Sunday, February 14, 2016

Negative Interest Rate Naysayers

Maybe I will turn into a Marxist.

Just kidding.

Still, when I read Bill Gross attacking negative interest rates, it makes me wonder.

I am a free market economist, and as far as I am concerned, the interest rate is a price.   The correct interest rate is the one that equates quantity supplied and quantity demanded.   If the supply of apples is so great compared to the demand that market clearing requires that people be paid to haul them away, then that is the least bad option.  

With interest rates, however, the relevant coordination is saving and investment.   Saving is that part of income not spent on consumer goods and services.   And investment is spending on capital goods.   If the interest rate that results in saving and investment matching up is less than zero, then that is the "right" interest rate.

Now, I certainly would agree that if there are government policies that discourage investment, then repealing them is a good idea.   That should raise investment demand and so raise the interest rate that coordinates saving and investment.   But I don't see how using monetary policy to keep nominal interest rates high, even above zero, is ever helpful.

And make no mistake--the Fed's policy of paying interest to banks for holding reserves is a policy aimed at keeping nominal interest rates up.

Situations where some real interest rates need to be less than zero for some period of time seem entirely plausible to me.    Since I don't see persistent inflation as desirable, that means that some nominal interest rates should sometimes be less than zero.   Situations where all real interest rates should be persistently negative seem pretty implausible to me.  In fact, I think excessive focus on a steady state, or worse, for those of the "Austrian" bent, thinking about the evenly-rotating economy, misses the point as to why negative nominal interest rates are sometimes coordinating.

It is the short and safe ones that should sometimes be negative.   It is pretty unlikely that the long and risky ones (or the expected rate of return on the typical real capital investment) should be negative.

Why Marxist?

Because negative interest rates mean that the wealthy can earn no income from merely holding wealth--postponing consumption--when this occurs.    And I wonder if the complaints we hear from people like Bill Gross are not gripes about the need to make risky commitments to earn capital income.    The "capitalists" are promoting their "class" interest in creating an economy where they can earn a riskless real rate of return.

But really, (as usual) I blame the Fed.   And, of course, their new Keynesian enablers.   The Fed likes to manipulate interest rates, so new Keynesian macro is about manipulating interest rates.   They are seeking to keep inflation and unemployment low.   So new Keynesian macro is a kind of social engineering about manipulating interest rates to optimize an objective function of deviations of inflation from target and real output from potential.  

Bill Gross can say that negative interest rates will fail to create jobs.   Isn't that what the Fed says it is trying to do with low interest rates?  Create jobs?

What the Fed can do and should be trying to do is control total spending on output.  Nominal GDP is probably the least bad measure.   Keeping spending growing at a slow, steady rate is the least bad goal.

There is good reason to believe that a drop, or even a slowdown, of spending on output will result in the "destruction" of jobs.  Or, more exactly, a tremendous slowdown in new hires, which results in net decreases in total employment and a rapid run-up of the unemployment rate.

If that has happened, there is good reason to believe that a prompt reversal and recovery of spending will result in a rapid increase in new hires and a reduction in the unemployment rate.   There have now been three recessions that have occurred with the Fed's policy of inflation targeting, which means no reversal and catch-up.  The recoveries have been very slow and gradual.   (I believe it is the misnamed "jobless" recoveries can be blamed for both Sanders and Trump.)   Fed thinking was little different during the Great Depression.  Sure, they wanted the deflation to end, but then they wanted prices to stabilize at the new low level.   Having prices recover would be "inflation."   Stagnation for years.

Maintaining or returning to an appropriate path of spending on output should never be understood as trying to create jobs or even control inflation.    Market forces must be allowed to control employment as well as the variety of prices and wages in the economy and the levels and rates of changes of indices of consumer or other prices.

In traditional monetary orders, chiefly metallic standards, the market process that generated recoveries from recession involved negative real interest rates and reflation.   Spending on output falls off, prices fall, with deflation causing a lower price level.   As the price level falls below its long run equilibrium, it is expected to rise again.  That is, there is expected inflation-- a reflation of prices.   Even if nominal interest rates cannot fall much below zero, the expected reflation makes real interest rates negative.   Now, this might not be all interest rates.  Risky long term bonds might have positive real interest rates.   But short and safe real interest rates might well be very negative.  This is the market force that causes the economy to bounce back rapidly.

A central bank that seeks to provide paper currency or deposit accounts that are perfectly safe and "free" keeps nominal interest rates from falling as low as they would if the only alternative was gold or silver coin. Worse, if the central bank pays interest on deposits, they can create an arbitrary floor on nominal interest rates well above zero.

And, if the central bank is committed to preventing any reflation, which it can do, even under a gold standard by accumulating sufficient gold reserves--then it keeps real interest rates from turning negative as well.   Inflation targeting under the sort of regime we have today is a commitment to prevent reflation.

I am aware that there is a market process that adjusts to a permanent increase in the equilibrium relative price of gold.   The level of prices and wages are permanently lower.   With an outside money like gold, it can even result in a permanent increase in the interest rate that coordinates saving and investment by a permanent decrease in saving supply.   Wealth held in the form of gold is worth more, and so there is less reason for saving.  

At one time, that was the key to my understanding of the market forces that generated recovery from recession.  (I haven't favored the deflationary wringer as an actual policy for several decades now.)  It is not clear that this market process works when there is no gold or silver base money and there is inflation targeting.   In my view, there is no real outside money.  It is all inside money--some mixture of government and private debt.

Today, I definitely take the view that negative nominal interest rates are better than allowing deflation and then reflation to generate the appropriate changes in real interest rates.    Sure, keeping expected nominal GDP on target might allow for long run price stability with even the shortest and safest nominal interest rates never falling to less than zero.   But it is better that all nominal interest rates be free to adjust with supply and demand.    Having an interest rate targeting central bank keep interest rates above market clearing levels is a bad policy.   Making sure that those holding wealth can always earn a risk less rate of return is not a goal that justifies price fixing.

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