May 24, 2003

A Question About the Zero Bound on Nominal Interest Rates

Kevin Drum asks what he describes as a "really dumb question":

CalPundit: Interest Rates: Now, I know this is a really dumb question (and yes, contrary to popular wisdom, there is such a thing as a dumb question), but why is this so? Why can't the Fed have negative interest rates? Walk up to the discount window, borrow a million dollars, and next month when it comes due you only have to pay back $900,000. Banks would then have an incentive to loan out this money at a negative rate too. As long as their rate was less negative than the Feds, they'd make money on the deal...

The problem comes at the second stage of your thought experiment. Yes, the Fed can loan money at negative nominal interest rates to banks. But the banks then have an incentive to simply put the cash in their vaults and keep it there. They could loan it out at negative interest rates and make money (as long as there was a spread), but they would make more money if they did not lend it out and just squirreled it away.

To break this greater incentive for banks not to squirrel the cash away, you need to do something to the money: put a microchip with a timer inside each dollar bill, and require that you pay the Federal Reserve one cent each three months to keep the bill "active" or it expires--that kind of thing.

But without such interesting expedients to make it costly to keep money in the vault or under the mattress, no central bank can ever push a market nominal interest below zero: the fact that you can make more profits by simply hoarding then by lending it out at a negative interest rate prevents it from happening.

Posted by DeLong at May 24, 2003 10:46 AM | TrackBack

Comments

If the Fed ever did begin lending at negative interest rates, consumption of loans from the Fed would quickly approach infinity.

Posted by: pj on May 24, 2003 11:31 AM

What if the Feds would lend to consumers and small business directly - at prime rate? Why screw around with the middleman? Oh, I know why. Because artificial scarcity of cash is the foundation of wealth for some very politically influential groups. And while Economists talk a lot about how terrible it is for sick old people to feel _entitled_ to medical care, the natural workings of the free market provide, naturally, that Chase and Citi get access to loans from the Feds at rates below what they will charge.

Posted by: citizen k on May 24, 2003 11:49 AM

At the risk of pushing the envelope too far, what about the possibility of having indexed financial instruments including bank reserves and cash. I'm not sure about the mechanics but wouldn't this make the absolute level of the nominal interest rate and inflation rate not relevant but only their difference? I'm sure there is something wrong with my query here, but I'm not sure what

Posted by: Hal McClure on May 24, 2003 12:46 PM

citizen k, the artificial scarcity of cash is not just the foundation of wealth for some very politically influential groups (though it certainly is), but the foundation of wealth for pretty much our entire society. I have no idea how I'd be able to carry out the commercial transactions that make the more interesting parts of my life possible without drastic artificial scarcity of cash. I suppose I'd be trading in gold or bartering or something.

And... uh... the Fed Funds rate and the discount rate have been pretty much synchronized. Since the FF rate, while pushed by the federal reserve, is not determined independently of financial markets as a whole (yes, the fed funds rate is very low, but inter-bank, overnight loans are also very low risk and very short term, so that's exactly what you'd expect, and open market operations also push the interest rates of other loans aound), so the discount window doesn't really subsidize banks that much, unless you consider the entire financial market subsidized by the Fed's open market operations.

Unless I'm confused, that is.

Though really, I suppose that if the situation were drastic enough (I don't think it is yet, nor do I anticipate it becoming so), the idea of the Fed loaning money at negative nominal interest rates directly to businesses and consumers might not be a bad idea, though there's the risk that THEY'LL sit on it, and, of course, I think that there's a high risk of.. erm... politically motivated loans when you have the Fed loaning money directly to people other than the government.

Hell, why bother with trying to get other people (small businesses and consumers, you suggest) to spend money when there's the risk that they'll do what banks would do: sit on it as nominal cash accumulates? Why not just have the government spend money directly, and have the central bank buy a lot of its bonds? At least there, there's not the risk of the government sitting on the money, since it's basic interest is not in enriching itself (enriching it's MEMBERS, perhaps, but probably not itself).

