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.