Because the Great Recession was triggered by the Financial Crisis of 2008, financial stability concerns have been high on the agenda of central banks. Indeed, some central bankers now worry about avoiding financial instability every bit as much as they worry about avoiding inflation and unemployment. So it is worth directly addressing financial stability concerns that some central bankers have about a robust negative interest rate policy.
The particular concern many people have is that lower interest rates might increase financial instability. There are several possible mechanisms for this:
- The simplest is that lower interest rates might make asset prices go up and this allows households and firms to borrow more without exceeding legal or customary ceilings on leverage. Then if the asset prices ever go back down, bankruptcy could be near at hand.
- The second is “reaching for yield” caused by institutional settings or psychological mindsets in which there is effectively a target expected return or “yield,” and the amount of risk bearing is adjusted in order to meet that expected return target. (See “Contra John Taylor” and “Reaching for Yield: The Effects of Interest Rates on Risk-Taking.”)
- The third is that low interest rates magnify the importance of the relatively distant future on the present value of an asset. Opinions on the relatively distant future are likely to differ from investor to investor and to change quite a bit over time even for the same investor. Because there is so little to go on, the human penchant for responding to stories can have relatively free play. (See “Robert Shiller: Against the Efficient Markets Theory” plus “Dr. Smith and the Asset Bubble.”)
- The fourth is that as interest rates fall, it becomes attractive to banks and other financial institutions to provide credit to people who previously were not considered creditworthy.
Although these are genuine concerns, it would be a mistake to let these concerns paralyze monetary policy–as they easily could: in “Monetary Policy and Financial Stability” I argue that central transmission mechanisms for monetary stimulus work through pushing up asset prices and relaxing credit constraints for those who previously had a hard time getting a loan.
As I discussed in “Meet the Fed’s New Intellectual Powerhouse,” to the extent that risk premia go down, showing a greater appetite for risk–or less fear of risk–it is appropriate to raise the safe interest rate; and conversely it is appropriate to lower the safe interest rate when risk premia go up–even aside from financial stability concerns. But I want to argue that if unemployment is high and inflation is low, it is appropriate to cut interest rates (even into the negative region) to stimulate the economy even if risk premia stay the same.
Three Arguments for a Robust Negative Interest Rate Policy Even in the Face of Financial Stability Concerns
1. High Equity Requirements are Powerful Enough to Mitigate Financial Stability Concerns. I view equity requirements (sometimes called “capital” requirements)–or equivalently leverage limits–as being powerful medicine to raise financial stability. If people are betting their own money by holding stock rather than borrowing money that someone expects back in full, any decline in the value of a bank, business, or other asset will be absorbed by the stockholders. Then there is no bankruptcy, no contagion, and no temptation for the government to do a bailout, because no debt is being defaulted on. I feel as passionately about the need for high equity requirements as I do about the need to have deep negative interest rates (including negative interest rates on paper currency) in the monetary policy toolkit. Here are links to some of what I have said about the importance of having high equity requirements:
- Anat Admati, Martin Hellwig and John Cochrane on Bank Capital Requirements
- Canadians as the Voice of Reason on Financial Regulation
- Miles on HuffPost Live: Getting Beyond Economics 101
- When Honest House Appraisers Tried to Save the World
- Cetier the First: Convertible Capital Hurdles
- Anat Admati’s Words of Encouragement for People Trying to Save the World from Another Devastating Financial Crisis
- Three Big Questions for Larry Summers, Janet Yellen, and Anyone Else Who Wants to Head the Fed
- How to Avoid Another Nasdaq Meldown: Slow Down Trading (to Only 20 Times Per Second)
- Banks Now (2008) and Then (1929)
- The Volcker Rule
- Big Banks’ Shadow Dance by Simon Johnson
- Anat Admati Makes Time’s 2014 List of 100 Most Influential People
- John Dearie, Miles Kimball and Others Debate High Equity Requirements for Banks
- “The Geography of Financial Misconduct,” by Christopher A. Parsons, Johan Sulaeman, Sheridan Titman
- The Wall Street Journal Editorial Board Comes Out for a Straight 15% Equity Requirement
- Why Equity Requirements for Financial Firms Should Be Dramatically Increased
- Crush Cuckoo CoCo Coddling
Why negative interest rates should be combined with high equity requirements: In times when unemployment is high, output is below its natural level, and inflation is coming down, low interest rates–and often negative interest rates–are called for. But negative interest rates are much safer in conjunction with high equity requirements. Conversely, when financial instability threatens, high equity requirements are called for, but they are safer when negative interest rates are ready to hand to deal with any negative aggregate demand effects of the high equity requirements.
At the top of this post, I diagram the idea that high equity requirements have a big positive effect on financial stability, but some negative effect on aggregate demand, while negative interest rates (or more generally low interest rates) have a big positive effect on aggregate demand, but have some effect in reducing financial stability. This means that if high equity requirements and negative interest rates are combined, it is possible to get both more financial stability and more aggregate demand. Low interest rates can more than make up for the reduction in aggregate demand caused by higher equity requirements, while the high equity requirements more than make up for the reduction in financial stability from the negative interest rates.
2. Negative Short-Term Interest Rates Raise Long-Term Interest Rates. Long-term interest rates matter more for asset prices than short-term interest rates. Therefore, those concerned about financial stability should worry most about low long-term interest rates. There are two reasons the ability to generate a brief period of deep negative short-term interest rates should raise long-term interest rates. The first is that a brief period of deep negative short-term rates is the path to economic recovery if the economy is in a deep recession or a potentially long-lasting slump. Businesses and households are much more eager to borrow when the economy looks healthy than when it looks sick. So interest rates tend to be higher when the economy is doing well than when it is doing badly. It may seem paradoxical that negative rates are the path to higher interest rates, but the paradox is dissolved when one realizes that economic recovery is in between. Because it is the long-term rates that matter most for asset prices, an extended period of years and years of zero interest rates is much more dangerous for financial stability than a brief period of deep negative rates followed by a return distinctly positive interest rates. One of the worst things for financial stability is an unending slump with the economy stuck at an unwisely maintained zero lower bound.
The second reason having deep negative interest rates in the toolkit allows higher long-term interest rates is that eliminating the zero lower bound and thereby bringing the possibility of deep negative interest rates into the picture means that quantitative easing is no longer needed. As practiced in recent years in the US, the UK and Europe, quantitative easing has involved pushing down long-term interest rates relative to short-term interest rates. This gives a high ratio of pushing asset prices up (”asset price inflation”) relative to the aggregate demand it provides. I claim that cutting short-term rates has a better ratio of extra aggregate demand provided to effect on asset prices. (I owe you an entire post on this point.)
3. Short of Monetary Policy that Allows a Perpetual Slump, the Medium- to Long-Run Real Interest Rate Situation is Not Affected by Monetary Policy.
Because central banks operate in important measure by changing interest rates in the short-run, many people think that they determine real interest rates in the medium- and long-run. But unless a central bank allows a perpetual slump, with output continually below the natural level, what happens in the medium- and long-run in real terms is not much affected by what the central bank does. That includes not just what happens to economic growth in the medium- and long-run, but also what happens to the real interest rate. (See “Mario Draghi Reminds Everyone that Central Banks Do Not Determine the Medium-Run Natural Interest Rate.”) So whatever the effect of real interest rates in the medium- and long-run on financial stability, that effect real interest rates in the medium- and long-run is beyond the power of monetary policy to affect–except to the extent the central bank makes things worse for financial stability by allowing a perpetual slump or better for financial stability by escaping a perpetual slump (Argument 2 above).
If medium- to long-run forces are causing financial instability, this must be fought with non-monetary tools. High equity requirements are the first line of defense. If greater financial stability is desired than high equity requirements (and perhaps a few complementary financial rules) alone can provide, another useful supplementary remedy is a contrarian sovereign wealth fund. (See “Roger Farmer and Miles Kimball on the Value of Sovereign Wealth Funds for Economic Stabilization.” Ever since I wrote “Q&A on the Financial Cycle” I have been aware that even if the economy is kept at the natural level of output at all times so that the business cycle has been stabilized, there would remain the issue of stabilizing the financial cycle if there are noise traders or other forces–such as some version Minsky mechanisms–that continue to cause a financial cycle even in the presence of high equity requirements.)
Negative interest rates are no panacea. They merely make it possible for decisive movements in short-term interest rates to accomplish the basic purpose of monetary policy: keeping the economy in medium-run equilibrium with output at the natural level.
Negative interest rates are a marvelous solution to empowering monetary policy to do its job, but negative interest rates are no economic policy panacea because monetary policy can’t do everything. In addition to not being the answer to generating long-run economic growth, monetary policy alone can’t create financial stability except at the cost of a sluggish economy. High equity requirements and other approaches to gaining greater financial stability are needed in addition to monetary policy to get good results. Fortunately, since aggregate demand is no longer scarce when deep negative interest rates are available, any drag on aggregate demand from higher equity requirements is not a serious concern. So it is reasonable to push quite far toward higher equity requirements in order to ensure financial stability.
Update: “Long-Run” vs. “Long-Term.” In the discussion of interest rates in the medium- to long-run above, it would be easy to confuse “long-run” with “long-term” and to confuse “medium-run” with “medium-term,” which in turn would make the argument hard to understand. The “medium-run” as the economic concept I mean is a period from about 3 to 12 years out, while the “long-run” is a period beyond 12 years or so. Going toward brevity in my terminology, the short-run is a period from 1 to 3 years out, while the ultra-short run is a period from now to 1 year out.
By contrast, according to the usual terminology in financial markets, “medium-term interest rates” might be interest rates available now covering a period from now to 2 years from now, or from now to 5 years from now. And interest rates available now covering a period from now to more than 5 years from now would typically be called “long-term” interest rates. Thus, most of the span covered by medium-term interest rates available now is what I would call the “short-run.” And the short-run is even an important part of the span covered by long-term interest rates available now.
My claim is that short-term forward real (inflation-adjusted) rates from 3 to 12 years out, and certainly beyond 12 years out should be mostly unaffected by any predictable monetary policy unless the central bank is allowing a perpetual slump by not breaking through the zero lower bound.