The Federalist Papers #7 B: Without Union, Economic Disagreements Would Drive the States toward Conflict with One Another—Alexander Hamilton

In the second half of The Federalist Papers #7, Alexander Hamilton shows a keen understanding of psychology when discussing the animosity between the states that could be engendered by economic disagreements if the states are not united.

Alexander Hamilton points to three areas of potential economic disagreement. Quoting him in each case,

  1. Each State, or separate confederacy, would pursue a system of commercial policy [that is, tariff policy] peculiar to itself.

  2. The public debt of the Union would be a further cause of collision between the separate States or confederacies. The apportionment, in the first instance, and the progressive extinguishment afterward, would be alike productive of ill-humor and animosity.

    • How would it be possible to agree upon a rule of apportionment satisfactory to all?

    • There are even dissimilar views among the States as to the general principle of discharging the public debt.

  3. Laws in violation of private contracts, as they amount to aggressions on the rights of those States whose citizens are injured by them, may be considered as another probable source of hostility.

The psychological reaction to these disagreements is similar whatever the particular cause among these three. Here are some of the key passages Alexander Hamilton pens on that score:

  • … distinctions, preferences, and exclusions … would beget discontent.

  • The habits of intercourse, on the basis of equal privileges, to which we have been accustomed since the earliest settlement of the country, would give a keener edge to those causes of discontent than they would naturally have independent of this circumstance.

  • WE SHOULD BE READY TO DENOMINATE INJURIES THOSE THINGS WHICH WERE IN REALITY THE JUSTIFIABLE ACTS OF INDEPENDENT SOVEREIGNTIES CONSULTING A DISTINCT INTEREST. [All caps is in the original]

  • It is not at all probable that this unbridled spirit would pay much respect to those regulations of trade by which particular States might endeavor to secure exclusive benefits to their own citizens. The infractions of these regulations, on one side, the efforts to prevent and repel them, on the other, would naturally lead to outrages, and these to reprisals and wars.

  • There is scarcely any that can be proposed which is entirely free from real objections. These, as usual, would be exaggerated by the adverse interest of the parties.

  • The procrastinations of the former would excite the resentments of the latter.

  • The citizens of the States interested would clamour; foreign powers would urge for the satisfaction of their just demands, and the peace of the States would be hazarded to the double contingency of external invasion and internal contention.

  • Their refusal would be too plausible a pretext to the complaining States to withhold their contributions, not to be embraced with avidity; and the non-compliance of these States with their engagements would be a ground of bitter discussion and altercation.

  • … delinquencies in payments on the part of some of the States would result from a diversity of other causes--the real deficiency of resources; the mismanagement of their finances; accidental disorders in the management of the government; and, in addition to the rest, the reluctance with which men commonly part with money for purposes that have outlived the exigencies which produced them, and interfere with the supply of immediate wants. Delinquencies, from whatever causes, would be productive of complaints, recriminations, and quarrels.

  • … there is nothing men differ so readily about as the payment of money.

  • We are not authorized to expect that a more liberal or more equitable spirit would preside over the legislations of the individual States hereafter, if unrestrained by any additional checks, than we have heretofore seen in too many instances disgracing their several codes.

  • We have observed the disposition to retaliation excited in Connecticut in consequence of the enormities perpetrated by the Legislature of Rhode Island …

Below is the relevant section of The Federalist Papers #7 in full, showing the context for these points:

The competitions of commerce would be another fruitful source of contention. The States less favorably circumstanced would be desirous of escaping from the disadvantages of local situation, and of sharing in the advantages of their more fortunate neighbors. Each State, or separate confederacy, would pursue a system of commercial policy peculiar to itself. This would occasion distinctions, preferences, and exclusions, which would beget discontent. The habits of intercourse, on the basis of equal privileges, to which we have been accustomed since the earliest settlement of the country, would give a keener edge to those causes of discontent than they would naturally have independent of this circumstance. WE SHOULD BE READY TO DENOMINATE INJURIES THOSE THINGS WHICH WERE IN REALITY THE JUSTIFIABLE ACTS OF INDEPENDENT SOVEREIGNTIES CONSULTING A DISTINCT INTEREST. The spirit of enterprise, which characterizes the commercial part of America, has left no occasion of displaying itself unimproved. It is not at all probable that this unbridled spirit would pay much respect to those regulations of trade by which particular States might endeavor to secure exclusive benefits to their own citizens. The infractions of these regulations, on one side, the efforts to prevent and repel them, on the other, would naturally lead to outrages, and these to reprisals and wars.

The opportunities which some States would have of rendering others tributary to them by commercial regulations would be impatiently submitted to by the tributary States. The relative situation of New York, Connecticut, and New Jersey would afford an example of this kind. New York, from the necessities of revenue, must lay duties on her importations. A great part of these duties must be paid by the inhabitants of the two other States in the capacity of consumers of what we import. New York would neither be willing nor able to forego this advantage. Her citizens would not consent that a duty paid by them should be remitted in favor of the citizens of her neighbors; nor would it be practicable, if there were not this impediment in the way, to distinguish the customers in our own markets. Would Connecticut and New Jersey long submit to be taxed by New York for her exclusive benefit? Should we be long permitted to remain in the quiet and undisturbed enjoyment of a metropolis, from the possession of which we derived an advantage so odious to our neighbors, and, in their opinion, so oppressive? Should we be able to preserve it against the incumbent weight of Connecticut on the one side, and the co-operating pressure of New Jersey on the other? These are questions that temerity alone will answer in the affirmative.

The public debt of the Union would be a further cause of collision between the separate States or confederacies. The apportionment, in the first instance, and the progressive extinguishment afterward, would be alike productive of ill-humor and animosity. How would it be possible to agree upon a rule of apportionment satisfactory to all? There is scarcely any that can be proposed which is entirely free from real objections. These, as usual, would be exaggerated by the adverse interest of the parties. There are even dissimilar views among the States as to the general principle of discharging the public debt. Some of them, either less impressed with the importance of national credit, or because their citizens have little, if any, immediate interest in the question, feel an indifference, if not a repugnance, to the payment of the domestic debt at any rate. These would be inclined to magnify the difficulties of a distribution. Others of them, a numerous body of whose citizens are creditors to the public beyond proportion of the State in the total amount of the national debt, would be strenuous for some equitable and effective provision. The procrastinations of the former would excite the resentments of the latter. The settlement of a rule would, in the meantime, be postponed by real differences of opinion and affected delays. The citizens of the States interested would clamour; foreign powers would urge for the satisfaction of their just demands, and the peace of the States would be hazarded to the double contingency of external invasion and internal contention.

