The interest rate should be set at zero

The discussion about the relative merits of monetary policy and fiscal policy is on-going. A regular billy blog reader has asked me to give some thought to this discussion, specifically in terms of whether monetary policy is a useful counter-stabilisation option. My view is that if one takes a modern monetary perspective then it is clear that the current reliance on monetary policy (accompanied by the budget deficit phobia) will always fail to deliver full employment and relies on the impoverishment of the disadvantaged for its ability to achieve low inflation. Accordingly, it would be far better for the government to set the short-term interest rate at zero and achieve full employment through appropriate levels of net spending (fiscal deficits).

In this neo-liberal era, prior to the current economic crisis, governments began to rely on monetary policy for counter-stabilisation. According to the logic, this rendered fiscal policy a passive player. Under the misguided inflation targetting regimes that emerged in the early 1990s, central banks adjusted short-term interest rates to control inflation and therefore saw the unemployment rate as a policy tool rather than a legitimate target in its own right. Given the erroneous belief that expansionary fiscal policy was inflationary and its use would compromise the primacy of monetary policy, governments began to pursue surpluses and put in place frameworks to punish deficits (for example, the Stability and Growth Pact that governs Euro-zone relationships).

The results have been clear. Economic growth has never been strong enough to fully employ the willing workforce and inequalities are rising throughout the Western world not falling. Further, the disparities between wealth and poor countries have widened. This approach also established the pre-conditions for the current crisis including the massive build-up of non-government debt and persistently high labour underutilisation.

The results indicate that this way of managing the economy cannot possibly be a sustainable long-term strategy.

Once we understand the way the monetary system works we realise that there are options that are not currently pursued which will make economic outcomes better for all. This understanding frees up our thinking and regardless of whether we are “right-wing leaning” or “left-wing leaning” or some “other-wing” we recognise that the fundamental principles of a modern monetary policy suggest that the policy mix should be in favour of fiscal policy with monetary policy playing a passive role.

One’s ideology (that is which “wing” you lean toward) will influence what you think the government should do with the options available to it but you will cease to support policies which deliberately constrain sustainable growth and full employment that are based on erroneous notions such as the government budget constraint. You will stop focusing on the size of the deficit and realise that the deficits are essential if the non-government sector is to save. You will instead be more mindful of issues such as spending gaps.

You might advocate large-scale military spending or extensive personal income tax cuts to fill the gap if you are of one political-ideological persuasion while another outlook may advocate hospitals, schools and community spaces with progressive taxation. But the point is that you won’t advocate leaving the spending gap open.

By all logic, all ideological camps would support a Job Guarantee unless one wanted to argue that it was better for a person to be doing nothing and suffering social exclusion than having them working for a wage on commuity and environmental development projects and getting training and skill development within a paid-work environment. Once you jettison the stupid notion that the Government cannot afford this type of policy then you would find it nigh on impossible to argue against it on grounds that the vast majority of us would find acceptable.

So why would I advocate, as part of this policy mix, setting the short-term interest rate at zero?

First, a refresher (for the 1000th time). But “when you have had too much modern monetary theory, then you have barely had enough” (borrowed from the Roy/HG sporting quote)!

A sovereign government is not revenue-constrained

Most economies (including Japan, the US, Canada, and Australia) have in place institutional arrangements with respect to the monetary system such that the national government is sovereign (is the monopoly issuer) of the currency in use and operates within a flexible exchange rate. The currency is non-convertible and has no intrinsic value.

There is no legitimate analogy to be drawn about the budgets of the government, which issues the currency, and the budgets of the non-government sector (households, firms etc) who use that currency. The former does not have a financial constraint and can spend freely whereas the latter has to “finance” all spending either through earning income, drawing down savings or liquidating assets.

The sovereign government may impose voluntary constraints of its capacity to spend – such as having to match $-for-$ their spending with private debt issuance and then imposing a ceiling on that debt (for example, the law in Australia currently only allows the government to borrow up to $A200 billion. That will change in the coming weeks but it is a voluntary constraint. The sovereign government is not revenue-constrained. Their cheques do not bounce!

Why impose taxes?

The government creates a demand for its spending in the currency by imposing tax obligations on the non-government sector which can only be relinquished in that currency. All private entitites will be happy to accept this currency in return for goods and services because they know they can use it extinguish their tax obligations to the government. In this way, the currency use generalises throughout the economy.

Taxation drains net financial assets (bank reserves) from the economy and thus can be used as part of a counter-stabilising fiscal policy to change how much disposable income different cohorts may have. So government may increase taxes if it wants households to have less disposable income (perhaps to counter an inflationary surge). This point is one of the fundamental insights of Abba Lerner’s functional finance approach to macroeconomic policy making which was espoused in the 1940s through to the OPEC oil price shock in the mid-1970s which heralded the return of neo-liberalism.