Posted by: Julian Elson on May 24, 2003 12:54 PM

(Mostly cross-posted to Kevin's comments)

Re your idea of breaking the incentives to hoard by "requir[ing] that you pay the Federal Reserve one cent each three months to keep the bill "active" or it expires."

Me possibly thick-headed, but isn't that a 4% (compounded annually) interest rate? (Less for larger bills, of course.)

I suppose the idea is that, if you give the bill to someone else, the clock resets. I'd guess that would lead to a lot of transactions where Bank A asks Bank B to break a billion twenties.

Posted by: Matt Weiner on May 24, 2003 01:03 PM

Actually, I was pondering why you couldn't do this in a deflationary environment, since that's what Krugman was talking about.

If deflation is running at -10%, you'd be better off loaning the money at -5% than just hoarding it.

Still lots of problems with this, I understand. But in principle isn't this true?

Posted by: Kevin Drum on May 24, 2003 01:29 PM

Nope. If deflation is running at 10%, then if you hoard a dollar in your mattress for a year, you've made 10% in real terms: your dollar now buys 10% more stuff.

If *inflation* is running at 10%, then that does act as a powerful spur to investment.

Posted by: Brad DeLong on May 24, 2003 01:32 PM

You can avoid the mattress-stuffing problem with an outlandish and totally impractical but low-tech solution. Have the Fed coordinate with the Bureau of Engraving and Printing to have dollar bills printed in each month be a different color. Thus, in May, a pinkback would be $1.00; in June, $.95; etc.

Posted by: Paul on May 24, 2003 02:13 PM

Is there any accuracy to the notion that capitalism cannot be sustained within a closed system that has limited resources without going into negative interest rates?

Posted by: Andy on May 24, 2003 02:26 PM

http://www.theage.com.au/articles/2003/01/28/1043534055981.html

ABN Amro Bank NV said it had loaned two other overseas banks 14.5 billion ($A207 million) at a negative rate, paying the borrowers to unload excess yen.

Posted by: Old European on May 24, 2003 02:51 PM

Erm, if you are lending money at -10%, does that mean that if you pay it back after a year, you only need to pay back 900,000, after 2 years, 810,000, etc? Or is a fixed limit on on the time that one can pay back the loan implied?
If there is no limit, it looks more like giving away money.

Posted by: Factory on May 24, 2003 03:07 PM

Erm, if you are lending money at -10%, does that mean that if you pay it back after a year, you only need to pay back 900,000, after 2 years, 810,000, etc? Or is a fixed limit on on the time that one can pay back the loan implied?
If there is no limit, it looks more like giving away money.

Posted by: Factory on May 24, 2003 03:07 PM

Erm, if you are lending money at -10%, does that mean that if you pay it back after a year, you only need to pay back 900,000, after 2 years, 810,000, etc? Or is a fixed limit on on the time that one can pay back the loan implied?
If there is no limit, it looks more like giving away money.

Posted by: Factory on May 24, 2003 03:10 PM

It isn't just ABN Amro, of course. I remember from Reuters that Socgen and BNPParibas have traded at a negative rate as well. So probably most foreign banks have done so.

Don't forget Switzerland in the 1970's, where foreign banks were charged a negative interest rate.

People think you can avoid negative interest rates by putting dollar bills in a mattress, but there is a cost to that - you risk losing them in a fire, or have them stolen. For large sums you do have to keep your money in a bank - or be willing to take a large amount of risk. (So probably the limit on how negative rates can be is the cost of insurance. 5% seems too high.)

Posted by: Andrew Boucher on May 24, 2003 04:09 PM

Paul--But can you trade the pinkbacks in for the greenbacks 1-1? If not, then you're not really lending at negative interest rates; if so, then you're just creating long lines at the bank at the end of the month. Well, nobody's actually proposing this.

Andrew B and Old European--Can you explain, to a neophyte, how this works? For instance, are the banks betting that the yen will deflate faster than their negative interest rate?