Suppose the difficulties of agreeing upon a rule surmounted, and the apportionment made. Still there is great room to suppose that the rule agreed upon would, upon experiment, be found to bear harder upon some States than upon others. Those which were sufferers by it would naturally seek for a mitigation of the burden. The others would as naturally be disinclined to a revision, which was likely to end in an increase of their own incumbrances. Their refusal would be too plausible a pretext to the complaining States to withhold their contributions, not to be embraced with avidity; and the non-compliance of these States with their engagements would be a ground of bitter discussion and altercation. If even the rule adopted should in practice justify the equality of its principle, still delinquencies in payments on the part of some of the States would result from a diversity of other causes--the real deficiency of resources; the mismanagement of their finances; accidental disorders in the management of the government; and, in addition to the rest, the reluctance with which men commonly part with money for purposes that have outlived the exigencies which produced them, and interfere with the supply of immediate wants. Delinquencies, from whatever causes, would be productive of complaints, recriminations, and quarrels. There is, perhaps, nothing more likely to disturb the tranquillity of nations than their being bound to mutual contributions for any common object that does not yield an equal and coincident benefit. For it is an observation, as true as it is trite, that there is nothing men differ so readily about as the payment of money.

Laws in violation of private contracts, as they amount to aggressions on the rights of those States whose citizens are injured by them, may be considered as another probable source of hostility. We are not authorized to expect that a more liberal or more equitable spirit would preside over the legislations of the individual States hereafter, if unrestrained by any additional checks, than we have heretofore seen in too many instances disgracing their several codes. We have observed the disposition to retaliation excited in Connecticut in consequence of the enormities perpetrated by the Legislature of Rhode Island; and we reasonably infer that, in similar cases, under other circumstances, a war, not of PARCHMENT, but of the sword, would chastise such atrocious breaches of moral obligation and social justice.

In the first half or The Federalist Papers #7, Alexander Hamilton talks about the likelihood of territorial disputes if the states are not part of a union. (See “The Federalist Papers #7 A: Divided, the States Would Fall into Territorial Disputes Likely to Lead to War Between the States—Alexander Hamilton.”) In the final paragraph of The Federalist Papers #7 Alexander Hamilton goes in a bit different direction, repeating an argument given by John Jay in The Federalist Papers #5. (See “The Federalist Papers #5: Unless United, the States Will Be at Each Others' Throats.”) Here is how he seconds that argument:

The probability of incompatible alliances between the different States or confederacies and different foreign nations, and the effects of this situation upon the peace of the whole, have been sufficiently unfolded in some preceding papers. From the view they have exhibited of this part of the subject, this conclusion is to be drawn, that America, if not connected at all, or only by the feeble tie of a simple league, offensive and defensive, would, by the operation of such jarring alliances, be gradually entangled in all the pernicious labyrinths of European politics and wars; and by the destructive contentions of the parts into which she was divided, would be likely to become a prey to the artifices and machinations of powers equally the enemies of them all. Divide et impera [divide and command] must be the motto of every nation that either hates or fears us. [In order that the whole subject of these papers may as soon as possible be laid before the public, it is proposed to publish them four times a week--on Tuesday in the New York Packet and on Thursday in the Daily Advertiser.]

PUBLIUS.

Here are links to my other posts on The Federalist Papers so far:

Avoiding Economic Carnage from the Coronavirus: There are Better Policies than Sending Everyone $1000

I had a chance to talk through economic policy responses to Covid-19 in my graduate business cycle class yesterday. I very much like Donald Marron’s take on it, which you can see in this Twitter thread, whose first tweet is shown above. I think what I have to say is very much consistent with what he says. He writes that while the epidemic is raging, we want to reduce economic activity in sectors such as restaurants, travel and in-person entertainment in order to reduce transmission of the coronavirus. I am on the side favoring very strong social-distancing measures. I am glad our republic is taking things more seriously than it did 10 days ago. Strong social-distancing measures should result in an intentional sharp recession of an unusual type: things that can be done remotely or at low enough human densities to be reasonably safe, or are essential, such as groceries, will continue, and health-care-related activities will increase, but other virus-unsafe and not-absolutely-essential sectors will basically shut down or contract markedly.

After we have brought the epidemic under enough control to allow economic activity to resume in almost all sectors, a big issue we face is that many people will have lost their jobs or self-employment income but still face bills such as the rent, mortgage payments, groceries, etc. There are many people of low and moderate incomes who would face serious economic hardship without aid. We should help them. Legally requiring forbearance by landlords and creditors is probably appropriate, but then puts a financial strain on those landlords and creditors which might need to be addressed in some cases.

More generally, small businesses and nonprofits that were totally sound in the absence of the epidemic may be facing bankruptcy. Personally, I don’t want my favorite restaurants to go under financially simply because they have to keep paying rent during the epidemic but have almost no revenue. Since the financial hit from the epidemic is not their fault, I am very sympathetic to the idea of bailing out small businesses that would fail without help only because of the coronavirus.

Note that I am not so worried about big businesses. For them, bankruptcy simply means that they end up owned by the bondholders instead of the stockholders, who are wiped out, but they can continue in operation. The government should only bail them out if their operations would be affected by the financial hit. Note that banks should be OK if appropriate aid is given to the people who owe money to banks and would be drive to bankruptcy in the absence of aid.

But how can we get aid to people quickly and still have time to carefully think through how to target it? Here is my proposal:

  1. Instead of mailing $1000 check to each person as is being discussed, mail each adult a government credit card with a $5000 line of credit. Mail similar government credit cards with lines of credit that are a certain percentage of previous revenue to small businesses that would be most strongly affected by the coronavirus. (Businesses that have filed a tax return at least once would be eligible according to a formula. Businesses newer than that would have to apply.) This allows households and business to meet their immediate bills to a much greater extent than a mere $1000.