Taxation can also be used to alter the allocation of resources such that undesirable activities are curbed (for example, tobacco taxes).

It is clear that the government has to spend first before people can get the currency to pay their taxes (among other uses). This creates a private sector motive to supply labour and goods to the government and allows the latter to pursue its socio-economic program. The government must spend in net terms at least the amount they tax and the amount that the private sector desires to save in that currency. Otherwise, the private sector would be squeezed for liquidity in the currency and run-down assets accumulated from past budget deficits. It is not a sustanable option for the national government to run indefinite surpluses.

The last point is very important: a fundamental role for budget deficits is to “finance” the the domestic and foreign sectors desire to net save in the currency of issue. There can be no net saving in any period that the government runs a surplus.

Why issue debt?

Why do sovereign government’s issue debt if they are not revenue-dependent? The first essential point to note is that at all times the supply of treasury securities (government bonds) that is offered by the federal government for sale is always equal to the newly created funds from the deficit. So the government cannot borrow before it spends.

The central bank conducts monetary policy by setting short-term interest rates (upon which other longer-maturity rates are based) and then managing bank reserves to maintain the desired target short-term rate. The short-term interest rate is also the overnight lending rate.

The main commercial banks are “members” of the central bank, which means they participate in the clearing house or “payments” system to ensure that the multitude of cheques issued each day clear and the appropriate debits and credits are made. To faciliate this clearing system the member banks keep accounts with the central bank which are called reserves. In Australia, we call these the Exchange Settlement Accounts but they are just reserve accounts at the RBA.

We define government high powered money (HPM) to be the sum of currency (notes and coins) on issue and bank reserves.

Fiscal policy transactions – spending and taxation – are continually altering these reserves. Government spending “adds” to reserves while reserve “drains” arise from taxation and bond sales.

So you can do the sums. A budget surplus will be a net reserve drain (because taxation is higher than spending), whereas a budget deficit comprises a net reserve add (because spending is higher than taxation).

But the story doesn’t end there. At present, the Australian Government (like most governments around the World) is running a daily budget deficit, which means the flow of HPM into bank reserves (credits) is greater than the flow out (debits). So the net reserve position is a credit.

Depending on the central bank policy with respect to these reserves – that is, whether it pays a support rate on excess reserves left overnight in the reserve accounts – this net credit has to be dealt with.


Because commercial banks don’t like to have “money” (reserves) sitting there doing nothing when it can lend it overnight for a non-zero return. Accordingly, when the Government is running a deficit – net credits to reserves – there is a likelihood that the banks will consider their reserve holdings to be excessive on any particular day. They are only obliged to keep these accounts in positive balance.

The excess reserves won’t be distributed evenly across all banks and some banks will have deficient reserves and thus need to bolster them on any particular day. Those banks with excess reserves then have an incentive to lend the funds out on the interbank market to the banks with reserve shortages. The latter have an incentive to borrow because the other option is to get the reserve shortfall from the central bank at a penalty rate via the discount window.

So the dynamic that accompanies a budget deficit is for competition in the interbank market (lending banks seeking borrowing banks) to compete the overnight interest rate down.

This is a major point that neo-liberal macroeconomics just fails to understand. They claim that deficits drive interest rates up because there is a scarcity of funds available to “finance” the deficit. But it is clear that bank loans are not constrained by deposits (reserves) and they will lend to any credit worthy customer.

So budget deficits, other things equal, put downward pressure on short-term interest rates.

This competition cannot rid the so-called “cash system” of the excess reserves. All transactions between the banks net to zero (for every asset created there is an offsetting liability created) and so they cannot change the net position. The competition just redistributes the excess reserves among the banks rather than eliminates it. So the downward pressure on rates is constant.

What happens next? It depends on the support rate that the central bank offers. In Japan and the US this has been zero whereas in Australia the RBA offers banks a return of 25 basis points below the current short-term rate on overnight reserves.

So the support rate in relation to the target rate creates the “corridor” in which the interbank competition will move the overnight rate. But the important point is that if the central bank wants to hold to its monetary policy stance – which manifests as the target rate – then unless it intervenes when there are excess reserves, the interbank competition will take control of the central bank and the monetary policy position will be compromised (lost)!

The only way to resolve the excess reserve position in the “cash system” is for a net drain to occur. Understanding this point then immediately clarifies why the Government issues debt when it doesn’t need to finance its spending.

The central bank has two options: (a) equate the support rate on reserves with its target rate and therefore eliminate the interbank competition; or (b) provide an interest-bearing financial asset that will be attractive to the banks seeking to earn a return on the excess reserves. This is accomplished by the central bank (or whatever institutional arrangement for debt management that the Government chooses to maintain) selling government paper (bonds or debt) to the private market which then “drain” the reserves from the system by destroying the HPM.

Role of the short-term central bank interest rate

The short-term rate set by the central bank is also considered to be a “benchmark” rate which allows the longer maturity (or investment rates) to be set. These rates include mortgage rates and rates governing capital infrastructure loans. The money markets price these longer-term loans at the short-term rate plus risk (normally).

To maintain high rates of private investment and keep home borrowing rates as low as possible, it is desirable to have the short-term rate as low as possible. So what is the best short-term interest rate stance?

The neo-liberal position is that short-term rates should be used to regulate spending such that inflation is held in check. But monetary policy is a very poor way to regulate spending because it is what we call a “blunt instrument”. It has no targetting capacity in regional or cohort terms and so the central bank might hike rates to control an asset price boom say in a major city but this will also damage regional centres which may not be participating in the real estate boom. This is exactly what was happening during the previous period of rate hikes in Australia, leading up to this current crisis.

But more importantly, it is not even clear that within normal rate bands the effect on spending is very strong. Raising rates damages borrowers but advantages lenders. Rate hikes also disadvantage home buyers but advantage rentiers. There might be differential spending propensities between lenders and borrowers but the empirical research is not definitive on this issue. The best guess is that the net spending impact either way is small and takes a long time to work its way out into the expenditure system.

So monetary policy is not a very satisfactory tool for counter-stabilisation purposes. The use of fiscal policy is superior because it is relatively direct – that is, the $s go into aggregate demand – immediately they are spent. It can also be targetted spatially and demographically to achieve various redistributive ambitions. It is also not revenue-constrained.

As a consequence, the “normal” state of affairs will see fiscal policy ensuring the spending gap is continually zero (as close as possible anyway) via a range of spending and taxation initiatives, which will always produce budget deficits as the sustainable long-term position. That is, unless the private saving desire is zero or negative which is very unlikely and certainly nigh on impossible over any medium- to long-term period.

Given that, we would always be witness a zero short-term interest rate unless monetary policy intervention chose to do otherwise (either by providing a non-zero support rate on excess reserves or draining the excess reserves with debt sales).


So my argument is that these additional interventions on the monetary policy side are unnecessary and add to the overall complexity of government business management. It would be far better to avoid them altogether which means a zero short-term interest rate.

This is exactly what Japan did for 18 or so years without negative results such as inflation or external exchange issues. They were able to provide the best investment support (lowest rates) possible to try to stimulate their ailing economy into growth supported by very large on-going fiscal deficits.

We could then put the brains in the central bank to work running a Job Guarantee system and doing research to advance the public good!

Isn’t that a better option? And then the deficit nazis would not be able to use the debt furphy to make their case. And then you would hear the rumblings from the lazy financial market players who would have to create a new non-government risk free benchmark upon which to price their longer maturity financial instruments. That is another story – for another blog though.


Fullwiler, S. (2004) ‘Setting Interest Rates in the Modern Money Era’, C-FEPS Working Paper No. 34, available electronically HERE.

Mosler, W.B. and Forstater, M. (200 ‘The Natural Rate of Interest is zero’, available electronically HERE.

This Post Has 8 Comments

  1. Great post, Bill (and thanks for the cite, as well).

    I’m presenting on this very topic in a few weeks in Toronto. A few additional points I will be making there (which have been made before for the most part in previous work by Eric Tymoigne, Randy Wray, and Warren Mosler).

    1. The central bank’s target should be a fixed nominal rate. First, nominal rates are what “matters” in the real world, not real rates, as contracting in the real world is in nominal terms and meeting nominal cash flow commitments is the real issue. Second, holding period return is what “matters,” not “real” returns. The former will vary substantially with changes to to a nominal interest rate target, potentially creating significant swings in the financial sector (as Minsky documented and which have continued), and will thereby spur all sorts of financial innovations and financial engineering to try and predict and profit from such movements.

    2. The zero rate target is not inflationary, as you note. The key issue here from a monetary policy standpoint is to recognize that it is only the overnight rate that is set at zero. Non-risk free rates and rates at greater maturities can be set at spreads above this as desired by markets. Also, it is not low interest rates that spur excessive credit creation, as we have had asset price bubbles in low and high interest rate environments. It is instead the combination of two things . . . first, the lack of regulation of the financial system in terms of its asset quality, leverage, and net cash position, and second, the expectation of capital gain (particularly when margins of safety in lending dwindle to mere loan collateral that is expected to appreciate).