Posted by: Matt Weiner on May 24, 2003 04:47 PM

Negative interest loans are generally "concessionary" loans: one institution is really giving money to another for one of two reasons. One is to get dead assets off their own books, the other is to get another party to do something.

Generally such negative loans are structured, not as loans with negative rate, but as a loan with a low rate, and a tax credit, subsidy or other incentive to make sure the money was used for the intended purpose.

The point on negative rates applies then, not to specific transactions which are structured as loans, but for general interest rates.

Posted by: Stirling Newberry on May 24, 2003 06:43 PM

If I'm recalling my economics courses correctly, the Fed doesn't actually control interest rates (except for the discount rate) directly. What they control is the money supply, which affects interest rates.

The Fed can create money at will and use that to buy bonds on the open market, or destroy it by selling bonds and taking the money out of circulation. Typically, they use their powers to target a desired interest rate level which will supposedly keep the economy on track.

So what's the problem? If there's danger of a liquidity trap, the Fed can make more money and use it to buy back bonds, which will take care of the debt load (enabling more expansionary fiscal policy) while getting people spending. Now, normally the Fed doesn't do this because all that extra money in circulation leads to inflation, but in a liquidity trap situation, you WANT inflation. It's a win-win all around.

Japan is in a pickle because their policymakers are so irrationally afraid of inflation that they are unwilling to get the printing presses rolling. That doesn't mean we have to be that way.

I'm just an undergraduate econ minor. What am I missing?

Posted by: Ben Adams on May 24, 2003 07:15 PM

Printing more dollars alone won't cut it because more dollars alone will not stimulate demand. In deflation, it still pays to save those dollars rather than invest. Just because there are more dollars around does not mean it is a good idea to buy a house for $250,000 this year that will only be worth $225,000 next year.

Wage inflation would help. This is where government money for infrastructure that requires labor would help. By driving up wages, demand will rise and overcapacity becomes more expensive shaking out the excess. As the least productive facilities responsible for overcapacity go belly up, then capital is freed for other endeavors. It takes a strong fiscal commitment from the government to ensure that the unemployed workers don't go under due to economic dislocations of the transition period. This is the part that the Bush administration does not get.

Posted by: bakho on May 24, 2003 08:01 PM

bakho--
Wouldn't that policy reduce unemployment overall, because people have to work on the infrastructure?

Stirling--
It looks like ABN Ambro was trying to unload yen. Don't know if that's what you mean by "dead assets." This passage:
"ABN Amro loaned money at a negative rate on Friday after reaching a self-imposed limit on the amount of cash it could keep at the BoJ. The bank capped the amount of cash it could hold at the central bank last year after Japan's credit rating was lowered."
makes it sound as though Amro is considering the possibility that BoJ might fail, so they don't want to have too much in it. (The equivalent of the mattress catching fire?) Is that right?

Also, anyone who can explain this:
"The Dutch lender still made a profit on the overnight yen loans because the rate at which it borrows US dollars is even lower, at minus 10 basis points."
feel free. (That can't mean that the rate on US dollar loans is negative, can it?)

Posted by: Matt Weiner on May 24, 2003 09:39 PM

Andrew,

Large scale conversions of bank assets to cash aren't exactly uncommon; see Argentina within the last few years, and the United States during the Depression before the Bank Holiday (among many, many other examples).

Matt,

Simply establish that all existing "greenbacks" will be arbitrarily considered to be the "April" color, discounted accordingly. Then, May will have pinkbacks, June will have lavenderbacks, and so on until we reach the ludicrous concept of printing our money on peach paper.

What? We're already doing that?

Posted by: Paul on May 24, 2003 10:14 PM

this 'negative interest rate' thing seems to me just an awkward way to discuss measures that actually are much like Milton Friedman's 'helicopter drop', i.e. printing money and regularly drop them on households until inflation rises to desired rate.

Posted by: Mats on May 25, 2003 11:03 AM

Cool. ABN Amro lent at negative rates because of counterparty risk with the BoJ. In other words they preferred to pay another bank to look after their money to insure against the risk of a default by the Bank of Japan!