  2. Couple the issuance of these government credit cards with their associated lines of credit with an announcement that the government would do means-tested loan forgiveness according to criteria that the government will take the needed time to work out.

This proposal is a version of my “Federal Lines of Credit” proposal. I have links to my posts on this proposal collected at the bottom of my post “Helicopter Drops of Money Are Not the Answer.” There is, however carefully targeted transfers in the form of loan forgiveness added to the Federal Lines of Credit.

The Federal Lines of Credit combined with the promise of means-tested loan forgiveness should go a long way toward supporting aggregate demand after the worst of the epidemic is over. But it may be necessary for the Fed to support aggregate demand by cutting interest rates further—into negative territory. My judgment of Fed performance so far in this epidemic is that they are doing a good job except for too much reluctance to consider negative interesting rates. (For example, they are doing a good job of keeping the functioning of the financial markets reasonably normal, and cut interest rates quickly to near zero.) I have links to my posts on negative interest rate policy here:

Also, I wrote a major post about negative interest rate policy just last Thursday:

Right now, the focus for fighting the coronavirus is appropriately on public health and medical interventions. But economists are tasked with thinking ahead to how we can avoid long-lasting economic carnage from the Covid-19 epidemic.

Update March 26, 2020: Ed Glaeser says in a Wall Street Journal op-ed that you can do the equivalent of loans through the tax system. Here is the relevant passage:

One way to do this would be to offer the payments to every American regardless of income, but then assess each recipient’s need after the fact and recoup the expense in a progressive manner. Everyone could get $2,000 right away, but if their household income exceeded $200,000 the following year they would be charged for 100% of the payment in taxes. Households below $100,000 might pay no tax, and intermediate earners could pay something in between. That way the money would be conditional, but people wouldn’t have to worry about it until the next tax season.

For the US, most of the details of a $2 trillion package are already baked in, but the policy for economic policy response to the novel coronavirus is likely still in flux in some other countries, and there is a chance additional economic policy response packages will be necessary in both the US and elsewhere. Economically, a lot depends on how long the unsafe, non-essential sector is shut down (as well as how broadly “essential” is interpreted). I discuss some relevant issues in today’s post “How Does this Pandemic End?”

Responding to Negative Coverage of Negative Rates in the Financial Times

In this post, let me present a solution before more fully presenting a problem for negative interest rate policy that shows up in news articles such as the three Financial Times articles shown above.

The Solution

It is time for the next step in negative interest rate policy. Even without any change in paper currency policy, it is possible to go to quite deep negative rates if banks are compensated financially for the difficulty of having negative rates on small checking and saving accounts.

Central banks are quite attentive to the strains on bank profits that can result from commercial banks’ understandable reluctance to make rates negative in modest-sized checking and saving accounts. There are two main ways that they help banks financially to make up for that. The most common is to have some amount of reserves kept with the central bank that can earn a positive or zero rate even though reserves held with the central bank beyond that are subject to a negative rate. The other way central banks help commercial banks financially is by lending to them at below-market interest rates (under certain conditions).

I see the next step in negative interest rate policy as more explicitly tying the financial help central banks give to commercial banks under negative rate policy to the provision by those commercial banks of nonnegative rates to households’ small checking and savings accounts.

Here is how it might work. In “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies” I write:

A “two-tiered system” in which a certain amount of deposits at the central bank get a zero interest rates and amounts above that get a lower interest rate seems hard to some of the ECB’s central bankers because that might hit banks harder in some countries than others. To me, the basic solution if a two-tiered system is desired is fairly straightforward: the two-tiered system should be designed to be equivalent to a subsidy to the deposit rates for household accounts below a certain size–say enough to provide a zero interest rate on an average balance over a month of 1000 euros worth of bank deposits per adult, for that adult’s main bank. (Those with more than one bank would have to designate one bank for this effective subsidy.) 

The value of tying the amount of deposits with the European Central Bank that a private bank can get zero interest rates on to the amount of household balances from accounts with 1000 euros or less is that this makes it natural for the private banks to pass on the negative interest rates to commercial and to the excess over 1000 euros in large accounts (which is helpful for transmission of the effects of the negative interest rates) while small household account are shielded from the negative interest rates (which is helpful politically). And it is easy enough to understand the rule and its intent that banks will be able to explain why they need to transmit negative interest rates to those with large accounts. (Of course, the cutoff could be set at some other level than 1000 euros, if desired.) And this policy is fully consistent with keeping bank profits unharmed by negative interest rates as long as they do pass on negative interest rates to large accounts and commercial accounts as they are supposed to.  

Experience in Switzerland, Denmark and Sweden suggests that the more sophisticated bank customers who have large accounts or have commercial accounts adjust quickly to negative interest rates after a few weeks of bitter complaining. The objective of a two-tiered system is to have negative interest rates prevail generally in the markets, but shield from negative interest rates those who are the least able to understand negative interest rates and perhaps to accomplish a bit of redistribution as well–though clearly not redistribution toward the poorest of the poor, who may not have bank accounts at all. 

I expand on this in “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.

Ruchir Agarwal and I expand on this even further in our IMF Working Paper “Enabling Deep Negative Rates to Fight Recessions: A Guide” in the subsection “Using the Interest on Reserves Formula to Subsidize Zero Rates for Small Households.” Here is the text of that subsection, in full:

The bank profitability problem arises in large measure from the difficulty banks face in passing on negative rates to their small retail depositors, which squeezes net interest margins. Experience with negative interest rates in Switzerland, Sweden, Denmark, and the eurozone indicates that as rates are cut below zero, negative interest rates are not immediately passed through to the small-scale bank accounts held by the typical household.

