Deeper Negative Rates Can Ward Off Secular Stagnation

I have often avoided the term “secular stagnation” on this blog because its meaning is ambiguous. Is “secular stagnation” just another term for a liquidity trap, does it mean forces that lower the real interest rate, or does it mean a slowdown in productivity growth?

Negative interest rate policy that paper currency policies that can reduce the rate of return on paper currency below zero are the straightforward solution to a liquidity trap: the liquidity trap is simply gone once one changes paper currency policy, and interest rate policy by the central bank can then proceed without constraint. (On how to change the rate of return on paper currency, or otherwise allow room for deep negative rates despite the existence of paper currency, see my bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.” I also have another paper coauthored with Ruchir Agarwal on the way.)

Long-run real interest rates and long-run productivity growth are beyond the power of monetary policy to change directly. (See my exposition of this standard view in “What Monetary Policy Can and Can't Do.”) But enabling deep negative rates allows monetary policy to do its job of stabilizing the economy, removing a large distraction that takes many economists and policymakers away from discussing ways to raise long-run productivity growth. Raising long-run productivity growth would also tend to raise the long-run real interest rate.

While arguing the opposite, Martin Wolf makes the case for adding deep negative interest rates to the monetary policy toolkit in his Financial Times op-ed “Monetary policy has run its course” in his summary of a paper by Lukasz Rachel and Lawrence Summers:

A recent paper by Lukasz Rachel and Lawrence Summers shines light on these questions. Its thrust is to support and elaborate the hypothesis of “secular stagnation”, revived by Prof Summers as relevant to our era in 2015. This paper’s principal innovation is to treat the big advanced economies as a single bloc. Here are four conclusions.

First, a dramatic and progressive decline in real interest rates on safe assets has occurred, from over 4 per cent in the 1980s to around zero now. Furthermore, shifts in risk preferences do not explain this decline, since spreads in yields of riskier over safe assets have changed little. (See charts.)

Second, this secular fall in real interest rates implies a roughly equivalent fall in the (unobservable) “neutral” or “equilibrium” rate — the rate at which demand matches potential supply.

Third, governments are not generating this structural weakness in demand. On the contrary, by expanding social spending, deficits and debt, governments have raised equilibrium long-term real interest rates, other things being equal.

Finally, changes in the private sector would, on their own, have generated a fall of more than seven percentage points in the equilibrium real rate of interest. Among the many factors driving this sharp decline must have been ageing; declining productivity growth; rising inequality; declining competition; and falling prices of investment goods.

A key point here is that fiscal policy has already been working hard. Trying to keep aggregate demand up without using lower interest rates requires quite extreme fiscal policy.

Martin Wolf dismisses negative interest rate policy in one paragraph:

Suppose, then, that our economies were to fall into a deep recession, yet still have near zero real interest rates and very low nominal rates, too. Suppose, too, that, inflation were somewhere between zero and two per cent. Then the response to a recession would require strongly negative short-term nominal interest rates, possibly as low as minus 5 per cent. That would, to put it mildly, create a wasps’ nest of technical, financial and political problems.

There are two answers to Martin: First, there has been progress in thinking through how to address the technical, financial and political problems that Martin is not fully aware of. Second, any solution to secular stagnation involves a wasp’s nest of technical, financial and political problems. There are no easy outs. In particular, fiscal policy is not the easy out that people think. As I point out in “Monetary vs. Fiscal Policy: Expansionary Monetary Policy Does Not Raise the Budget Deficit,” fiscal policy not only adds to the national debt, but is almost unavoidably tangled up in political struggles.

By contrast, in many countries governments have given central banks broad enough authority that negative interest rate policy beyond what has been done so far can be executed by an independent central bank without additional legislation. Politicians can then distance themselves from the negative interest rate policy. A central bank that does so will, of course, get some blowback, but central bankers pride themselves on being willing to raise interest rates when appropriate even when such a move meets with criticism. They should take a similar pride in being willing to lower interest rates deeper below zero when appropriate even when that move meets with criticism.

Also, there is a set of arguments that work equally well against both fiscal policy and quantitative easing as alternatives to negative interest rate policy. A large enough dosage of either fiscal policy or quantitative easing is likely to have important side effects. Fear of these side effects is likely to keep the dosage of fiscal policy and quantitative easing below the dosage that would be necessary to get quick recovery during a serious recession in which interest rates were not cut very much. And waiting to see if a dosage of quantitative easing within historical experience or a dosage of fiscal policy within the most likely range can deliver enough stimulus is likely to lead to a delay in recovery costing trillions of dollars worth of social welfare relative to going to deep negative interest rates immediately.

Another way of putting the argument that delay is very costly, in relation to quantitative easing, is that the “buying time” that Mohamed El-Erian talks about in “How Western Economies Can Avoid the Japan Trap” is a bad thing, not a good thing:

Large-scale balance sheet operations like quantitative easing (QE) can buy time by seeking to inject more liquidity directly into the system. But they don’t address the underlying issues, and they come with their own set of costs, forms of collateral damage, and unintended consequences.

The sentence right before this passage is just plain wrong:

Monetary policy, after all, is less effective near the “zero bound” and in scenarios where other “liquidity trap” factors are in play.

On the contrary, to a good approximation, if all interest rates are lowered, including the paper currency interest rate (as is easily possible) monetary policy is just as effective per basis point in the negative region, and there is no limit to how far interest rates can be cut other than the danger of overstimulating the economy.

Altering paper currency policy also alleviates other worries Mohamed El-Erian has. He writes:

… persistently low – and in some cases negative – interest rates tend to eat away at the institutional integrity and operational effectiveness of the financial system, thereby reducing bank lending and limiting the range of long-term products that insurance/retirement firms can offer to households. Another indirect effect stems from expectations about the future. The longer growth and inflation remain low, the more tempted households and companies will be to postpone consumption and investment decisions, thus prolonging low growth and inflation.

With paper currency interest rates going down along with other interest rates, there is no reason for the spreads that financial firms live off to be dramatically different. As one salient example, relying on negative interest rate policy instead of quantitative easing allows for a more historically typical yield curve. As another example, for large accounts that go beyond the quantity for which the central bank provides a subsidy for along the lines I discuss in “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies,” deposit rates can go down enough that the interest rate margin between interest rates on loans banks make and the deposit rates they pay can be substantial.

As for people postponing investment and consumption, low enough interest rates can counteract any such tendency: a negative interest creates a penalty for postponing investment or consumption.

In my view, the future will be on a safer track if the prominent economists and journalists who are now advocating preparations for dramatic fiscal expansion began advocating more vigorous innovation in in negative interest rate policy—either instead of, or in addition to a dramatic fiscal expansion. A great deal may rest on whether they do so.