    3. The zero rate target is not “unfair” in the distributive sense, as some Post Keynesians argue. Again, it is merely the overnight risk-free rate that is set at zero. Those investing in equities should get a greater return based upon the growth rate of the economy (which should set earnings growth and given a fairly stable P/E ratio over the long run) and dividend yields, while those investing in bonds should get a return between this and zero, based upon financial participants’ portfolio preferences for default risk, maturity, etc. Also, for the latter, as above, a fixed nominal interest rate target could raise returns as there would be less interest rate risk associated with changes in short-term interest rates.

  2. Once we understand the way the monetary system works we realise that there are options that are not currently pursued which will make economic outcomes better for all.

    This is key. Fractional reserve banking is only needed when money system is gold-based. There is zero upside to it otherwise, as it amplifies risk and has built-in moral hazard issues. Then the government has to constantly watch the banks to see what they are doing with the money that government adds via deficit spending. This is not money that banks “earned”, but they get to control it and this forces the government to jump through hoops to prevent them from crowding out fiscal policy. I have a hard time believing that if the banks had access to 8 Trillion in deposits in a boom period with, say 5% inflation and rising real estate prices, that they would not find creative ways of “investing” that 8 Trillion in land but would just sit on it…

    CalculatedRisk recently excerpted a cease-and-desist order from a Florida bank that was later seized:

    (a) Prior to June 2009, the Bank reached its legal lending limit under Florida law with respect to the aggregate loans outstanding to a borrower and his related interests. In June 2009, Williams permitted the Bank to make loans of an additional approximately $60 million to straw borrowers who were related interests of the borrower referred to above in continuing violation of the Florida legal lending limit statute (the “June 2009 loans”);

    The creation of money should be the responsibility of government, so let banks serve as underwriters and performers of credit analysis, but have all money lent come from the government at a government decided interest rate. This is a long term (e.g. 10 year) interest rate, to match the duration of the loan. I believe it should be set at the desired level of wage growth — ideally the expected nominal GDP growth rate, otherwise it will put downward pressure on wage growth — but that is up to debate. In either case, there should be no such thing as a government set “overnight” rate, as this has nothing to do with lending except to support fractional reserve games.

    Then bond sales are no longer an interest rate support mechanism, but I believe bond sales still serve an important purpose and should not be dropped entirely.

    But now there is no relationship between the amount of deposits and the amount of loans. If loans don’t perform, then the loss comes from pledged capital. Banks make money from the spread of their government set rate and the rate charged. You can also just pay banks an a fee for service basis. Government can supply deposit services to the public, or the private sector can do this in exchange for a fee. In the era of electronic money, it does not need to be expensive.

    You still have private sector credit markets — those who want to “lend” their deposits to others for a return. That should be 100% reserve with your own investment funds, and you take full losses and gains by investing in these markets. You should only be allowed to “pool” money from those who are qualified investors (i.e. > $1 million in assets), and there would be no deposit insurance or other support mechanisms. Government should leave those markets alone, IMO, except to enforce full disclosure, regulate the types of contracts allowed, and intervene to coordinate mass bankruptcies as they occur.

  3. Bill,

    Looking at the RBA archives, I noticed that in the 1970’s and early 80’s there seems to have been no “target for the cash rate” such as there is today. There was only the 90 day bank bill rate.

    I take it that in those days, the 90 day bank bill rate – which if I understand correctly, was/is simply the rate at which the central bank lends to the member banks over that term – was synonomous with the official interest rate?

    With both in existence today, I also notice that there seems to be little difference between the 90 day bank bill rate and the target for the cash rate.


  4. Dear Lefty

    There are some old discontinued series that you may not have found – the 11 am call rate in the cash market was published up until November 2003 (from 1959). This was the short-term interest rate that monetary operations influenced.

    But also the RBA did not always run monetary policy in the way it did now. For example, in the 1980s they experimented with monetary targeting (driven by their ideological take-up of Monetarist ideas). Prior to that they used reserve controls (LGS, SRDs) etc.

    The changing dimensions of monetary policy indicates why the information they present is now different.

    best wishes

  5. So….what happens if the base interest rate is actually below zero….?

    How bizarre would that really be ?

    There is a sense in which the rate would be net negative if inflation was running higher than the headline interest rate. Does that offer any clues ? There must have been times when such conditions prevailed even if only temporarily.

  6. I doubt if 5% of Australian economists have even looked at the RBA website based on their poor understanding of how monetary policy is implemented.

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