Banks are likely to make a distinction in their strategy towards legacy customers and hot-money customers. Legacy customers with de facto loyalty to a given bank are a long-run source of profits; if their accounts are not too large, shielding them from modest negative interest rates may not cost that much and may be worth a lot in not alienating them. Hot-money customers have little loyalty; the fact that they take advantage of a bank’s above-market zero deposit rate today doesn’t mean they will be there generating profits next year. So, there is relatively little lost from making new customers who are more likely to be hot-money customers face negative deposit rates. In addition, customers who have very large accounts are expensive to give a zero deposit rate in a negative rate environment. Moreover, those who are most expensive to give an above-market rate to tend to be more sophisticated and so less likely to quit a bank out of sheer emotional pique over negative rates. The upshot is that in an environment of negative interest rates, banks may shield most retail depositors (but not large, sophisticated depositors) from negative rates. Shielding retail depositors from negative rates may hurt banks’ profitability.

The bank profitability problem can be readily handled by transferring funds to banks when necessary, using existing central banking tools. For example, several central banks have already been doing this using a tiered interest-on-reserves formula. Danmarks Nationalbank has a negative interest rate on its certificates of deposit (CDs) but allows banks to place amounts up to a certain limit in their current account at a zero interest rate. The current account limit is set low enough to ensure transmission from the CDs to the money-market rates. The Swiss National Bank (SNB) allows a similar exemption from negative interest rates on any amount of deposits a bank holds below an exemption threshold. The SNB sets the exemption threshold at twenty times the minimum reserve requirements in reporting period 2014, minus the net increase in cash holdings since then. The Bank of Japan (BoJ) uses a three-tier system: reserves up to a certain balance earn 0.1 percent (basic balance), the next tier earns 0 percent (macro-add on), while the rest is subject to negative interest rates (policy-rate balance).

As mentioned above, another tool that has been used to transfer funds to banks is the European Central Bank’s negative lending rate through its targeted longer-term refinancing operations (TLTROs). Under TLTRO II, banks are able to borrow at the deposit facility rate (-0.4 percent) up to a limit, as long as they meet certain benchmarks for lending targets.

Building on these precedents, we recommend that central banks pursuing any approach to negative interest rate policy—including the clean approach—use the interest-on-reserves formula to subsidize banks in providing zero rates to small household deposit accounts. For example, a two-tiered system could be designed to be equivalent to a subsidy to the deposit rates for household accounts below a certain size–say enough to provide a zero interest rate on an average balance over a month of, say, 5000 euros for a couple or 2500 euros for an individual, for an adult’s main bank. Such a system could be based on fully voluntary reporting by banks after individuals voluntarily sign up to get the subsidy. (Those with more than one bank would have to designate one bank for this effective subsidy.) Rogoff (2016) has advocated similar mechanisms to shield small depositors from negative rates.

We see four virtues to tying the amount of deposits with the central bank that a private bank can get zero interest rates on to the amount of household balances up to a given per-adult limit:

  1. It takes care of the bank profitability problem, or the bulk of the bank profitability problem.

  2. The limit defining what amounts of money are over the limit provides a marker for banks in explaining to customers that large accounts will have the over-the-limit amount subject to negative interest rates. This should make pass-through to large accounts a bit easier for the banks.

  3. Being able to get zero interest rates on small-scale deposit accounts should reduce the incentive for households to do small-scale paper currency storage.

  4. Avoiding negative interest rates on small deposit accounts avoids a potential political problem for the central bank. Because this would also be a customer relations problem for the commercial banks, the central bank should be able to rely on the commercial banks to avoid negative deposit rates as long as those banks can do so without hurting the bottom line. The subsidy through the interest-on-reserves formula ensures that banks can provide zero rates for small deposit accounts without hurting their bottom line.

If (i) the central bank is successful at avoiding massive paper currency storage, with its attendant disintermediation (a key objective in most of the policies discussed in this paper) and (ii) the central bank subsidizes the provision of zero rates to small deposit accounts, banks should only have a profitability problem if they fail to pass on negative rates to those with large deposit accounts. Fortunately, experience in Switzerland, Denmark, and Sweden suggests that the more sophisticated bank customers who have large accounts or have commercial accounts adjust quickly to negative interest rates after a few weeks of bitter complaining. The objective of a two-tier system is to have negative interest rates prevail generally in the markets, but shield from negative interest rates those who are the least able to understand negative interest rates—and perhaps to accomplish a bit of redistribution as well

(though clearly not redistribution toward the poorest of the poor, who may not have bank accounts at all).

[The following is the footnote at the end of the subsection:] Note that worrying about redistribution per se is typically not a mandated central bank objective in the context of monetary policy. Monetary policy actions do have redistributive effects. For example, there has been criticism of the regressive redistributive effects of quantitative easing (QE). By contrast, the policies proposed here do not present such concerns—and in fact have the opposite impact by redistributing towards lower-income households (although not redistribution towards the poorest of the poor, who may not have bank accounts at all.)

The Problem

This post is mainly about the bank profits problem, but I should mention the other two problems raised by negative interest rate policy, the paper currency problem and the political problem.

Martin Arnold’s September 4, 2019 article “ECB set to consider damage done by negative rates” has this to say about the paper currency problem:

Even if it launches these mitigation measures, some analysts believe the ECB is rapidly approaching the point at which the economics shift in favour of hoarding cash.

Klaus Wiener, chief economist at the German Insurance Association, said one insurer had recently been quoted a price for storing its cash of 0.2 per cent of its value, including insurance — half the cost of the ECB’s deposit rate.

There is some evidence that hoarding has already started. The amount of physical cash held in vaults and safes has swelled 57 per cent to €81.5bn since negative rates were introduced five years ago, ECB data shows — though that remains tiny compared to the over €6tn in eurozone bank deposits.

I doubt this quote of a 1/5 % all-in per year storage cost for paper currency is accurate, or we would likely see much more paper currency storage in the euro zone than we do see. If the ECB did see a more serious rise in paper currency storage, it could inhibit it with a version of the policy the Swiss National Bank and the Bank of Japan use: arranging the interest on reserves formula to penalize commercial banks that make net withdrawals of paper currency at the central bank’s cash window.

Leaving aside the political opposition of banks, which can be muted by anything that solves the bank profits problem, Richard Milne and Martin Arnold’s February 19, 2020 article “Why Sweden ditched its negative rate experiment” has this to say about the political problem:

One of the reasons the Riksbank gave for its decision to end negative rates was that the public struggled to understand the policy and thought it “strange”. 

