Thanks to JP Koning for giving permission to mirror this excellent Moneyness post (link above) as a guest post on supplysideliberal.com. Although the 5% upper bound in the bad old days was a disequilibrium interference with the market that created a gap between supply and demand, while the current zero lower bound is a promise of unlimited government supply of an asset earning 0%, what they have in common is a bound induced by policy, that can be repealed.
The zero-lower bound is the well-known 0% floor that a note-issuing bank hits whenever it attempts to reduce the interest rate it offers on deposits into negative territory. Should the bank drop rates below zero, every single negative yielding deposit issued by the bank will be converted into 0% yielding notes. When this happens, the bank will have lost any ability it once had to vary its lending rate.
The ZLB is an artificial construct. It arises from the way the banking system structures the liabilities that it issues, namely cash and deposits. We can modify this structure to either remove the ZLB or find alternative ways to get around it. Much of the discussion over the econblogosphere over the last few years has been oriented around various ways to get below zero.
There is another artificial bound, this one to the upside—let’s call it the 5% upper bound, or FUB. The FUB is an archaic bound. Up until 1854, the Usury Laws prevented the Bank of England from increasing rates above 5%. This constraint meant that for almost two centuries, the Bank of England’s discount rate was bounded within a narrow channel that had as its upper limit the 5% mark as stipulated by the Usury Laws and a lower limit of 0% due to the existence of 0% yielding banknotes (see chart above).
Imagine that we had a time machine and transported the econblogosphere, still hot over the ZLB debate, back to 1809. What sorts of discussions would we be having if we had risen up against the FUB? Given that the conventional route of increasing rates was constrained by the usury prohibitions, what sort of unconventional monetary policies would bloggers be providing to the Directors of the Bank of England to deal with inflationary booms? Would this advice be symmetrical to the policies they have been advocating for escaping the ZLB?
1809 is a significant date because the convertibility of the pound into gold had been suspended for over a decade. Although convertibility would be resumed in 1821, England would be on a ‘fiat’ standard very similar to our own for another decade. In the years since suspension, the pound had gradually depreciated against gold and other European currencies. A healthy debate began to flourish over whether the Bank of England was responsible for the pound’s depreciation (ie. inflation) or if external events such as crop failures were to blame. It was in that context that banker/economist Henry Thornton published his famous Enquiry into the Nature and Effects of the Paper Credit of Great Britain. Although Thornton was circumspect on the precise causes of the deprecation of the pound, he drew attention to the difficulties that the Usury Laws caused in controlling the volume of credit. Here is Thornton:
In order to ascertain how far the desire of obtaining loans at the bank may be expected at any time to be carried, we must enquire into the subject of the quantum of profit likely to be derived from borrowing there under the existing circumstances. This is to be judged of by considering two points: the amount, first, of interest to be paid on the sum borrowed and, secondly, of the mercantile or other gain to be obtained by the employment of the borrowed capital…
The borrowers, in consequence of that artificial state of things which is produced by the law against usury, obtain their loans too cheap. That which they obtain too cheap they demand in too great quantity.
Thornton pointed out that if there was a large deficit between the price at which a businessman could borrow from the Bank of England and the mercantile rate of profit—the rate at which the same businessman could invest the borrowed money—then the demand for and granting of credit would become excessive. While nudging the discount rate higher would normally be sufficient to reduce this excess, the laws against usury might prevent these increases from taking place.
If we were to drop Nick Rowe into the 1809 economic debate, he would complement Thornton quite well by making good use of the same pole-on-a-palm analogy he has so aptly used to explain the ZLB. Running an inflation targeting central bank is sort of like balancing a long pole upright in the palm of one’s hand, says Nick. The bottom of the pole is the interest rate and the top is the inflation rate. As the pole starts to lean (ie. the price level begins to change), the holder needs to quickly move their palm far enough in the same direction (ie. interest rates must be changed) so as to stop the pole from falling over. A wall to the either the north or south impedes the holder’s palm from moving sufficiently far and will cause the pole to tumble over.
Applying this analogy to monetary policy, the Directors of the Bank of England might be required to stop excess inflation by moving rates north of 5%. With the Usury Laws in place, the Director’s efforts would be impeded. Nick’s illustration is Thornton all over again.
Scott Sumner, Lars Christensen, David Beckworth, and other monetarist-types have been strong advocates of quantitative easing as a way to get below the ZLB. Whisk them back to 1809 and would they advocate getting above the FUB by quantity dis-easing, or QD — mass repurchases of Bank of England notes through the liquidation of the Bank of England portfolio of assets?
