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Wednesday, June 3, 2020

Closer to Negative Interest Rates, Part 1

The money printing that follows in the footsteps of the CARES Act and other coronavirus stimulus bills, is pushing our country and its economy to a place we don't want to be: negative interest rates. This is the first of two articles about what this means in reality.

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Here we go... On the one hand, reports CNBC:
Getting the U.S. economy back to strong growth could require negative interest rates, according to a St. Louis Federal Reserve economist. As many economists dismiss the likelihood of the current record-breaking slump being followed by an equally aggressive recovery, central bank economist Yi Wen said in a paper on the St. Louis Fed’s website that achieving that kind of a rebound is necessary and possible.
On the other hand, they say:
The key, he said, is using aggressive stimulus even beyond what authorities deployed during the financial crisis, and that could include taking interest rates below zero. Wen compared the response to two major U.S. economic downturns: the Great Depression and the financial crisis. He found that the use of aggressive fiscal response through President Franklin Delano Roosevelt’s New Deal helped generate a V-shaped recovery after the Depression, while primarily monetary responses like low interest rates and Fed asset purchases during the financial crisis produced an L-shaped recovery in which GDP failed to reach potential.
In his original paper, economist Yi Wen compares long-term growth rates to actual growth rates in an effort to make the case that America needs more fiscal and monetary stimulus. His argument is concentrated into the following figure:



Figure 1

Source: Federal Reserve Bank of St Louis

In addition to more government deficit spending, Yi believes that our economy needs negative interest rates. He explains:
I found that a combination of aggressive fiscal and monetary policies is necessary for the U.S. to achieve a V-shaped recovery in the level of real GDP. Aggressive policy means that the U.S. will need to consider negative interest rates and aggressive government spending, such as spending on infrastructure.
I am surprised every time I see an economist advocate negative interest rates without looking at how sadly ineffective they have been in Japan and, in particular, the euro zone. Especially the European case should be a big red flag for anyone venturing down below zero interest rates.

If someone chooses not to care about empirical evidence, there is still a strong theoretical argument to be made against negative rates. It does not matter if you are a Keynesian or an Austrian - economic theory still does not support negative interest rates. But even if we don't The concept at the center of this debate is the liquidity trap, which I recently explained in a two-part article. Then we have the very purpose behind all that monetary stimulus, namely welfare-state spending that actually hampers growth and makes it even harder for the economy to catch up with its long-term path.

Again, this last point depends on the premise that there actually is a long-term growth path for the economy. That is not the case. Yi Wen, like so many other econometricians, likes to suggest that such a path exists. They need it in order to anchor their model around a rigorous solution in their forecasts. That does not mean there is a long-term growth path - there isn't - but it does not stop econometricians from making that very ontological leap of faith.

Furthermore, mainstream economic theory is built around the idea that there is a long-term general equilibrium. This has to do with price theory and the difference between, on the one hand, new classical macroeconomics and on the other hand heterodox theory. Without delving into that debate here, it is important to note the consequences of the difference:
  • Heterodox theory concludes that there is no such thing as a long-term general equilibrium; instead, the economy is in a process of constant, organic evolution that does not lend itself to rigorous quantitative analysis above the microeconomic level;
  • Orthodox theory - where new classical macroeconomics belongs - concludes that because economic agents have perfect foresight (except for isolated instances of imperfect information) the economy always, automatically reverts back to its full-employment, long-term trajectory.

The case for negative interest rates is based in the orthodox tradition. There, government spending does not weigh down the economy, but actually stimulates growth by means of two transmission mechanisms. The first is the fiscal multiplier, according to which government spending stimulates growth roughly in the same way private consumption does. There is no account for the loss to growth and efficiency in the use of economic resources.

The second transmission mechanism is the interest rate. It is often assumed - usually without much evidence - that negative interest rates stimulate the economy in the same way as positive interest rates do. Specifically, a cut in interest rates from zero to minus one percent would generate the same growth in investments as a cut from four to three percent.

First of all, there is very little evidence, if any at all, that changes in interest rates have any discernible effects on business investments. You can generously explain about a dime of every new dollar in increase in investments by a lower interest rate, but that does not hold for negative rates. The reason is partly the negative rate per se, partly the macroeconomic environment within which negative rates appear.

A negative interest rate signals losses on long-term financial commitments. Whoever wants to borrow money at a negative interest rate will have to convince the lender that it is worth the risk for him to lend money at a loss; at zero risk, a negative interest rate means that the lender gets less back than the loan he initially gave out. The higher the risk, the more he potentially stands to lose. All other things equal, the supply of credit shrinks while demand for it rises.

The only source for new credit will be the one that the central bank provides through the commercial banking system. The Federal Reserve provides banks with cheap credit that they, in turn, can lend to, for example, non-financial corporations for capital formation. The problem is that our banks are already overloaded with marginally performing equity in the form of Treasurys; they don't want more of that. Even if the Federal Reserve gives away money - again the definition of negative interest - the only way banks could make money is by giving away less of it. The margins are simply too slim to make it worth the while.

Our banks already have access to dirt-cheap Federal Reserve funding, and they are lukewarm at best toward it.

And this is all, again, before considering the macroeconomic environment of negative interest rates. More on that in Part 2. For now, let us return briefly to the CNBC article, which quotes Federal Reserve chairman Colin Powell and other Federal Reserve officials as expressing
strong doubts about whether negative interest rates would ever be used in the U.S., as they have in Europe and Japan. They cite little evidence that below-zero yields are effective, and Powell pointed out, in a discussion last week, that they tend to be detrimental to banks. “We don’t think that’s an appropriate tool here in the United States,” Powell told former Fed Vice Chair and now Princeton University economist Alan Blinder. “I would say the evidence on whether it actually works is mixed. There are clearly some negative side effects, as there sometimes are with these things, and it’s just not clear to my colleagues and to me on the Federal Open Market Committee that this is a tool that would be appropriate to deploy here in the United States.”
That is good news, but it is also worth mentioning that the interest rates on Treasurys are below one percent for all except the bonds maturing in ten years (1.32 percent) and 30 years (1.56). They have been so since late March.

However, the Damoclean Sword of negative interest rates is going to continue to hang over our economy so long as Congress refuses to go into fiscal rehab for its deficit addiction.

More on this in Part 2, where we will discuss the macroeconomic environment of negative interest rates.

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