Lack of understanding can certainly contribute to the political flak a central bank will get from negative interest rate policy. (To help people understand, I have a children’s story about negative interest rate policy.)

“Why Sweden ditched its negative rate experiment” also recounts Isabel Schnabel’s efforts to deal with the political problem:

Isabel Schnabel, a German economist who recently joined the ECB board, says that criticism of its monetary easing policies in her country “is all too often combined with claims and accusations that have no basis in fact”. While the average German saver is €500 out of pocket because of negative rates, Ms Schnabel says an average borrower is €2,000 better off and the overall gains outweigh the losses, with Berlin saving billions of euros on interest payments. 

On the bank profits problem, Clair Jones lays out the perspective of banks in her April 3, 2019 article “Draghi’s ECB tackles negatives of contentious interest rate policy”:

ECB president Mario Draghi pushed the world’s leading central banks into uncharted territory in 2014 when the eurozone deposit rate — what commercial banks pay to hold money at the ECB — went negative. Further cuts have pushed the rate to minus 0.4 per cent since 2016, part of a policy to spur banks to lend money rather than sit on it. Banks were dismayed at what has been in effect a tax on their activities, which ECB insiders say amounts to €7.5bn a year.

Similarly, in “ECB set to consider damage done by negative rates” Martin Arnold writes:

Critics say that negative rates weaken the eurozone’s already struggling banking system, discouraging lending and motivating insurers, banks and savers to hoard physical cash. Volker Hofmann at the Association of German Banks said eurozone lenders pay €7.5bn a year in negative rates on the excess deposits they hold at the ECB, adding: “It is a remarkable burden for banks who find it more or less impossible to convey this cost to retail savers.”

And in “Why Sweden ditched its negative rate experiment” Richard Milne and Martin Arnold write:

Eurozone banks say they have paid €25bn in negative rates to the ECB since it cut rates below zero in June 2014, eating into their already weak profits. 

…

The Association of German Banks said in a recent report that negative rates had cost eurozone lenders a total of €25bn since they were introduced. “This burden is depressing the profitability of the banks and will ultimately even constrain their lending capacity,” it warned. 

The same article mentions Markus Brunnermeier and Yann Koby’s paper with its brilliant title for marketing purposes: “The Reversal Interest Rate.” Richard and Martin write:

Much of the debate about negative rates hinges on the idea of a “reversal rate” below which lending activity by banks is subdued and starts to fall. 

Research published last year by Princeton University economists Markus Brunnermeier and Yann Koby found that many of the benefits of negative rates are front-loaded — such as gains in asset prices on bank balance sheets — while the corrosive side-effects last longer. 

The idea of a “reversal rate” beyond which interest rate cuts are contractionary is simply a theoretical restatement of the bank profits problem. (See “Markus Brunnermeier and Yann Koby's ‘Reversal Interest Rate’.”) If a central bank did nothing to address the bank profits problem, then at some point further interest rate cuts would weaken banks enough to be counterproductive. Fortunately, real-world central banks are quite attentive to the bank profits problem.

Tiered Interest on Reserves and Below-Market-Rate Lending as Remedies to the Bank Profits Problem. So far, the two main central bank policies to deal with the bank profits problem are tiered interest-on-reserves formulas and lending to commercial banks at below-market rates. Let’s look at both of them.

Claire Jones writes this in “Draghi’s ECB tackles negatives of contentious interest rate policy”:

One consideration is a three-tiered system, with part of each bank’s deposits at the ECB paying zero interest, and another portion attracting a positive rate.

…
A change to a tiered system on deposit rates would help him to win the argument for changing forward guidance from council members such as Mr Villeroy de Galhau, who are concerned that keeping expansionary monetary policy in place for so long will harm the region’s banks, already under pressure from sluggish growth.

…

Frederik Ducrozet, of Pictet Wealth Management, said Mr Draghi and other ECB doves, with the tacit support of Mr Villeroy de Galhau, appeared to be laying the ground for a change. “This does look like a mini coup,” he said. “[They are] forcing a discussion …Come September, if for some reason the ECB needs to extend forward guidance, a tiered reserves system is likely to emerge as an option to mitigate the cost of negative rates.”

In “ECB set to consider damage done by negative rates” Martin Arnold writes:

Christine Lagarde, who is set to succeed Mr Draghi at the helm of the ECB, last week said that “while I do not believe that the ECB has hit the effective lower bound on policy rates, it is clear that low rates have implications for the banking sector and financial stability more generally”.

The ECB should “closely monitor whether adverse side effects may emerge in the future, the longer low interest rates are in place”, she added.

…

One option is a tiering system in which a portion of banks’ excess deposits are exempt from negative rates. Other countries with negative deposit rates, including Switzerland, Denmark and Japan, have similar systems. And the ECB has another option: subsidised lending.

There is a geographical difference between the effects that these two mitigating measures have across Europe. Tiering is likely to provide more relief to German, French and Dutch banks, which hold more excess deposits; cheap loans help southern European banks, which have higher funding costs.

Why There Is a Bank Profits Problem. Since banks live on spreads (differences between interest rates), they wouldn’t be a bank profits problem if all interest rates went do in tandem, with spreads unaffected. And indeed, declines in interest rates—including declines in the negative region—tend to result in net capital gains because banks have long-term assets and short-term liabilities. So what is the problem? It is that rates on bank deposits such as checking and savings accounts may not go down smoothly. Evidence suggests that the bank profits problem is more severe for banks that rely heavily on retail deposits as a source of funds. Here, from “ECB set to consider damage done by negative rates”:

Research published last month by economists from the US Treasury department, the University of Bath, the University of Sharjah and Bangor University found “robust” evidence that bank lending growth was weaker in countries with negative rates.

The impact was greatest on banks funded mainly by retail deposits, they said. It has become more common for European banks to charge fees for current accounts, but they only mitigate a fraction of the extra cost of negative rates.

