own priors were in line with your thoughts, but this guy made money and the correlation between daily stock prices moves and the forward pricing of the Fed seemed to confirm his view. I guess there is a “behavioral” issue there, as you put it. My guess is that the behavioral issue is at the banks and their clients rather than in how the markets react to the reality in place.  In other words, the traders are processing the reality fine, but the reality itself has a behavioral component?

I wonder if it might disappear as the experience with very low rates lengthens. You might want to address that in your work on this. I bet there would be a lot of interest.

Miles: This Powerpoint file for the new paper Ruchir and I are working on has some relevant graphs–and I think you will be interested in it generally. We would be glad for comments on it. It is quite new and we are eager to improve it. 

Gerard: I really liked it and it is why I contacted you in the first place. Before I offer thoughts on it, I should be clear that I am not an academic.  I have an MA from Queen’s in Kingston Ontario and have spent 25 years as a business economist. I was most recently at SAC for 11 years and prior to that on JPM’s buy side for about 5 years. In those roles, I tried to arb the gap between what Wall Street knows and what academics know, but I am not an academic.  Rather, I am inclined to the dreaded “literary” approach to economics, as Noah dismissively calls it! ;)

I don’t want to waste your time, so I will offer my thoughts in bullet form.

You might want to mention Neo Fisherianism if only to be clear that you dismiss it. Clearly, you assume it is wrong.

Miles: If you mean the idea that high interest rates raise inflation and low interest rates make inflation fall, yes, I think it is pretty silly. My main intended audience doesn’t believe that anyway, so I haven’t spent a lot of time addressing it.  

Gerard: This may be idiosyncratic of me and less interesting to you, but I am very interested in what causes banks not to marginal cost price. I guess it is some combination of market power and behaviorism. It would be great to get to the bottom of that.  Practitioners insist that the slippage between mortgage rates and policy rates that you show in one of your charts may UNDERSTATE the issue. Some claim banks have minimum profitability targets and will ream mortgagers to get back the damage to profits caused by negative policy rates.  That is pretty slippery economics, but I know the idea is out there. If you could demolish it, then that would be a great contribution and I know Wall Street would be very interested in that. But again, that is idiosyncratic of me.

Miles: The basic problem is that banks always want more profits. So if they could raise profits by raising lending rates, why not do that before? Something has to change as a result of the negative rates. I think the relevant thing that might change given negative rates is that the regulatory authority might feel bad for the banks and be less strict in anti-trust enforcement. In the same direction, in Switzerland, the central bank wanted lower rates in relation to the foreign exchange markets, but actually wanted higher mortgage rates because they feared a house-price bubble. So they encouraged the banks to keep high mortgage rates.

Absent a shift in implicit or explicit government policy about banks raising lending rates, the story gets very difficult. It needs to be banks doing something to help with a short-term liquidity crunch at the expense of long-term profits.  

Gerard: Willem Buiter has written on time stamping reserves to get around the lower bound. I found his piece dense, and you have probably already read it. But just in case.

Miles: I have credited Buiter in several ways. Most memorably, he appears as “Willem the Wise Warlock” in my children’s story about negative rates.

Gerard: In your first chart, you channel Summers in mentioning that curing recessions usually takes rate cuts of more than 5%. I think your chart highlights that AND that the zero bound is why rates stopped falling. Rates are high, not low! Or at least they have been. Maybe that is your main point and that the title might reflect that?

Miles: Yes. Large cuts in interest rates are standard in a recession if the zero lower bound doesn’t get in the way. At the Brookings conference on negative rates, they said that the usual model suggests that rates should have been cut to -6% in 2009, rather than the -4% I suggested in “America’s Big Monetary Policy Mistake: How Negative Interest Rates Could Have Stopped the Great Recession in Its Tracks”

Gerard: Some might argue with you that closing the Gold Window was a monetary policy regime shift.  It allowed more inflation as a matter of fact, but it need not have. Minor point.

Miles: Actually, this is an excellent parallel. It is the cut in the target rate and the interest rate on reserves that is the main monetary policy instrument. Going off paper so that the paper currency interest rate can go negative can be viewed as enabling those cuts in the target rate and the interest rate on reserves.

Gerard: On slide 11, is being “subtle” really a feature? Maybe you want to hammer households over the head? Or are you worried about the income effect?

I don’t need any transmission from regular households seeing negative deposit rates. And the transmission from lower lending rates to households will mostly be from lower but still positive rates for cars, mortgages, appliances, etc. Credit card rates start so high, they would still be high even after cuts.

On slide 16, I know what you mean by “backed by”, but what you really mean is any sort of currency holdings.  Don’t let funds fake it.

Yes, defining “backed by paper currency” would probably mean a strict limit on the fraction of assets that could be paper currency.

On slide 17, you see mortgage rates actually go up a bit there. Small, but riles up the practitioners.

Miles: Mortgage rates went down in Denmark and Sweden. The Swiss National Bank effectively encouraged banks to raise mortgage rates, and the banks obliged. Japan has only cut rates by a tenth of a percentage point, so whatever happened to mortgage rates there is unlikely to have anything to do with that small cut in rates, other than the mechanism of the authorities feeling sorry for the banks and lightening up on anti-trust attitudes.  

Gerard: On slide 18, I may well be wrong here, but isn’t a tiered deposit rate system just an untiered system plus a subsidy to the banks? I think it would be better to deal with the behavioral/market power issues directly. If not, why hide what is really happening? Call it what it is: a subsidy to reflect that the standard banking model has not worked so well with negative rates. Or maybe I am wrong technically on that? Either way, honesty first!

I think calling it “an effective subsidy through the interest on reserves formula as I do is pretty honest.” It is appropriate to point to the formal mechanism through which the effective subsidy is provided is appropriate.  

On slide 43, I love your point about helicopter money. So true. Related, eliminating currency would further weaken the case for heli money, unless you unwound the regime change when rates went back positive. Not related to your main thesis, but fun in my view.

Miles: Did you see my post “Helicopter Drops of Money Are Not the Answer”?

Gerard: On slide 44, you say higher inflation is easier said than done. I so agree. And I think this relates to the heli money issue. The “calibration” issue with H money is not really resolved. The efforts at resolving it (Turner, Bernanke) are just taxes on the banking system, disguised as ongoing “money” finance.

The beauty of negative rates is that we have an excellent idea of how much each basis point does, since it is essentially the same

Slides 47-49 remind me of a pet peeve, again because I agree. I think much of the clarion call for higher rates to fight bubbles is related to confidence that higher rates will NOT work.  People who benefit from bubbles or would be hurt by a serious effort to improve financial stability can hide behind the pretense that they are against bubbles — as evidenced by their whining about the Fed!

Miles: I agree. A large amount of debate about various issues is really talking points by people who have a particular self-interest. The main solution to financial stability problems is very high equity requirements. That solution is against the self-interest of those who benefit from taking risks with an implicit taxpayer guarantee if things go south.

Gerard: The contrarian SWF is a very fun idea.  I see that Blanchard believes that QE was so potent that Macro textbooks should now include it as the one (worth-mentioning) determinant of the term premium. That actually made me laugh or cry.  But market segmentation would seem to be a bigger issue in risk assets, so I think that idea is cool. I think Delong has  blogged on it too, no?

Miles: Yes.

Gerard: Speaking of QE, on 57 you say it was “seen as radical” but later “gained traction.”  IMHO, how it was “seen” is irrelevant. Whether it gained traction is also a bit subjective. Does the evidence show it worked as indicated on the label?  Personally, I would say not. But Noah has the hate mail to show many disagree.

Miles: One of the main pieces of evidence is the better recovery that the US and UK have had as compared to the eurozone. Also, asset markets move with QE announcements, so it is clear the markets believe QE has effects.