Assuming that the threat of QD is able to increase the expected purchasing power of the pound (just as the threat of QE is supposed to reduce the same), then the Directors could initiate a QD program to improve the real return on pound notes and deposits. As soon as the real return on notes and deposits exceeds real returns on capital, the inflationary boom will come to a halt. Conveniently for the Directors, the nominal 5% rate will have remained in place — only real rates will have increased — thereby allowing the Directors to abide by the Usury Laws.
What about New Keynesians like Paul Krugman? Promising to hold off on future interest rate increases after a recovery has begun is the sort of advice New Keynesians have given to the Fed as a way to bridge the ZLB. This is called providing forward guidance. As Krugman says, a central bank needs to “credibly promise to be irresponsible”.
Parachute Krugman into 1809 and he would be counseling the Directors to do the opposite: hold off on reducing rates from 5% after a contraction had already set in. In other words, the Directors need to “credibly promise to be hard-asses.” As long as this promise is taken seriously by the market, the promise of future monetary tightening translates into lower inflation in the present, and the real interest rate rises. This should reign in the inflationary boom. Much like Sumner and Christensen, Krugman’s advice would allow the Director’s to hold steady at the 5% nominal rate dictated by the Usury Laws, letting real rates do the job of reeling in prices and slowing down the economy.
What about Miles Kimball? Transport Miles back to 1809 and he’ll probably be the most aggressive in the outright removal of the Usury Laws. Just as he is currently campaigning for the ability of central banks to set negative rates on deposits, I’m sure he’d by picketing outside of Parliament for the right of the Director’s to bypass the Usury Laws and set 6-7% nominal rates.
Incidentally, what did the Directors of the Bank of England actually do? According to Jacob Viner, there is evidence that
bankers found means of evading the restrictions of the usury laws. In 1818, the Committee on the usury laws stated in its Report that there had been “of late years … [a] constant excess of the market rate of interest above the rate limited by law.” Thornton notes that borrowers from private banks had to maintain running cash with them, and borrowers in the money market had to pay a commission in addition to formal interest, and that by these means the effective market rate was often raised above the 5 per cent level. Another writer relates that long credits were customary in London and a greater discount was granted for prompt payment than the legal interest for the time would amount to.
More convincing evidence that the 5 per cent rate was not of itself always an effective barrier to indefinite expansion of loans by the banks is to be found in the fact that the directors of the Bank of England, although they professed that they discounted freely at the rate of 5 per cent all bills falling within the admissible categories for discount, in reply to questioning admitted that they had customary maxima of accommodation for each individual customer and occasionally applied other limitations to the amount discounted.
In Paper Credit we find Henry Thornton verifying Viner’s claim, noting the “determination, adopted some time since by the bank directors, to limit the total weekly amount of loans furnished by them to the merchants.”
So the Director’s preferred route for getting out from under the thumb of the Usury Laws was to maintain the 5% discount rate, but ration the quantity of loans issued at these rates, thereby limiting the quantity of credit in circulation. While this policy might not have been sufficient to prevent an inflationary boom, it may have prevented a hyperinflation from breaking out.
Before I sign off, I want to reverse something I said at the outset. I wrote that the 5% upper bound was archaic, but that’s not entirely true. Sure, high interest rates are no longer illegal. But high nominal interest rates have never been politically palatable. Central bankers are not independent of politics, and therefore probably still operate with something akin to a 5% upper bound. Let’s call it an “upper-ish” bound, or the point at which a central banker starts to get dirty looks from those who have the power to reappoint him. Central bankers may need to resort to unconventional techniques to free themselves of the upperish-bound. The Fed’s motivations for adopting quantity targets in 1979, for instance, may have been such a technique. An overt jacking-up of interest rates to 15-20% would have been political suicide, goes the theory, so the FOMC chose to engage in a bunch of hand-waving about hitting money supply targets, thereby distracting would-be critics with a new set of monetary verbiage. This left Paul Volcker free to implement what would be at its peak a tremendously onerous 22%+ fed funds rate.
We’re of course not anywhere near the upper bound these days, at least not in the developed world, but it’s still an interesting puzzle to work through in order to help understand the current situation.
Labels: Bank of England, Henry Thornton, history of thought, inflation, Miles Kimball, Nick Rowe, nominal interest rates, open market operations, Paul Krugman, real interest rate, Scott Sumner, usury, zero lower bound