It is important to realize that the stickiness of retail deposit rates at zero is worse for small accounts. Richard Milne and Martin Arnold write in “Why Sweden ditched its negative rate experiment”:

Negative rates turn the principles of finance on their head by forcing commercial banks to pay to store money at the central bank rather than earn interest on it. At the same time, some countries and companies have been paid to borrow. Most recently, some individuals across Europe have begun paying to deposit large sums of money in banks, while mortgage borrowers in Denmark have received money from their house loans rather than having to pay interest. 

There is a way to make this stickiness of retail deposit rates worse. From the same article:

Olaf Scholz, Germany’s finance minister, said recently that he would examine whether it was possible to protect savers by banning banks from passing on the cost of what he called the ECB’s “penalty rates”.

By contrast, if banks are given an incentive to maintain nonnegative deposit rates for small savers in a way that supports bank profits, as I discuss in the first half of this post, Olaf Scholz can get a big chunk of what he wants without worsening the bank profits problem.

How the Paper Currency Problem Contributes to the Bank Profits Problem. Note that an important part of banks’ reluctance to lower retail deposit rates comes from their fear that small depositors would simply use paper currency instead of putting their money in the bank. Lowering the rate of return on paper currency is a good way to combat this. But trying to make sure that banks continue to provide nonnegative rates to small checking and saving accounts can also combat this. Paper currency is convenient in small amounts, but becomes less convenient for large sums of money. And the government has miscellaneous ways to discourage massive paper currency storage by the very wealthy or by large organizations. So getting those with small amounts of money to keep much of their money in the bank is an important win in the effort to avoid excessive paperization of the economy.

Note that I have written extensively on how in practice to lower the rate of return on paper currency. See “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide” for an organized bibliography.

Answering Two Other Attacks on Negative Interest Rate Policy.

Beyond the genuine problems raised by paper currency policy—the bank profits problem, the paper currency problem and the political problem—there are problems blamed on a central bank’s use of negative interest rates that are either (a) arguments against any interest rate cut, even in the positive region, or (b) pointing to problems arising from the decline in the long-run natural interest rate, which is beyond central banks’ control.

One of the most important arguments against interest rate cuts in general, even when they are needed to fight a recession, is that they might cause asset bubbles. For example, Richard Milne and Martin Arnold write in “Why Sweden ditched its negative rate experiment”:

Another risk from negative rates is that they inflate asset price bubbles, while also keeping alive zombie companies that without cheap money would collapse. In Sweden, the big concern has been the housing market, with Mr Ingves repeatedly issuing warnings about record levels of household debt. 

A series of measures to make mortgages harder to access have eased Swedish fears.

I have written several responses to this concern about asset bubbles:

One key problem caused by the decline in the long-run natural interest rate is the greater difficulty people have in saving for retirement—often pointed out by pension funds that have the responsibility of helping people save for retirement. This is a genuine problem, one I am very concerned about for my personal retirement saving. But it is a problem beyond the power of a central bank to affect—other than by avoiding the downward drag on long-term rates from long-lasting negative output gaps. Here is some of what I have written on this issue:

Conclusion

As a central bank goes to deeper negative rates, at some point it will have to address the paper currency problem—at least by penalizing commercial banks for withdrawing extra paper currency at the cash window as the Swiss National Bank and the Bank of Japan do, and ideally be taking paper currency temporarily off par, as I have long advocated as a key measure in the monetary policy toolkit. But as I say in “What is the Effective Lower Bound on Interest Rates Made Of?” it is currently worries about the bank profits problem—not the paper currency problem directly—that is most inhibiting central banks at negative rates from using deeper negative rates.

Using the interest-on-reserves formula to give banks incentives to provide nonnegative rates for small checking and saving accounts and keep banks from suffering for doing so is a way to take care of by far the biggest piece of the bank profits problem and help a great deal with the political problem at the same time. If there are headlines about negative deposit rates for regular people it is an unforced error for a central bank. They should get out ahead of any such headline by volunteering that they have a policy to encourage banks to avoid negative rates for small accounts.

The Federalist Papers #7 A: Divided, the States Would Fall into Territorial Disputes Likely to Lead to War Between the States—Alexander Hamilton

Image Source: “Alternate History Weekly Update”Link to the full text of the Federalist Papers #7

Image Source: “Alternate History Weekly Update”

Link to the full text of the Federalist Papers #7

In the first half of the Federalist Papers #7, Alexander Hamilton makes one of the most persuasive arguments for a particular counterfactual history that I have seen. He argues that if the Union dissolved into separate groups of states, territorial disputes over western territories would be severe, and could easily lead to war. One reason this is so persuasive is that 73 years later, disputes over which states would be slave territories and which would be free territories did in fact lead to civil war. If disputes over whether territory was “slave” or “free” led to civil war, it is not hard to believe that disputes over full ownership of western territory by initially eastern states could have led to war. And those dispute probably would have come to a head much earlier than the actual American Civil War in 1860.

See if you aren’t persuaded by Alexander Hamilton’s argument. Here is the full text of the first half of the Federalist Papers #7:

|| Federalist No. 7 || 

The Same Subject Continued: Concerning Dangers from Dissensions Between the States
For the Independent Journal.

Author: Alexander Hamilton

To the People of the State of New York:

IT IS sometimes asked, with an air of seeming triumph, what inducements could the States have, if disunited, to make war upon each other? It would be a full answer to this question to say--precisely the same inducements which have, at different times, deluged in blood all the nations in the world. But, unfortunately for us, the question admits of a more particular answer. There are causes of differences within our immediate contemplation, of the tendency of which, even under the restraints of a federal constitution, we have had sufficient experience to enable us to form a judgment of what might be expected if those restraints were removed.