Georgi Kantchev, Christopher Whittall and Miho Inada Write a Balanced Assessment of Negative Rates for the Wall Street Journal

Link to the August 8, 2016 Wall Street Journal Article “Are Negative Rates Backfiring? Here’s Some Early Evidence”

I had a very interesting interview with Georgi Kantchev a bit ago that is nicely reflected in an August 8 Wall Street Journal article he wrote with Christopher Whittall and Miho Inada. Despite the negative tone of the headline, and its collection of person-in-the-street quotations from people horrified by negative interest rates, in its analysis, it is actually quite a nuanced and balanced article. 

A. Consider the following pairs of quotations:  

1a. Some economists now believe negative rates can have an unintended psychological effect by communicating fear over the growth outlook and the central bank’s ability to manage it.

“The signal to the consumer is that something is wrong—it’s a crisis measure,” says Carl Hammer, chief currency strategist at Swedish bank SEB.

1b. University of Michigan economist Miles Kimball believes rates should be lowered even deeper into negative territory. If people are getting scared by negative rates, he says, it is the fault of central banks’ inability to communicate effectively, not the policy itself.

“They should say that this is a normal tool of policy,” he says, “and then people wouldn’t freak out.”

2a. In Germany, Europe’s largest economy and a nation known for thrift, savings as a percentage of disposable household income rose to 9.7% in 2015, according to preliminary data from the OECD. That is the highest rate since 2010, and the OECD expects the savings rate to rise further this year, to 10.4%. 

2b. In the broader eurozone, where saving isn’t as ingrained in the psyche as in Germany, the household savings rate has edged lower since negative interest rates were introduced in 2014.

3a. Yves Mersch, a member of the ECB’s executive board, said in June that it is possible “households are hoarding even more” because they need to save more to build up the same amount of wealth over the same time span.

3b. Peter Praet, the ECB’s chief economist, says the focus should also be on borrowers, who are more inclined to spend than savers, and are seeing a boost to their disposable income because ultralow rates reduce the cost of servicing debt.

B. In the second and third pairs of quotations, the authors of the article show an understanding of the principle I enunciated in “Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates”: 

The Principle of Countervailing Wealth Effects: It is easy to forget about some of the wealth effects. Applying the general principle that all the wealth effects cancel–other than overall expansion of the economy and differences in the marginal propensity to consume across economic actors can help in making sure one hasn’t missed a wealth effect, much as double-entry accounting helps in making sure one doesn’t miss something. An example of a particularly large wealth effect that is easy to miss is that a fall in interest rates raises the present discounted value of household labor income. The other principle that helps to avoid missing a wealth effect is to remember that there is always another side to every borrowing-lending relationship. If the economic actor on one side of the borrowing-lending relationship gets a negative hit to effective wealth, the economic actor on the other side will get a positive boost to effective wealth–again with the exception of the overall expansion of the economy. …

I discussed this principle again in “Responding to Joseph Stiglitz on Negative Interest Rates”:

… because there are two parties to every borrower-lender relationship, what is a negative wealth effect to one party is a positive wealth effect to the other. And on the whole, borrowers–who tend to get a wealth effect boost from lower rates–are better spenders than lenders. So if all the wealth effects are accounted for rather than cherry-picking a wealth effect here or there, they will be in the direction of greater stimulus from lower rates. Here is the overall story about transmission mechanisms for lower rates, in the negative region as well as the positive region: In any nook or cranny of the economy where interest rates fall, whether in the positive or negative region, those lower interest rates create more aggregate demand by a substitution effect on both the borrower and lender, while other than any expansion of the economy overall, wealth effects that can be large for individual economic actors largely cancel out in the aggregate.

Anyone who discusses the effects of negative interest rates by talking only about lenders without talking about borrowers is missing at least half of the story. Georgi Kantchev, Christopher Whittall and Miho Inada avoid that mistake. 

I give a non-obvious example of this principle of considering borrowers as well as lenders in “Responding to Joseph Stiglitz on Negative Interest Rates”:

…think of senior citizens who lend instead to the federal government. Lower interest rates reduce the deficit and tend to lead to more government spending fairly directly by deficit reduction rules biting less. Even though senior citizens have a high marginal propensity to consume, I think the effects of deficit numbers on government behavior make the effective marginal propensity to consume of the federal government out of a change in interest expense even higher. Those who like the idea of fiscal stimulus should be happy about this stimulus from negative interest rates–especially since the negative wealth effect is only for the relatively well-off senior citizens who are not just living on social security, but have interest income to live on on top of that.

