Thursday, March 19, 2009

Yes, Virginia, The Fed Can Push Interest Rates Below Zero

From Greg Mankiw's blog via Clusterstock:

Some people are concerned that in the the fight against recession, the weapons of monetary policy are nearly out of ammunition. That is certainly the case for the standard monetary weapon--cuts in short-term interest rates. After all, short-term interest rates are already about zero, and the Fed cannot cut interest rates below zero.Or can it? In a discussion at a Harvard seminar recently, a clever grad student proposed a solution to the zero-lower-bound problem.

Let's begin with the basics: Why can't the Fed cut interest rates to below zero? Why can't the Fed announce, for example, an interest rate of negative 2 percent? You borrow $100 today and repay $98 a year from now. A negative interest rate would certainly encourage people to borrow and spend, thereby expanding aggregate demand. And if negative 2 percent wasn't enough to get the economy going, we could try negative 3 percent. And so on.

The problem, you might reply, is that no one would lend money on those terms. Rather than lending at a negative interest rate, you could hold onto cash by, for example, stuffing it in your mattress. In other words, the interest rate on loanable funds cannot fall below zero because holding cash guarantees a rate of return of zero. If the Fed tried to cut interest rates below zero, money would dominate debt instruments as a portfolio investment.

With this background, I can now state the proposed solution: Reduce the return to holding money below zero. Imagine that the Fed were to announce that, one year from today, it would pick a digit from 0 to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 2 percent. Losing 2 percent is better than losing 10. Of course, some people might decide that at those rates, they would rather spend the money by, for example, buying new car. But since expanding aggregate demand is precisely the goal of the interest rate cut, that incentive is not a bug but a feature!

Okay, I understand that this plan is not entirely practical. But you have to give the student credit for thinking out of the box. And his plan does address a fundamental problem facing the economy right now: Given the fall in wealth, increases in risk premiums, and problems in the banking system, the interest rate consistent with fully employment might well be negative.

Clusterstock's John Carney comments:

We'd like to think that this is actually the example that proves the danger of expecting the Fed to rescue us. It proposes that we'd actually have to destroy savings in order to increase employment, literally making dollars worthless in a form of smart bomb hyperinflation. If that's what it takes, maybe we'd be better to stop imagining we can be rescued by central bankers and get back on track with rebuilding market processes to set the level of economic activity.

Note that there could be serious legal problems with this proposal. Cancelling dollars sounds a lot like a taking that would be prohibitted by the constitution unless the owners were compensated, which would undermine the whole program

No comments: