Wednesday, May 5, 2010

Interest Rates as a Market Price

Last March, Charles Schwab had an op-ed in the Wall Street Journal criticizing low interest rates. When laymen, even bankers and other financiers, write about economic topics, I sometimes read the most shocking things. Schwab sees the current situation as the Fed keeping interest rates low to enhance the profits of banks. The problem he sees is that senior citizens are earning too little on their savings.

In April, Toby Baxendale, of the free-market Cobden Center echoed these remarks. He claims:

The imposition of negative interest rates is one way to totally devastate the poor, pensioners, and all people on fixed income. A Keynesian sees this as the lesser of two evils – getting out of the deflation in Japan. Thrifty people who have provided for themselves and for their future should be punished: this is the world of Keynes.

To me, these are perfect examples of the layman's approach to price, supply, and demand. That prices provide the information and incentives necessary to coordinate the plans of households and firms just never crosses most minds. Instead, prices are what the buyer pays the seller. A higher price means the buyer pays more and the seller receives more. The buyer is worse off and the seller is better off. A lower price means the buyer pays less and the seller receives less. The buyer is better off and the seller is worse off.

From this perspective, a low interest rate is about punishing those who have saved. What is the proper level of the interest rate? Presumably, it would be a level that fairly distributes benefits between seller and buyer. In this situation, the seller is the saver. And the buyer? Who is that? The banks?

From an economic point of view, the role of the interest rate is to provide intertemporal coordination between and among households and firms. Roughly, if the demand for investment is less than the supply of saving at the current level of the interest rate, then the interest rate is too high to do its job--coordinate. While it is true that a lower interest rate may "punish" savers and benefit others, providing a just distribution of benefits cannot be the role of market prices if they are too provide for coordination. If saving is greater than investment, the interest rate needs to fall enough until saving and investment are equal.

What is saving? Saving is income less consumption. To save is to spend less on consumer goods and service than is earned from contributions to the production of goods and services. Saving is a flow through time.

Household wealth is net worth--assets minus liabilities. Other things being equal, saving adds to net worth. Households save by accumulating assets, like stocks, bonds, real estate, bank balances, or currency, or else by paying down existing debt.

Households with positive net worth can earn interest income--interest on some or all of the assets they hold less any interest they must pay on their liabilities. The senior citizens and others worrying Schwab and Baxendale have saved and accumulated wealth and are earning interest income.

For a single household, saving provides a valuable service in two situations. In the first situation, other households may value the consumer goods and services more. That is, other households may want to dissave. Dissaving is consumption greater than income. To dissave to to spend more on consumer goods and services than is earned from contributions to the production of goods and services. A household can dissave by borrowing or else by funding current consumption out of accumulated wealth.

In the second situation, the resources that would be necessary to produce the consumer goods and services can instead be used to produce capital goods. The production of capital goods is valuable because they add to the ability to produce consumer goods and services in the future. While the additional output that capital goods can generate is objective, this is only signaled through the market process by particular firms demanding capital goods, and their demands include estimates of the real volume of product they will be able to generate in the future combined with their estimates of what households or other firms will be willing to pay for those products in the future.

If there are no other households who want to consume now and no firms that want to use the capital goods that could be produced with the resources that could be freed up by reduced consumption, then a household's saving is providing no value to anyone else. While thrift, including past thrift, no doubt involved sacrifice, the market doesn't reward people for making sacrifices. Market prices are paid to people for contributing something of value to others.

Suppose an individual household wants to save anyway? They aren't providing any service to anyone else--at least not one that anyone is willing to pay for. Surely, they should be able to save if they are willing to accept zero interest?

Perhaps they "should" be able to save at zero interest--as a matter of "social justice," but the role of market prices isn't to provide for such justice. If an individual household refrains from consuming now and saves, they are building up net worth and an ability to consume in the future. At some future time, whenever they intend to use the saved funds for consumption, there will be a claim on resources to produce those consumer goods. But the people earning income at that time will have every right to use their income to purchase those consumer goods. The person who saved in the past will be making some claim on those future efforts.

Of course, if the saving of one household had been used to provide consumption to other households who had dissaved, then there are others who are obligated to give up consumer goods in the future. Similarly, if the saving had been used to fund investment in capital goods, then those capital goods would be producing extra consumer goods in future.

But suppose the individual household wants to exercise the virtue of thrift and no other household wants to dissave and no firm wants to use the freed up resources for capital goods? Does the saving household simply exploit future households?

Not necessarily.

All that is necessary is that the interest rate become negative. The household who wants to save provides an incentive for other households to dissave through borrowing by paying them. The saving household gives up consumer goods today in exchange for fewer consumer goods in the future. The dissaving households receive consumer goods today in exchange for fewer consumer goods in the future. Similarly, firms using resources freed up by the decrease in current consumption will find projects using capital goods profitable, even if what people are expected to pay for the consumer goods produced in the future are worth less than the current resources used in the project.

For those households earning the bulk of their income from labor, the negative interest rates make saving costly--perhaps prohibitively so. If a household is "saving" because no current consumer goods or service have any value, then the solution is obvious--work less. Enjoy leisure and restrict work hours to what is necessary to purchase the consumer goods and services demanded. Minimize saving and so the interest cost of saving. On the other hand, if households are saving for future expenditures that cannot be pushed into the present, then they will simply have to pay.

I don't want to dismiss that hardship that is faced by those living off of accumulated wealth--from their interest income. With negative interest rates, they have no interest income. All consumption for such households would be dissaving. They would have to sell off assets and use the proceeds to maintain consumption. Those who greatly value future consumption and are willing to pay the negative interest would be buying these assets. It is their competition for those assets that would be driving the yields down to the point where interest rates are negative.

Unfortunately, many people, including some economists, have difficulty thinking about negative interest rates because they assume that people will hold money with a zero nominal yield rather than hold assets with negative yields. Of course, the obvious response is that this entire analysis should be understood in real terms. The lower limit to the real interest rate is the negative of the inflation rate. With an inflation rate of 2 percent, the real interest rate can fall as low as minus 2 percent. With higher inflation rates, even more negative real interest rates are possible.

The current monetary regime has the Fed manipulating short term interest rates to control the inflation rate. The current target for the inflation rate appears to be 2 percent. That means that if the Fed targets short term rates below 2 percent, it is choosing a negative real rate of interest. The lower limit is approximately -2 percent. The current target for the federal funds rate between zero and .25 percent implies a target for the real interest rate (on short and safe assets) of somewhere between minus 2 percent and minus 1.75 percent. Of course, the actual inflation rate has been lower than 2 percent. Still, both the realized and any plaustibe expectation of real interest rates have been negative for some time.

I do not favor having the Fed manipulate nominal interest rates and the inflation rate at all, and certainly not in order to generate expectations of inflation so that some real interest rates are sometimes negative. Market forces should control all nominal market interest rates, and while the Fed should not intervene to lower them, neither should it raise them to keep real interest rates from being negative. Promoting some version of social justice where savers must receive fair compensation for their thrift is not an appropriate role for the monetary authority. If saving equals investment at a negative real interest rate, then the Fed should not intervene in credit markets to keep real interest rates positive.

I favor keeping cash expenditures on a 3 percent growth path. If the productive capacity of the economy grows 3 percent, this provides for price level stability--both zero inflation and a stable price level. However, if the productive capacity of the economy should grow more slowly, or even shrink, then the result would be inflation during that period. If the productive capacity of the economy should return to a 3 percent growth rate, but on a lower growth path, the price level would be higher and the inflation rate would return to zero.

Similarly, if the productive capacity of the economy should grow more rapidly than 3 percent, my preferred monetary regime would generate deflation. If the productive capacity of the economy then returns to a 3 percent growth rate, but on a higher growth path, then the price level will be lower, but the inflation rate will return to zero.

I believe that nominal interest rates should change with supply and demand. The real interest rate, then, would be the market determined nominal interest rate less the expected inflation rate determined by the given rule for aggregate cash expenditures and expected changes in the market-determined productive capacity of the economy.

Given this alternative monetary regime, even if nominal interest rates remain greater than zero, then negative real interest rates would be possible when the productive capacity of the economy is growing less than trend. Of course, there is nothing to prevent nominal interest rates from being greater than the expected inflation rate, so that real rates could be positive in that scenario as well. It depends on supply and demand--saving and investment.

