How Low Can It Go? Negative Interest Rates

Negative Interest Rates? Do you think this is a good deal? It certainly sounds good if you are on the borrowing side, but not so good if you money is in a savings account. This does not make sense, does it? This must have something to do with the flations: inflation or deflation – right? Pleas read Professor Bill Woolsey’s article below to better understand the economic history and current situation to help you determine whether it is time to borrow and buy now or save your money to buy when you can afford it. Read “How Low Can It Go? Negative Interest Rates”.

By Bill Woolsey, Special Economic Correspondent of The Free Enterprise Foundation

Harvard economist Greg Makiw recently proposed to randomly make money worthless. Periodically, the Fed would announce that dollar bills with randomly-chosen serial numbers would no longer be accepted for deposit. If that happened to one percent of the currency each year, everyone could expect to take a one percent annual loss from using currency. In a similar approach, almost a century ago, Silvio Gesell proposed requiring people to periodically buy a special stamp to place on each dollar bill in order for it to be used. If the stamp cost a penny, and one must be added each year, then the annual cost of using currency would be one percent.

There is a method to what may appear madness. Rather than seeing these as proposals to tax currency, consider interest rates. Usually, lenders earn interest. Putting money in a savings account is a loan to the bank that earns interest. Borrowers pay interest. Obtaining a loan to finance a car requires monthly payments including both principal and interest. The nominal interest rate is the amount of money transferred between borrower and lender beyond repaying the principal. The real interest rate is the amount of purchasing power transferred between borrower and lender. Finding the real interest rate requires an adjustment for the purchasing power of money—the nominal interest rate minus the inflation rate.

Nominal interest rates are almost always greater than zero—borrowers pay money to lenders. However, last December, there were a few days when some Treasury bills had negative yields. By holding those bills, the investors were paying to make a loan. Real interest rates are often negative. For more than a decade, the Federal Reserve has tried to keep the inflation rate at about two percent. Sometimes, low-risk, short-term interest rates have been lower. Lenders give up real purchasing power to make a loan.

How does this relate to currency, the paper money that is used to make small, face-to-face purchases? Paper money is a method of borrowing by the issuer. It is a loan made by those who use it by receiving, holding, and then spending it.

Before the Civil War, all paper money in the U.S. was issued by private banks obligated to pay it off with gold or silver. The banks were borrowing, but they hardly ever paid interest. They were borrowing at a zero nominal interest rate. Long ago, governments began to scheme to grab this source of interest free loans.

Today, the Fed has a monopoly on paper currency, and because the U.S Treasury obtains most of its profit, the government now obtains most of the benefit. Since the Fed aims for two percent inflation, the issue of currency allows the government to benefit from borrowing at a -2 percent real interest rate.

These arrangements occasionally lead to serious macroeconomic difficulty. Interest rates are market prices that need to coordinate the choices of millions of households and firms. If interest rates are at the proper level, their plans will mesh. If not, there will be disruption—shortages or surpluses on the market. Because households and firms can always “lend” to the Fed at a zero nominal interest rate by just holding onto currency, no other nominal interest rate can fall much below zero. This is called the “zero nominal bound.” Under normal circumstances, when people expect that the Fed will generate two percent inflation, that results in a -2 percent lower bound on real interest rates.

If all credit markets clear at nominal interest rates above zero, the economy works well. Two sorts of problems can develop, however. While the Fed seeks two percent inflation, actual inflation varies. If the result is deflation—a negative inflation rate—real interest rates can rise. For example, between October and November of 2008, the CPI dropped at a 23 percent annual rate. The 4-week T-bill yield fell from a less than ½ percent to .2 percent. While the nominal interest rate was very close to zero, the real interest rate was about equal to the 23 percent deflation.

Credit markets might sometimes require a negative real interest rate. The most likely scenario would be great uncertainty about the future. While few households want to borrow funds they may not be able to repay, many households want to save in order to maintain future consumption. Similarly, firms save current profits and avoid borrowing because of fear of future loss. The resulting increase in the supply and decrease in the demand for funds will lower nominal interest rates. With sufficient fear, the nominal interest rate can hit the zero bound, and the real interest rate will equal the negative of the expected inflation rate. If credit markets don’t clear, then spending, sales, production and employment can collapse.

Worse, some interest rates may be at the zero nominal bound while others remain well above it. For example, if investors shift away from risky and long term assets to low risk and short term assets, some nominal and real interest rates will rise and clear markets, but there could remain a shortage of the safe and short term assets when their yields hit the zero nominal bound. It is not at all unreasonable for people to be willing to pay in order to temporarily keep their funds safe and liquid. For example, last Fall, many people sold stocks and bought T-bills, waiting to see what would happen to the stock market.

The ideal solution is for nominal interest rates to be negative whenever necessary to clear markets, but this cannot occur if the Fed issues currency at a zero nominal interest rate. Randomly making currency worthless or requiring stamps on currency are too inconvenient to be realistic solutions. Fortunately, the recession appears to be easing. The Fed had plenty of room for further quantitative easing and didn’t have to pay interest rates on reserve balances. Still, allowing nominal interest rates to clear markets—even when negative—would help avoid future economic disasters.

Copyright © 2009 by William Woolsey and The Free Enterprise Foundation. All rights reserved

About the author: Professor William Woolsey a regular contributor to The Mercury and a member of The Free Enterprise Foundation's editorial staff and senior writer on national economy reporting. Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress. Copies of his earlier columns can be found The Free Enterprise Foundation.

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