C. You might be interested in the email I sent to Georgi:

Dear Georgi,

It was great talking to you. Let me try to remember all the links I promised you:

1. I have links to everything I have written (including two academic policy papers) on negative interest rates in this bibliographic post that I update every few weeks:

2. You can see the video of the afternoon session of the Brookings conference I mentioned here: 

My 20 minute talk comes first, giving more background on my recommendations. You can hear reactions to what I said as well. The panel discussion after is where you can hear several people say that the interest rate movement in at least the case of Japan is small compared to other things going on.  

3. The actual Brookings website for that conference has both the afternoon session and the morning session:

This morning session has a lot of excellent talks, including the heavy-duty talk by Massimo Rostagno about his work with coauthors looking at what the markets believe is the lower bound on interest rates and the value Massimo sees in having negative rates in order to lower the market’s beliefs about what the lower bound on interest rates is, which allows long-term rates affected by QE to fall further. We talked about this in the context of central bank communication policy and the value of telling the markets that you can and will take interest rates as low as necessary. (The key point of my work is that there is no lower bound on interest rates if a central bank uses an appropriate mix of policies.)

4. Here is Naranaya Kocherlakota (who recently stepped down as President of the Minneapolis Fed) saying that negative rates should be treated as a normal part of monetary policy as we discussed:

and here is my reaction:

I had forgotten that this was a few weeks before he started writing for Bloomberg View. Narayana Kocherlakota has written a lot about central bank communication and negative interest rates in his Bloomberg View columns:

5. Here is my advice that central banks should use the interest-on-reserves formula to effectively subsidize the provision of zero rates (rather than negative rates) to small household accounts:

6. Here is a relatively heavy-duty post taking on Mark Carney to argue that there are many, many channels through which cutting interest rates–including cutting interest rates in the negative region–will stimulate the economy: 

Not all of these channels involve banks. So a low enough rate can get all needed stimulus even if banks are malfunctioning. (Of course, it is bad directly if banks are malfunctioning; I am just saying that monetary policy can do its most basic job even if they are.)

I also addressed this issue here:

7. On the evidence that negative interest rates have the usual effects of interest rate cuts on financial markets despite some commentary to the contrary by bankers who are busy lobbying against negative rates, see this very nice post by Scott Sumner:

In case that link doesn’t work, I also got Scott’s permission to mirror it on my blog:

Let me know if there is anything else I forgot or if you have any other questions. I’d love to talk to you again sometime. 

–Miles

The Progress of Negative Interest Rate Policy Understanding

Zurich

Quite a few months back (about last Fall), I had an interview with a journalist in Zurich that did not result in an article. For that interview I had prepared some thoughts that I wanted to share with you. Keep in mind 

1. Because of my visits to central banks, these proposals are getting wide discussion within central banks, and because of the two London conferences in May 2015, between central banks as well. Under the surface, there is a much bigger consensus than what you would assume.

2. The two countries I would bet on to introduce a negative paper currency interest rate first are the UK–as I predicted early on before even visiting (see “Could the UK Be the First Country to Adopt Electronic Money?” ) and his been borne out by subsequent events, and Switzerland, which currently has rates in the deepest negative territory (see “The Swiss National Bank Means Business with Its Negative Rates”  and “Swiss “Pioneers! The Swiss as the Vanguard for Negative Interest Rates.”

3. The economics of my proposal is clear, and has withstood detailed questioning by central bankers all over the world. But with few exceptions, those who serve on monetary policy committees have sensitive political antennae and are worried about the politics of a negative paper currency interest rate.

4. Because of the political sensitivity of a negative paper currency interest rate, the only central bank officials to have alluded to it publicly are Bank of England Chief Economist Andrew Haldane (who refers directly to my work) and the Swiss National Bank officials involved in cosponsoring the conference on “Removing the Zero Lower Bound on Interest Rates” in London on May 18, 2015. So far, other central banks do not want to discuss my solution publicly, but there are many central bank staff economists around the world who are enthusiastic, believing as I do that from a technical point of view it would work well and solve an important problem. 

Update Since Last Fall: Three former members of the FOMC have now discussed my proposal: Ben Bernanke, Narayana Kocherlakota and Donald Kohn. You can hear all of them talk about it in this video from the Brookings conference on negative interest rates at which I spoke. Ben Bernanke was also asked about my proposal in an interview by Ezra Klein; you can see his answer here. Narayana Kocherlakota also wrote about my proposal here.

5. One important virtue of my approach is its continuity with the current system: in small doses it is almost indistinguishable to ordinary households from the way we do things now.

6. If I were closely consulted on introducing a paper currency interest rate through a crawling-peg exchange rate between paper currency and electronic money, I would advise making it sound very bureaucratic and boring. I would start very subtly, with a dose small enough that there would be no chance of any significant negative side effects.

7. A cut of 50 basis points by the SNB would be well worth doing because it would have a substantial effect on foreign exchange rate for Swiss Francs.

8. Even if you do not want to cut interest rates now, you want to prepared for the next recession.

9. An exchange rate on paper money by the SNB would be a blessing for other countries. They could see in Switzerland that it works. Moreover, it could have an important stabilizing effect on world financial markets because it would help allay the fear that the world economy might be doomed to replicate the performance of the Japanese economy in the last two decades.

See links to everything I have written about negative interest rates in my bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”

Confessions of a Supply-Side Liberal in Thai

Link to supplysideliberalth.tumblr.com

I am delighted that my former student Suparit Suwanik has volunteered to translate some key posts from supplysideliberal.com into Thai. Suparit holds a Masters of Applied Economics degree from the University of Michigan, and has returned to work at the Bank of Thailand (Thailand’s central bank). He was a student in my “Monetary and Financial Theory” class, and is the author of two guest posts (in English) on supplysideliberal.com: “Putting Paper Currency In Its Proper Place” and “Hope for a Phase-out of the 500 Euro Note.”

Suparit has already translated the first column I wrote about negative interest rate policy: “How Subordinating Paper Currency to Electronic Money Can End Recessions and End Inflation.”

Scott Sumner on Negative Interest Rate Policy

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Link to Scott Sumner’s post “Miles Kimball on Negative Interest Rates” on his blog “The Money Illusion”

I am grateful to Scott Sumner for permission to mirror his post “Miles Kimball on Negative Interest Rates” as a guest post here. This will gives you an idea of what Scott thinks of one of my main emphases. Here is Scott:

David Beckworth did a very interesting podcast with Miles Kimball. You probably know that Miles is an economics professor at Michigan and blogs under the name “Supply Side Liberal” (a label not far from my own views.)

Here are some good points that Miles emphasized:

1. If the Fed had been able to do negative interest back in 2008, the average interest rate over the past 8 years would probably have been higher than what actually occurred. Lower in 2008-09, but then higher ever since, as the economy would have recovered more quickly. He did not mention the eurozone, but it’s a good example of a central bank that raised rates at the wrong time (in 2011) and as a result will end up with much lower rates than the US, on average, for the decade of the “teens”. Frustrated eurozone savers should blame German hawks.

2. He suggested that if the Fed had been able to do negative interest rates back in 2008-09, the financial crisis would have been milder, because part of the financial crisis was caused by the severe recession, which would itself have been much less severe if rates had been cut to negative 4% in 2008.

3. Central banks should not engage in interest rate smoothing. He did not mention this, but one of the worst examples occurred in 2008, when it took 8 months to cut rates from 2% (April 2008) to 0.25% (December 2008.) The Fed needs to be much more aggressive in moving rates when the business cycle is impacted by a dramatic a shock.

Although I suggested negative IOR early in 2009, I was behind the curve on Miles’s broader proposal (coauthor Ruchir Agarwal), which calls for negative interest on all of the monetary base, not just bank deposits at the Fed. To do this, Miles recommends a flexible exchange rate between currency and electronic reserves, with the reserves serving as the medium of account. Currency would gradually depreciate when rates are negative. Initially I was very skeptical because of the confusion caused by currency no longer being the medium of account. I still slightly prefer my own approach, but I now am more positively inclined to Miles’s proposal and view it as better than current Fed policy.

Miles argued that the depreciation of cash against reserves would probably be mild, just a few percentage points. Then when the recession ended and interest rates rose back above zero, cash could gradually appreciate until brought into par with bank reserves. He suggested that the gap would be small enough that many retailers would accept cash at par value. As an analogy, retailers often accept credit cards at par, even though they lose a few percent on the credit card fees.

If cash was still accepted at par, would that mean that it did not earn negative interest, and hence you would not have evaded the zero bound? No, because Miles proposes that the official exchange rate apply to cash transactions at banks. This would prevent anyone from hoarding large quantities of cash as an end run around the negative interest rates on bank deposits. So that’s a pretty ingenious idea, which I had not considered. Still, I think my 2009 reply to Mankiw on negative IOR holds up pretty well, even if I did not go far enough (in retrospect.)

Why is negative interest still not my preferred solution? Because I don’t think the zero bound is quite the problem that Miles assumes it is, which may reflect differing perspectives on macro. Listening to the podcast my sense was that he looked at macro from a more conventional perspective than I do. At the risk of slightly misstating his argument, he sees the key problem during recessions as the failure of interest rates to get low enough to generate the sort of investment needed to equilibrate the jobs market. That’s a bit too Keynesian for me (although he regards his views as somewhat monetarist.)

In my view interest rates are an epiphenomenon. The key problem is not a shortfall of investment, it’s a shortfall of NGDP growth relative to nominal hourly wage growth. I call that my “musical chairs model” although the term ‘model’ may create confusion, as it’s not really a “model” in the sense used by most economists. In my view, the key macro problem is the lack of one market, specifically the lack of a NGDP futures market that is so heavily subsidized that it provides minute by minute forecasts of future expected NGDP. If the Fed would create this sort of futures/prediction market (which it could easily do), then the price of NGDP futures would replace interest rates as the key macro indicator and instrument of monetary policy. Recessions occur when the Fed lets NGDP futures prices fall (or shadow NGDP futures if we lack this market). Since there is no zero bound on NGDP futures prices, we don’t need negative interest rates. However, in place of negative rates the central bank may need to buy an awful lot of assets. You could say there is a zero lower bound on eligible assets not yet bought by the central bank. Which is why we need to set an NGDPLT path high enough so that the central bank doesn’t end up owning the entire economy.

To conclude, although Miles’s negative interest proposal is not my first preference, put me down as someone who regards it as better than current policy.

PS. I was struck by how many areas we have similar views. For instance he thought blogging was really important because what mattered in the long run was not so much the number of publications you have, but whether you’ve been able to influence the younger generation economists (grad students and junior faculty).

PSS. I will gradually catch-up on the podcasts, and then do another post on the 2nd half of the Brookings conference on negative IOR.

Dominic Chu Interviews Miles Kimball for CNBC about the Need for the Fed to Reverse Course More Often

Link to CNBC segment “Economist: Fed needs to be more flexible”

Link to Alex Rosenberg’s companion article “The Fed resembles a defective car — here’s how to fix it: Economist”

I was very pleased at how this interview turned out. Take a look. Both links above have the video. Only 6 minutes and 26 seconds!

Alex Rosenberg made this happen, and does an excellent summary in the accompanying article, which also discusses Narayana Kocherlakota’s column “The Fed Needs More Than One Direction.”

I learned an interesting fact along the way. I did this interview for free, but CNBC paid the University of Michigan $700 for the use of the video facilities and personnel and satellite link at the University of Michigan to do the videotaping.  