Territorial disputes have at all times been found one of the most fertile sources of hostility among nations. Perhaps the greatest proportion of wars that have desolated the earth have sprung from this origin. This cause would exist among us in full force. We have a vast tract of unsettled territory within the boundaries of the United States. There still are discordant and undecided claims between several of them, and the dissolution of the Union would lay a foundation for similar claims between them all. It is well known that they have heretofore had serious and animated discussion concerning the rights to the lands which were ungranted at the time of the Revolution, and which usually went under the name of crown lands. The States within the limits of whose colonial governments they were comprised have claimed them as their property, the others have contended that the rights of the crown in this article devolved upon the Union; especially as to all that part of the Western territory which, either by actual possession, or through the submission of the Indian proprietors, was subjected to the jurisdiction of the king of Great Britain, till it was relinquished in the treaty of peace. This, it has been said, was at all events an acquisition to the Confederacy by compact with a foreign power. It has been the prudent policy of Congress to appease this controversy, by prevailing upon the States to make cessions to the United States for the benefit of the whole. This has been so far accomplished as, under a continuation of the Union, to afford a decided prospect of an amicable termination of the dispute. A dismemberment of the Confederacy, however, would revive this dispute, and would create others on the same subject. At present, a large part of the vacant Western territory is, by cession at least, if not by any anterior right, the common property of the Union. If that were at an end, the States which made the cession, on a principle of federal compromise, would be apt when the motive of the grant had ceased, to reclaim the lands as a reversion. The other States would no doubt insist on a proportion, by right of representation. Their argument would be, that a grant, once made, could not be revoked; and that the justice of participating in territory acquired or secured by the joint efforts of the Confederacy, remained undiminished. If, contrary to probability, it should be admitted by all the States, that each had a right to a share of this common stock, there would still be a difficulty to be surmounted, as to a proper rule of apportionment. Different principles would be set up by different States for this purpose; and as they would affect the opposite interests of the parties, they might not easily be susceptible of a pacific adjustment.

In the wide field of Western territory, therefore, we perceive an ample theatre for hostile pretensions, without any umpire or common judge to interpose between the contending parties. To reason from the past to the future, we shall have good ground to apprehend, that the sword would sometimes be appealed to as the arbiter of their differences. The circumstances of the dispute between Connecticut and Pennsylvania, respecting the land at Wyoming, admonish us not to be sanguine in expecting an easy accommodation of such differences. The articles of confederation obliged the parties to submit the matter to the decision of a federal court. The submission was made, and the court decided in favor of Pennsylvania. But Connecticut gave strong indications of dissatisfaction with that determination; nor did she appear to be entirely resigned to it, till, by negotiation and management, something like an equivalent was found for the loss she supposed herself to have sustained. Nothing here said is intended to convey the slightest censure on the conduct of that State. She no doubt sincerely believed herself to have been injured by the decision; and States, like individuals, acquiesce with great reluctance in determinations to their disadvantage.

Those who had an opportunity of seeing the inside of the transactions which attended the progress of the controversy between this State and the district of Vermont, can vouch the opposition we experienced, as well from States not interested as from those which were interested in the claim; and can attest the danger to which the peace of the Confederacy might have been exposed, had this State attempted to assert its rights by force. Two motives preponderated in that opposition: one, a jealousy entertained of our future power; and the other, the interest of certain individuals of influence in the neighboring States, who had obtained grants of lands under the actual government of that district. Even the States which brought forward claims, in contradiction to ours, seemed more solicitous to dismember this State, than to establish their own pretensions. These were New Hampshire, Massachusetts, and Connecticut. New Jersey and Rhode Island, upon all occasions, discovered a warm zeal for the independence of Vermont; and Maryland, till alarmed by the appearance of a connection between Canada and that State, entered deeply into the same views. These being small States, saw with an unfriendly eye the perspective of our growing greatness. In a review of these transactions we may trace some of the causes which would be likely to embroil the States with each other, if it should be their unpropitious destiny to become disunited.

How to Fight Global Warming

I have run into a surprising number of people who think global warming has a good chance of causing an apocalypse that will destroy the world as we know it within the next few decades. I think that unlikely. We should be very concerned about the small chance that Earth could become like Venus, but in the long history of the Earth it has been very warm before, and it is not that likely that things will go completely off the rails this time.

Some of the biggest harms of global warming and the rise in atmospheric carbon dioxide riving global warming are likely to be:

  1. effects on the ocean, including acidification

  2. a combination of rising oceans and local climate changes that drives mass migrations that lack of sympathy for desperately poor “economic migrants” is likely to turn into humanitarian catastrophes

  3. extinctions of many species

(Let me know what I forgot.)

Economists tend to favor a “carbon tax” on carbon dioxide emissions as a highly efficient and effective way to slow global warming. This kind of tax can also be applied to methane leaked into the atmosphere. Atmospheric methane is a powerful greenhouse gas, but also much, much shorter-lived than atmospheric carbon dioxide.

In their working paper “Making Carbon Taxation a Generational Win Win,” Larry Kotlikoff, Felix Kubler, Andrey Polbin, Jeffrey Sachs, and Simon Scheidegger argue that because many of the benefits of slowing global warming accrue to future generations, it is appropriate to rack up additional national debt—that future generations would have to deal with—if those funds are used to slow global warming.

Here is my favorite version of compensating the current generations for their efforts to reduce carbon dioxide emissions. I think once enacted, it could solidify political support for fighting global warming. Give all adult citizens an equal amount of transferable “carbon tax equities,” with additional equities created to give to children who reach age 18. These carbon tax equities would distribute the proceeds of carbon taxes in proportion to carbon tax equity holding. They would become worthless if carbon taxes were ever reduced to zero. So those who had bought up a lot of carbon tax equities would lobby strenuously against carbon taxes being reduced to zero, and could rightly claim it was unfair to do so when they had purchased the carbon tax equities under the expectation that there would be carbon taxes. Being given assets of substantial value, backed by carbon taxes for many years to come also makes it easier for people to finance an education or the purchase of a home.

Creating assets that help solidify a political settlement has important precedents. Alexander Hamilton argued (successfully) for the assumption of state debts by the new federal government because it would give bondholders a stake in the success of the new federal government. The Meiji government gave samurais “samurai bonds” to compensate them for their samurai stipend being cut off and allowed those samurai bonds to be used to capitalize banks. (There is a working paper on this: “Swords into Bank Shares: Finance, Conflict, and Political Reform in Meiji Japan,” by Saumitra Jha, Kris Michener and Masanori Takashima.)