Posted by: Jack on May 25, 2003 04:55 PM

Um, maybe I'm missing something, but it seems to me that a rule on the banks requiring them to loan at at a negative interest rate is otherwise called a redistributive tax.

Question comes up...could this bizarre form of negative income tax be sold to the current government, perhaps under the name of a bank user fee? I have the awful feeling it might be possible.

Posted by: Randolph Fritz on May 25, 2003 05:36 PM

Ben -

Actually, that's a bit of undergraduate textbook hokum. The fed does not "control" the money supply. The mechanism you describe is accurate, but if you trace it through you'll realiize that the Fed operates in a completly reactive role: if there's a general shortage it must supply enough reserves for all banks to meet their reserve requirements, and if there is a general excess it must withdraw enough reserves to maintain non-zero interest rates. It can target interest rates fairly easily, but since the money supply shrinks and expands based on the lending and investment decisions of private individuals, in practice the Fed cannot control it, and after the disastrous monetarist experiments of the early 80's it no longer tries. (I always think of the Fed as being like an electric utility: it can set the voltage on the line (interest rates), but it must continually adjust the current it supplies (reserves) in order to maintain that voltage. So even though all current comes from the utility's generators, when someone flips a light switch, it doesn't have discretionary control over whether or not it will supply the current to turn it on...)

Posted by: jimbo on May 25, 2003 08:45 PM

Dear Brad

Please read new the tax cut analyses on the Brookings website. This is frightening stuff. Whatever have we done?

Anne

Posted by: anne on May 26, 2003 06:51 AM

It's also important to consider popular attitudes regarding money if you're going to consider negative interest rates because of the control it implies. Normally, paper money works out ok because positive interest rates give everyone (but thieves) an incentive to 'register' their savings with the economy. But with negative interest rates this registration needs to be enforced to allow for removal of interest. And people aren't going to like this, whether it is done by having tangible money decay or if it is done by allowing only electronic money, because they will consider it to be a govenrnment taking away their money which they have the right to possess.

Also, the end of ordinary 'anonymous' paper money is considered by some to signal the coming of Armageddon. They would pretty much consider any intrusion into their ability to hold a bill in their pocket to be a sign of this and would oppose putting chips into their money or having to keep their money registered with some institution. Privacy zealots would also freak out over steps such as these as they might be perceived to lead to or potentially lead to loss of privacy from governments or corporations.

A quick web search turned up some organizations which would not be too happy if time decay chips were implanted in their money. To them it would just be the next step.

http://www.endtimeprophecy.net/~tttbbs/EPN-1/GroupPages/grupmrk1.html

http://www.countdown.org/end/mark_of_the_beast_02.htm


Posted by: snsterling on May 26, 2003 11:37 AM

Millenial sects: An unexpected reason to favor pinkbacks!

Posted by: Paul on May 26, 2003 01:08 PM

"I have no idea how I'd be able to carry out the commercial transactions that make the more interesting parts of my life possible without drastic artificial scarcity of cash."

Why do you consider the scarcity "artificial?"

Is it because printing presses could print a whole lot more of it (which would result in requiring much more of it for each unit of product to be purchased)?

If the printing presses printed a whole lot more money, why not consider it to be an "artificial glut," rather than an absence of an "artificial scarcity"?

Posted by: Mark Bahner on May 26, 2003 01:29 PM

"Japan is in a pickle because their policymakers are so irrationally afraid of inflation that they are unwilling to get the printing presses rolling."

My thinking about Japan is that it's possible that their policymakers aren't making a mistake, so much as they are rsponding to the desires of the Japanese people.

Since Japan is a nation of heavy duty private savers, and savers that are increasingly closer to retirement (as Japan ages, without young people being born), the people of Japan definitely don't like inflation. A person who is retired, on fixed income, actually prefers deflation, if they have some savings.

So I think the Bank of Japan is simply doing what many Japanese people want.

Posted by: Mark Bahner on May 26, 2003 01:49 PM

snsterling--
I'm no millenarian--I'm a straight-up liberal Democrat, more or less--and I'd object pretty strongly to microchips in paper money too. I suppose, since I use my debit card so much, that the government wouldn't have much trouble keeping track of my financial transactions. But I think it would be a civil liberties nightmare if the government kept track of every piece of cash in the country.

(Mind you, no one's suggesting the microchips seriously around here, I don't think; if I'm following the discussion, the microchips still wouldn't be enough to make negative interest rates practical.)

Posted by: Matt Weiner on May 26, 2003 04:41 PM

Well the microchip idea may not be practical, but how would you feel if debit/credit cards were the only way to pay (assume the costs of this service were kept down by enforcing free competition). Would you be opposed to the elimination of anonymous cash transfers if the government would only have the same access to your financial transactions as they do currently? (obtaining court's permission to access your bank or credit card statements I suppose is now needed)

It would probably control crime in addition to forcing cash holders to shop around for the best rate even if that happened to be -3%. Do law abiding citizens really have anything to worry about? And is it so bad if practices such as paying someone off the books were stopped because fo this?

Posted by: snsterling on May 26, 2003 08:45 PM

jimbo:

I thought the "monetarist experiments of the 80s" weren't really monetarism, but a particularly severe version of a standard contractionary policy dressed up to look like monetarism.

As to "undergraduate textbook hokum" well, I guess that's why they're not letting guys with undergraduate-level understanding of economics make economic policy. Hrm, except for fiscal policy, which seems to be run by guys who know less than I do.

Posted by: Ben Adams on May 27, 2003 01:52 AM

The artificial scarcity of cash is due to centralized control of finance. While from 50,000 feet up one may see a generalized availability of credit at a certain rate, there are major regional, racial, business sector, and other variations that have negative effect on the economy, but accord with the bureaucratic structure of the concentrated lending firms. Obviously, bigger firms prefer larger financial transactions, since this allows them to centralize operations and avoid the expense associated with a lending office in each neighborhood. But there is a social cost to this. Instead of a small business in South LA or Whynot North Carolina looking for capital at its local thrift, capital can only come from a transnational that is going to be both socially and economically disposed to prefer investing in some larger scale trade on the international market. When you toss technology in the mix, it gets even worse. To evaluate a loan application by a LA machine shop to invest in an R&D effort to make low cost textile manufacturing robotics would take a high level of technical expertise. So imagine a black woman from LA asking for $1M for expanding her machine tool business - asking a bunch of inbred white boys with MBAs from the same three schools to take a risk with their own careers by investing out of step in something they have no ability to understand, in a neighborhood they'd be afraid to visit, on a small transaction that won't help them if it works out and that will be harder to securitize.

Posted by: citizen k on May 27, 2003 03:14 AM

Well, the unbanked amoung us already often are forced to pay 2-3% to cash paychecks (consulting clients checks in my case). One of my regular clients is no trouble, their bank cashes their checks to me. Another banks with the evil Wells Fargo, who, in a devilish twist, won't cash checks to me as I only have a drivers license for ID (no credit card, do to a double whammy of a divorce and a business insolvency in one year).

So I have to go to a check cashing place to cash those, at a 3% fee. Insane.

Now, if you implemented anonymous digicash, and/or mandated a strictly debit card for the currently unbanked, you could in practice remove cash from the picture.

Barring the wacko's concerned about The End Times of course.

But 3% to spend cash that I already have to pay 3% to get in the first place would be madness.

Posted by: Name Withheld on May 27, 2003 03:39 AM

Brad DeLong's comment about how the endogenous dynamics of money supply creation reach a sort of tipping point at zero nominal interest rates is really interesting. I'd never thought of it that way. Scary.

Another point. Liquidity as we head for zero nominal interest rates is at an all time high. Not surprising:

http://www.cm1.prusec.com/yararch.nsf/(Files)/sta210.pdf/$file/sta210.pdf

Posted by: Jim Harris on May 27, 2003 09:44 AM

I think Mark Bahner's response to citizen k's comment about 'artificial scarcity of cash' is almost on the point. In the sense that 'all things that exist' are by their very nature limited, cash is not infinite. Further, since our desires are open ended, cash will always be 'scarce.'

Since cash, i.e., paper money, is no longer tied to anything tangible, like gold, silver or other precious things, you can argue that cash doesn't really exist. The amount of 'cash,' in this scenario, is totally arbitrary.

Running the printing presses so that there is no 'artificial scarcity' of cash would enable those who participate to enjoy a reprise of the German economy in the 30's.

Welcome to rampant inflation.

Posted by: George JP JAcobs on June 1, 2003 05:17 PM

"artificial scarcity of cash" - money is just a tool used to measure (imperfectly) one good or service against another. So it allows me to make calculations like "if I work for one hour I can buy one book, or a meal out" or whatever good or service you want to buy. The amount of goods and services in the economy is finite, because the resources available in the economy is finite (growing over time with increased human ingenuity, but still finite). If people want more goods and services than is available, then there is going to be scarcity.

Cash is scarce because goods are scarce. If it wasn't scarce it would be no use for using as a measurement for necessarily scarce goods. Read Douglas Adam's books, I can't remember what book but he has a nice bit where a group of people decide to use leaves as money and are shortly all very rich but face a small packet of peanuts trading at about three forest-worths of trees.

Posted by: Tracy on June 18, 2003 09:25 PM

"artificial scarcity of cash" - money is just a tool used to measure (imperfectly) one good or service against another. So it allows me to make calculations like "if I work for one hour I can buy one book, or a meal out" or whatever good or service you want to buy. The amount of goods and services in the economy is finite, because the resources available in the economy is finite (growing over time with increased human ingenuity, but still finite). If people want more goods and services than is available, then there is going to be scarcity.

Cash is scarce because goods are scarce. If it wasn't scarce it would be no use for using as a measurement for necessarily scarce goods. Read Douglas Adam's books, I can't remember what book but he has a nice bit where a group of people decide to use leaves as money and are shortly all very rich but face a small packet of peanuts trading at about three forest-worths of trees.

Posted by: Tracy on June 18, 2003 09:30 PM

If nominal interest rates were below zero, that would create a demand for dollars. But that won't create a supply of dollars; that is fixed.

Money sitting in a bank account doesn't count as cash, it is actually an investment, and banks can set whatever negative interest rate on this they want. Only real folding money is guaranteed to pay (or cost) 0%. The existence of cash doesn't really matter to this discussion because there simply isn't enough physical cash to honour all the bank balances. People will be forced to use banks because they won't be able to get cash; and lots of banks already pay negative interest (i.e. service charges) on cash.

If the government tries to print enough money to satisfy demand, you'll get inflation; and there goes the negative inflation rate, at least until everyone has all the cash they want. Now, I can't quite imagine an economy where everyone insists on being paid in cash, but I don't think there is any inherent reason that it is impossible. It is certainly possible to charge negative nominal interest rates.

There is no reason to think that negative nominal interest rates are fundamentally different than positive nominal interest rates. Aren't we taught that real rates matter, not nominal rates? Why should the sign of the nominal rate matter? I think society could adjust to negative nominal interest rates, just like Brazil adjusted to high nominal inflation. If loan agreements are drafted that require that loan balance cannot increase in real terms, that will take care of handling negative nominal rates.

For example, suppose the nominal rate is -5% and the inflation rate is -10%, yielding a real rate of 5%. Someone borrows $100,000. After a year, their account is credited with $5000 and their balance is now $95,000 (i.e. the lender "charged" the negative interest payment). But this balance is higher in real terms than the original balance. Because of deflation, the original $100,000 is now equivalent to $90,000. Since the loan contract requires that the real balance doesn't increase, the borrower is required to pay $5000 to the lender. So, the lender earned $5000 (the real interest rate), and the value of the borrower's outstanding balance is still the same in real terms. This is no different than a positive interest rate environment, and anyone who is willing to lend at a real rate of 5% will be happy to make this loan (assuming they can't invest in better-yielding cash instead).

Everyone seems to think that borrowers are only required to pay nominal interest on their loan, and ignore the outstanding balance; then use this common loan agreement to argue that negative interest rates are bad because they raise rather than lower the real debt burden with time. Well, it is only a happy coincidence that covering the nominal interest rate will cause the real outstanding loan balance to decline over time when inflation is positive; the same effect can be achieved with legal agreements in a negative inflation environment. There are already agreements like this in place for most consumer loans; you have to repay a little principal with most mortgage payments after all.

We have never seen an economy with negative interest rates, so there are no procedures in place to deal with them (just like hyperinflation makes fixed-rate loans very risky). But I don't think there is any inherent reason that we couldn't create rules to deal with it. I am still not convinced that nominal rates don't matter when they are positive (real rates matter), yet they suddenly do matter when the sign changes. I think nominal rates never matter.

Posted by: jimsum on September 9, 2003 01:39 PM

If nominal interest rates were below zero, that would create a demand for dollars. But that won't create a supply of dollars; that is fixed.

Money sitting in a bank account doesn't count as cash, it is actually an investment, and banks can set whatever negative interest rate on this they want. Only real folding money is guaranteed to pay (or cost) 0%. The existence of cash doesn't really matter to this discussion because there simply isn't enough physical cash to honour all the bank balances. People will be forced to use banks because they won't be able to get cash; and lots of banks already pay negative interest (i.e. service charges) on cash.

If the government tries to print enough money to satisfy demand, you'll get inflation; and there goes the negative inflation rate, at least until everyone has all the cash they want. Now, I can't quite imagine an economy where everyone insists on being paid in cash, but I don't think there is any inherent reason that it is impossible. It is certainly possible to charge negative nominal interest rates.

There is no reason to think that negative nominal interest rates are fundamentally different than positive nominal interest rates. Aren't we taught that real rates matter, not nominal rates? Why should the sign of the nominal rate matter? I think society could adjust to negative nominal interest rates, just like Brazil adjusted to high nominal inflation. If loan agreements are drafted that require that loan balance cannot increase in real terms, that will take care of handling negative nominal rates.

For example, suppose the nominal rate is -5% and the inflation rate is -10%, yielding a real rate of 5%. Someone borrows $100,000. After a year, their account is credited with $5000 and their balance is now $95,000 (i.e. the lender "charged" the negative interest payment). But this balance is higher in real terms than the original balance. Because of deflation, the original $100,000 is now equivalent to $90,000. Since the loan contract requires that the real balance doesn't increase, the borrower is required to pay $5000 to the lender. So, the lender earned $5000 (the real interest rate), and the value of the borrower's outstanding balance is still the same in real terms. This is no different than a positive interest rate environment, and anyone who is willing to lend at a real rate of 5% will be happy to make this loan (assuming they can't invest in better-yielding cash instead).

Everyone seems to think that borrowers are only required to pay nominal interest on their loan, and ignore the outstanding balance; then use this common loan agreement to argue that negative interest rates are bad because they raise rather than lower the real debt burden with time. Well, it is only a happy coincidence that covering the nominal interest rate will cause the real outstanding loan balance to decline over time when inflation is positive; the same effect can be achieved with legal agreements in a negative inflation environment. There are already agreements like this in place for most consumer loans; you have to repay a little principal with most mortgage payments after all.

We have never seen an economy with negative interest rates, so there are no procedures in place to deal with them (just like hyperinflation makes fixed-rate loans very risky). But I don't think there is any inherent reason that we couldn't create rules to deal with it. I am still not convinced that nominal rates don't matter when they are positive (real rates matter), yet they suddenly do matter when the sign changes. I think nominal rates never matter.

Posted by: jimsum on September 9, 2003 01:49 PM
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