One common objection to low interest rates–and even more to negative interest rates–is that it will lead to too much debt. It occurred to me that this is looking at things only from the standpoint of the borrower’s desires. But the amount of debt is determined in a market equilibrium in which the lender’s desires are also part of the picture. A similar one-sided logic would be to claim that low interest rates encourage too little lending. But with little lending, there would also be little debt. So which is it? Do low interest rates lead to more debt (because borrowers want more debt) or less debt (because lenders want to give them less and so borrowers can’t borrow and end up less in debt)?

If the central bank does its job well (better than existing central banks have managed so far), the economy would be near the natural level of output most of the time. Think of that as approximately the same state as if the economy had perfectly flexible prices and monetary policy had no effect on anything real. At the natural level of output, the level of national debt has to do with taxing and spending policy, while the level of private debt has a lot to do with heterogeneity–how different people are from one another in the sense of a wealth-weighted variance of preferences. 

Starting from that benchmark, a positive output gap might mean there are more good-looking projects for which there would be both demand and supply of loans. So low central bank interest rates might lead to more debt simply because the economy then boomed, while high central bank interest rates might lead to less debt because the economy contracted and their were few projects for which there was both supply and demand for lending. 

In this discussion, I haven’t yet adequately distinguished between debt in the sense of fixed-income securities and equity finance. This distinction matters. To the extent debt causes problems for financial stability, it is almost always fixed-income securities that are the problem. The easiest way to reduce debt is to have tight leverage limits–or equivalently, high equity requirements–for banks and other financial firms, for individual mortgages (with mortgage reform such as Andy Caplin’s share appreciation mortgages) and for any other type of firm that has shown a high propensity toward threatened bankruptcy. Even student loans can easily be put on a more equity-like and less debt-like basis by having some of the payment stated as a percentage of income instead of as a fixed amount. 

If policy is trying to push arrangements toward more equity and less debt, negative interest rates can be quite helpful, because they make safety look like a loss, which makes potential lenders more willing to put their funds into securities that look like equity. 

A related concern is the concern that negative interest rates might encourage people to take on too much risk. But if the risk is funded by equity instead of debt, risk can be taken on without seriously raising the probability of bankruptcy. And as long as bankruptcy probabilities are low because the fraction of equity-funding is high, risk-taking seems to me like a good thing, not a bad thing. 

Now I may be missing something here. If so, I would be interested to here what. One question I have is whether junk bonds are enough like equity that what I said about equity can be applied to them, or whether junk-bonds sometimes occur in industries where the deadweight loss from bankruptcy is so high that there is a lot of inefficiency to having junk-bond financing instead of equity financing. One would hope that junk bonds would mainly be an attractive funding vehicle in equilibrium in industries where the deadweight loss from bankruptcy was especially low.