What if we can’t get carbon taxes enacted in enough countries? In the Q&A after presenting “Making Carbon Taxation a Generational Win Win” at the 2019 North American Summer Meetings of the Econometric Society, Larry Kotlikoff said something fascinating: stopping the burning of coal alone can get one most of the way toward the benefits of an ideal carbon tax. Why is coal so bad? When combined with oxygen in the air by burning, every atom of carbon has the potential to make a molecule of carbon dioxide, and coal is almost entirely carbon atoms. By contrast, natural gas is mostly methane, CH4, which has four atoms of hydrogen for every atom of carbon. Oil is also a hydrocarbon, though it has a higher carbon to hydrogen ratio. The hydrogen atoms generate a lot of energy when combined with oxygen to form H2O: water. So there is a lot of energy from natural gas that isn’t coming from the carbon in it. In any case, burning coal is very, very bad—worse than burning natural gas, oil or other hydrocarbons. An international agreement to quit building coal power plants and to begin to phase out the existing coal plants would be a huge step forward for slowing global warming—a much, much bigger step than any international agreement so far to try to deal with global warming.

The horror of coal has an important implication for environmental activists: demonizing coal would do more than almost anything else they could do to save the planet. In my view, demonizing coal is quite possible if environmental activists focus on this goal. Inevitably if one tries to get across a dozen messages, each of those messages loses some punch. They can get lost among all the other messages. But if the horror of coal became the main message, I think people would remember. Demonizing coal seems quite doable because coal looks dirty. That is, coal is not only bad, it looks bad.

(I am not a big hashtag user on Twitter, myself but there are many tweets that bear the hashtag #killcoal. Here are some of my tweets with the words “Kill coal.”)

For those who are worried about apocalypse during their lifetime, let me give one more word of reassurance. climate engineering such as aerosols to block some fraction of sunlight may have bad side effects, but in a pinch they are quite doable. (See the Wikipedia article “Climate engineering.”) The cost is relatively modest. Moreover, unlike restraining carbon dioxide emission, for which it is crucial to get most nations on board, since a few big nations can emit a lot of carbon dioxide, climate engineering can be done unilaterally by one nation without any need of getting other nations on board. Bad things will happen in the world in the future, and many of those bad things in the future may result from global warming, but I think nuclear holocaust is a much more likely route to true “end-of-the-world”ish apocalypse than global warming.

Update, April 4, 2020: One of my students had some important questions about this post. Let me put my answers down on paper here.

First, what is an example of what I talk about in this passage?

... because many of the benefits of slowing global warming accrue to future generations, it is appropriate to rack up additional national debt—that future generations would have to deal with—if those funds are used to slow global warming.

The simplest case would be if some type of government purchases—say research spending—is important for slowing global warming. 

But what if a carbon tax is the main tool for stopping global warming? Then giving the current generation carbon tax rebates that are bigger than the current revenue from the carbon tax would be an example of racking up government debt to make it all a good deal for the current generation as well as for future generations. My proposal of carbon tax equities is in this spirit. 

Let me explain the carbon tax equities. "Equity" simply means something that works like a stock. Stock gives you ownership of a slice of a company's profits. Carbon tax equities are pieces of paper that give you a slice of carbon tax revenue. Just like stock, if you want, you can sell your rights to your future slice of carbon tax revenue. My idea is that the current generation gets the carbon tax equities. The value of these carbon tax equities is greater than the value of all the carbon taxes the current generation will pay, since the carbon tax equities include the value of carbon taxes future generations will pay. So the current generation is getting more back than it pays. This is arguably fair to future generations because they get a non-destroyed planet—it is in the interest of future generations to compensate/bribe the current generation to slow global warming. 

Fasting Before Feasting

Suppose you are concerned about your weight and have a time of feasting coming up: a holiday, friends or family coming to town, or as I do, a retreat that will have a lot of good food. Suppose also that you have had a good experience with fasting in general, heeding all of the cautions about fasting that I repeat at the beginning of my post “Increasing Returns to Duration in Fasting.” (By “fasting,” I mean not eating food, but continuing to drink water.) Is it better to fast before feasting or fast after feasting? The answer is “Fasting before feasting is better,” and follows from an interesting logic.

In “Increasing Returns to Duration in Fasting” I write:

I theorize that when you end your fast and resume eating, you will have an enhanced appetite in order to replenish your glycogen stores. By contrast, I think of the amount of body fat having a weaker effect on appetite.

Everything I say from here on is predicated on that theory. If the body’s desire to replenish glycogen stores enhances appetite after a sustained period of fasting, then it will feel natural to eat somewhat more than usual after a period of fasting. Thus:

  • If you fast right before a time when you were planning to feast anyway, that isn’t extra at all.

  • But if you fast after feasting, then you will have an additional period when you are like to eat extra after your fast. That would be over and above the feast before your fast.

So, if your appetite is enhanced by the body’s desire to replenish glycogen stores after a fast, you will probably end up at a lower weight if you time that extra appetite to coincide with the feasting that you were going to do anyway instead of having that extra appetite come later, when it is likely to lead to an additional time of heavy eating.

Another totally equivalent way of looking at things that will make more sense if you read “Increasing Returns to Duration in Fasting” is that if you time a fast so it comes before a time of feasting you were going to do anyway, you escape the “fixed cost” of a period of fasting coming from the extra appetite to rebuild glycogen stores after your fast is over. In saying this, I am using the calories in/calories out identity, but treating calories in as something highly endogenous that depends on your appetite. And I am assuming that you are eating low on the insulin index so that calories out don’t change much while you are fasting. (See “Forget Calorie Counting; It's the Insulin Index, Stupid.”)

Note that eating low on the insulin index leaving calories out at a normal level is closely related to eating low on the insulin index making fasting easy: if your body were trying to reduce calories out it would likely make you feel sluggish at best and truly crummy at worst, which is no fun. But if your body is expending just as many calories as normal, you have a good chance of feeling fine during fasting, at least once you have adapted to the new way of eating when you do eat. (See “David Ludwig: It Takes Time to Adapt to a Lowcarb, Highfat Diet.”)

For annotated links to other posts on diet and health, see: