Why Scott Fullwiler Misses the Point in “Why Negative Nominal Interest Rates Miss the Point”

Philippe James recently tweeted me a link to Scott Fullwiler’s July 11, 2009 post “Why Negative Nominal Interest Rates Miss the Point.” He begins by noting

Willem BuiterGreg Mankiw, and Scott Sumner have all recently proposed negative nominal interest rates on reserves or currency as a way to stimulate consumer spending and bank lending.

Then he mention’s Silvio Gesell’s plan, which differs from mine but also yields a negative nominal interest rate on paper currency:

The classic example of a negative nominal interest rate—long suggested by a number of economists for avoiding deflation—is a tax on currency …

Scott questions the effectiveness of this plan, saying:

Well, I don’t know about you, but my response would be pretty clear if the Fed made such an announcement: I’d stop holding currency and just use my debit card (most major purchases already aren’t done with currency, anyway). And so would most everyone else. Banks would then sell their currency back to the Fed and the Fed would pay banks reserve balances in exchange (as it usually does). I highly doubt this would lead any bank to cut its lending rates, as Mankiw thinks.

The response and result are in essence unchanged if instead you require individuals to periodically pay to have their currency “stamped” for validation (which Buiter also describes)—I would use a debit card or go to the ATM machine on the day I was going to spend.

Here Scott points to the necessity of something I emphasize every time I talk to central banks about breaking through the zero lower bound: it is important for central banks to move all four key interest rates in tandem:

  • the target rate (= federal funds rate in the US)
  • the interest rate on reserves 
  • the lending rate (= discount rate in the US)
  • the paper currency interest rate.

If the central bank lowers just the target rate and the paper currency interest rate without lowering the interest rate on reserves, it will be just as ineffective at lowering the market interest rate as if the central bank lowers the target rate and the interest rate on reserves without lowering the paper currency interest rate. Market rates can still be pushed down if the lending rate is left higher, but a lending rate lower than the other rates would interfere with trying to push market rates up.   

So pointing out that lowering one of these rates won’t do much is not an objection to negative rates. To be effective, there has to be no place to hide from the negative rates, except by either buying foreign assets (which is a capital outflow and stimulates net exports) or by actually buying something, either to invest, store, or consume. Of course the central bank should lower all the rates it controls, not just one. 

In the remainder of Scott’s post, his analysis focuses on income effects. For example, even though he points out that for every saver earning less interest, there is a borrower paying less interest (and borrowers probably have higher propensities to consume than savers) he doesn’t think those offsetting effects plus the greater incentive to borrow will have much effect.

When Scott says the interest sensitivity of spending is low, that could well be true for nondurable consumption, but it is not true for durable consumption or investment. The stimulus I expect from negative interest rates is not primarily from the nondurable consumption Euler equation that is what comes to mind for many economists. It is primarily from durable consumption, investment and net exports. Indeed, even if there were no stimulus whatsoever to nondurable consumption, negative interest rates would be very powerful.   

Scott also worries about the effects on bank equity of below zero interest rates. As we have all seen, there are many other mechanisms to bail out banks whose equity is too low other than keeping interest rates too high. And looking forward to the future, we should, in any case, make sure that banks go into the next recession with much, much higher levels of equity than they went into this recession. Under those circumstances, negative interest rates might make it take longer for banks to get out of their capital conservation buffer, so it would be longer before they could again pay dividends or buy back stock, but the economy would be fine.   ’

Finally, in answer to Scott’s question

why not a simple payroll tax holiday, for example, as my fellow bloggers have proposed?

One answer is that negative interest rates can have a bigger effect on aggregate demand than even cutting payroll taxes all the way to zero. I should also mention that whether or not a payroll tax holiday stimulates the economy at all depends greatly on the monetary policy response. In the context of this argument it probably does have some positive effect in conjunction with the monetary policy response of staying at the zero lower bound. But away from the zero lower bound, the monetary policy response might easily cancel out the other effects of a payroll tax holiday on aggregate demand. (On this principle of short-run monetary dominance, see my column “Show Me the Money!”)

The other answer to Scott’s question is that relative to cutting interest rates to get the same effect on aggregate demand, a payroll tax holiday means higher taxes or lower spending later on–both of which are painful. Monetary stimulus is cheap, fiscal stimulus expensive. On this topic, you might like my post “Monetary vs. Fiscal Policy: Expansionary Monetary Policy Does Not Raise the Budget Deficit” has an enduring popularity. If huge amounts of government revenue fell from the sky due to, say, undersea natural gas–much more than could productively be spent on defense, scientific research and other public goods–it would be great in steady state to subsidize wages to help counteract the effect of various labor market distortions. But for most countries, that kind of government revenue doesn’t fall from the sky. It has to be raised through taxes.