Alex Rosenberg interviewed me on the phone the day before the videotaping. Don’t miss his other interviews of me, in these posts:

The Financial Times Endorses Negative Interest Rates

Link to “The wrong lesson to take from negative yields”

The Endorsement

On June 10, 2016, just four days after a remarkable Brookings conference on negative interest rates, the Financial Times gave a ringing endorsement of a vigorous use of negative interest rates. The subtitle, “Central banks should be pushing ahead with monetary stimulus,” aptly describes the tenor of the editorial. The strength of this editorial is in directly answering complaints by bankers about negative rates:

Predictably, banks and investors have renewed their complaints that a negative-rate environment is causing havoc with the financial system and risks a cataclysmic cascade of losses if prices fall and yields go up sharply. Some have explicitly blamed central banks such as the Bank of Japan and European Central Bank which have cut short-term interest rates below zero.

These criticisms are wrong-headed. Long-term yields are not heading below zero because central banks are arbitrarily planning to keep short-term interest rates down for years on end. They are reflecting expectations of anaemic nominal economic growth, with both real expansion and inflation strikingly low, for decades ahead.

The answer is not for central banks to abandon the negative-rate experiment but to continue to find every means possible to deliver the stimulus that will increase growth and, with it, inflation and yields.

Further on in the editorial, the Financial Times drives home the message that the need for negative rates is sad, but the negative rates themselves are part of the solution:

Negative short-term rates are not the problem. They are evidence of central banks’ determination to try to address the problem, which is the weak growth and inflation that is driving longer-term yields to zero and below. Investors and policymakers who fail to see this are making a serious mistake.

Bond yields at or below zero are a bad sign. Savers and banks suffering from them should recognise that throwing as much stimulus at the economy as possible is the answer, not raising short-term interest rates to the levels of earlier decades and imagining that the normality of the past will then return.

Right before that, the Financial Times even answers a potential objection that low rates could hurt financial stability:

If they are worried about the distortion in the financial system caused by low or negative rates, they should turn to their macroprudential tools, such as direct controls, to prevent excessive lending against housing, rather than holding rates higher than is warranted by the growth of nominal demand.

Discussion

Overall, this is a very strong endorsement of negative interest rate policy by the Financial Times editorial board, that bears comparison to, say, Narayana Kocherlakota’s strong endorsement of negative interest rates policy in these Bloomberg View columns:

One reason I think this comparison is apt is that, like the Financial Times editorial board, Narayana still wishes for fiscal policy help along with negative rates, while I argue that going further with negative rates is preferable to relying partially on fiscal policy. You can see my discussion of that here:

I also tend to think that the conventional monetary policy of negative rates should be used instead of relying partially on the term-premium compression of QE. 

Once short-run output gaps are close by interest rate policy, then it will be clearer what the appropriate fiscal policy is from a long-run perspective, which I discuss in 

as well as what kind of financial market interventions along the lines of QE might be appropriate for medium-run or long-run reasons. On that last, see the links in my my post 

Narayana Kocherlakota: Negative Interest Rates Are Nothing to Fear

Link to Narayana Kocherlakota’s column “Negative Interest Rates Are Nothing to Fear” on Bloomberg View

I had a good chance to talk to Narayana Kocherlakota in person at the Brookings conference on negative interest rates on June 6, 2016, and you can see him on the video nodding when I said that we should be telling people that deep negative interest rates are possible if needed. And sure enough, on June 9, Narayana wrote about the possibility of eliminating the zero lower bound in his Bloomberg View column “Negative Rates Are Nothing to Fear.” Here is the relevant passage: 

Negative interest rates could eventually become an even more powerful tool. Some economists – such as University of Michigan economist Miles Kimball, who presented at the Brookings conference – point out that central banks are capable of taking rates as far below zero as they deem necessary. To increase the cost of holding currency, for example, they could charge banks a fee to change it into electronic central bank money.

Economically useful as such an option would be, central bankers must recognize that the prospect of being charged, say, 6 percent a year just to hold cash could unsettle people. For such a policy to work as intended, officials would have to do a lot of explaining ahead of time – communication that could have the added benefit of ensuring that the public understands the central bank’s goals and supports its methods of achieving them.

The Brookings conference on negative interest rates was a milestone in many other ways as well. Let me go so far as to say that no journalist writing about negative interest rates is well informed unless they have watched that Brookings conference.