More troubling are the scenarios where productive capacity is expected to remain at trend, but the real interest rate necessary to keep saving and investment equal is negative. Or worse, perhaps productive capacity is expected to grow faster than 3 percent, leading to expected deflation. If the real interest rate where saving equals investment is less than the expected growth rate of the productive capacity of the economy, then the only way for market interest rates to properly coordinate saving and investment is for nominal interest rates to fall below zero. (I am aware that rapid growth in productive capacity plausibly results in high investment demand and low saving supply and so a higher natural interest rate--with perfect information.)

The current monetary regime is based upon tangible, hand-to-hand currency with a zero nominal yield. While other forms of money are quantitatively more important, ultimately, these other forms of money (and for that matter, all debt instruments) are tied to zero-nominal interest currency.

If, on the other hand, the monetary regime is not based upon hand-to-hand currency with a zero nominal interest rate, then nominal interest rates can become negative when necessary to coordinate saving and investment. If other nominal interest rates are negative, and it is impractical to have negative nominal interest on currency, then maintaining an issue of hand-to-hand currency would involve losses for the issuer(s.) With privately-issued hand-to-hand currency, the most likely result would be that no one would issue it. The only money remaining would be transactions accounts, presumably with negative nominal interest rates. Since hand-to-hand currency is especially useful for some types of transactions, these benefits would be sacrificed. It is possible that the conveniences of hand-to-hand currency are inconsistent with low inflation and a real interest rate that coordinates saving and investment.

If, on the other hand, a central bank issues hand-to-hand currency at a loss, then these benefits could be kept. Of course, it is difficult to see how a central bank could avoid having people use currency as a store of wealth. And so, simultaneously, the central bank would be providing a subsidy to savers. In practice, central banks keep nominal market interest rates slightly above zero, but this just means that they generate whatever monetary disequilibrium needed to keep the real rate no lower than the negative of the expected inflation rate.

For the most part, I have been discussing the possibility that "the" interest rate needed to coordinate saving and investment is negative. But, of course, there is not just one interest rate, there are many interest rates. Personally, I am not too interested in possible worlds were the real interest rate needed to coordinate saving and investment remains negative forever. I think this generates paradoxes for the site values of land and perhaps even "treasure" like gold and jewels. I am confident that the real interest rates needed to coordinate saving and investment are usually positive. It is rather that it is possible that the real interest rate needed to coordinate saving and investment over some short run time horizon might be negative. The implication is that long rates should generally remain positive, though short rates might sometimes need to be negative to keep saving and investment equal in the short run.

Further, there is the question of risk. The service that is provided by the individual household who saves is to give up consumer goods now. This either allows dissaving households to obtain those consumer goods now or else frees up resources to produce capital goods which can produce consumer goods in the future. Households that save are making claims on consumer goods in an uncertain future. Risk is necessarily involved. For some household to be able to save without risk requires that someone else bear the risk. If those who bear the risk require more compensation, then those whose risks are covered have less return remaining. While the interest rate that coordinates saving and investment may be positive if the savers are bearing the risk associated with the investment, it is possible that low risk real interest rates need to be negative.

In conclusion, if the real interest rate necessary to coordinate saving and investment is negative, then those providing saving are not providing a service for which anyone is willing to pay. Quite the contrary, they acting now to make claims on others in the uncertain future. Coordinating saving and investment requires that they pay. The real interest rate needs to be negative.

In practice, however, the savers who worry Schwab and Baxendale, are people who are trying to play it safe by keeping their wealth in short term, low risk assets. Over the last few years, the real interest rate on 10 year, BAA corporate notes increased sharply during the worst of the crisis, and remain relatively high. They have remained well above zero. People willing to share some risk and make the sort of commitment of resources through time needed to fund real investment projects can earn a real return. The "problem" is that those who want to bear little or no default risk or make any commitment of time are unhappy about the negative real yields on Treasury bills and FDIC insured bank deposits.

Who is supposed to bear this risk for them? In my view, no one. Sometimes some real interest rates should be negative.


  1. Aren't you doing a disservice to Schwab and Baxendale? Surely their belief is that interest rates are being kept artificially low.

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