Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
On July 8, 2009 a world first occurred in Sweden when the Swedish Riksbank (its central bank) made announced that its deposit interest rate would be set at minus 0.25. While this has set the cat among the pidgeons around the financial markets, it is a classic example of “central banking gone crazy” or more politely “quantitative easing on steroids”. The only problem is that performance enhancing drugs seem to make athletes ride or run faster. This move will do very little to make the Swedish economy increase output or employ more people. For a background to my analysis on this event in central banking history you might like to read my blog – Quantitative Easing 101.
First, what does it actually mean? The rate of minus 0.25 means that commercial banks will now have to pay the central bank for positive reserve balances they hold at the Riksbank as part of the payments system. Up until recently reserve balances held overnight attract a “support rate” that could be zero (as in Japan and the US) or some positive rate (for example, in Australia the RBA pays 25 basis points below the target rate). Recently, in the face of the crisis, the US Fed relaxed this and now pays the funds rate (which is not much of a change given the funds rate is down to 0.5 per cent anyway.
In the Financial Times last week (August 30, 2009) Wolfgang Münchau wrote that:
The zero lower bound is one of the great myths of monetary economics. It is the statement that interest rates cannot fall below zero, for otherwise people would hoard cash. Generations of central bankers have treated it as the equivalent of zero degrees Kelvin, the lowest theoretically possible temperature.
So Sweden has exposed the myth. This has never been a myth to a proponent of what we might call Modern Monetary Theory (MMT) because the central bank can do what it likes with respect to the rate it charges or pays on reserves. It just means that the banks are now effectively fined for holding excess reserves.
So the question is why do this? Well the reason they are doing it is sourced in the fundamental misunderstanding of the fiat monetary system. You have to wonder how such a major ignorance could actually be perpetuated in the daily lives of central bankers in a not insignificantly educated nation such as Sweden. Anyway, Münchau summarises the intent as follows:
… the Riksbank hopes that by charging banks for saving their money, rather than paying them, it will encourage them to increase their lending to individuals and businesses, boosting the economy. It also hopes that it might encourage them to divert the money into other assets, such as government bonds or even highly rated corporate bonds. This would bring down bond yields and act as an stimulant.
The reasoning is a little more complex than this though. The interest rate being adjusted is a nominal rate (that is, how much money is changing hands) rather than a real rate (that is, what is the equivalent of the money changing hands in purchasing power terms). The real interest rate is the nominal rate minus the inflation rate.
The Swedish Riksbank has done this because real interest rates are out of whack with its inflation targets – there is very significant deflation occuring there as a consequence of the recession and nominal rates are not too high.
Before I return to the debate, it will help to have a look at some relevant statistics from Sweden.
What’s been going on in Sweden?
First, here is the relationship between unemployment and inflation in Sweden since 1994. You should compare this graph to the ones that follow (which show monetary policy adjustments) to convince yourselves that the Swedish Riksbank (an unelected body in a democracy) has targetted the jobs of its citizens in its fight against inflation. I don’t call that democracy or even sensible. But the RBA and other central banks do the same thing – that is what the neo-liberal policy era wrought!
To let you see what the relationship between nominal and real interest rates means I produced a series of graphs showing the relation between nominal and real interest rates. The three rates of interest are defined by the Riksbank as:
The repo rate is the rate of interest at which banks can borrow or deposit funds at the Riksbank for a period of seven days.
The deposit rate is the rate of interest banks receive when they deposit funds in their accounts at the Riksbank overnight and is normally 0.75 percentage points lower than the repo rate.
The lending rate is the rate of interest banks pay when they borrow overnight funds from the Riksbank and is always 0.75 percentage points higher than the repo rate.
It is the deposit rate which is now set at minus 0.25 as at July 8, 2009.
The first graph shows the evolution of the three nominal interest rates since June 1, 2006 (left-hand axis) and the relevant inflation rate (CPI) (right-hand axis) at the date that the rates were adjusted by the Riksbank. I just made some continuous assumptions about the evolution of inflation and extrapolated accordingly. The assumption will not alter anything material but just allows me to assign inflation rates to the infrequent dates when the central bank made their monetary policy decisions.
You can see that the central bank has been obsessed with following the inflation rate religiously. Relate that back to the unemployment graph and you will see how monetary policy has deliberately used unemployment as a policy tool.
This graph just zooms into the previous graph from 2006 to show you more clearly the current relationship between nominal interest rates and inflation. You can see that the recession is deflating the economy so quickly that the nominal interest rates are now considered to be “too high” in the sense that real interest rates are rising above zero.
The following graph just presents the information from the previous graph differently to show you the evolution of the nominal deposit rate (blue line) and the real deposit rate (red line). As the nominal rate soared in their 2006-2008 tightening period, the rate of inflation was enough to keep the real rate at low levels and even negative from July 2008. However, as the recession has started to really scorch their economy, central bank monetary policy has been in a race against deflation and you can see that even though the nominal deposit rate is minus 0.25, the real rate is now positive, so the penalty they are imposing on the commercial banks is worse in real terms.
The final statistical chart is taken from the Swedish National Accounts and shows the contributions to change in GDP in percentages from 2004-2009 using quarterly data. As GDP growth has plunged since the fourth quarter 2008, fiscal policy has been all but absent. The way the Swedes present their national accounts data makes it had to disentangle government investment spending from total investment spending. So the blue bars capture all investment spending. It has severely shrunk in the last three quarters.
So apart from a small positive contribution in the first quarter 2009 (via public consumption spending), the graph shows you how little they are relying on fiscal policy to provide counter-stabilisation. In the current period, the government contribution to output growth is negative! This is neo-liberalism at its best! Not! Compare that to Australia’s current situation which I wrote about yesterday.
Back to the debate …
I thought it would be useful to put the data up to give you a feel for what is going on. Now back to the debate about negative interest rates. You can see from the graphs, that it was only the deposit rate that the Riksbank rendered negative. The logic of this move is as clear as it is stupid. The central bank wants to, in Münchau’s words:
… discourage banks to hoard their surplus liquidity in the form of central bank deposits, as opposed to lending it to customers. By cutting only the deposit rate below zero, the Riksbank only partially transgressed the zero lower bound. It used negative interest rates for the purpose of a highly targeted operation. Negative interest rates are therefore not an all-or-nothing proposition.
I hope everyone feels secure that not all rates were set below zero. Just in case you were feeling uncomfortable you can rest assured it doesn’t matter much either way.
There is a lot of resistance among central bankers to the negative interest rate idea. Some consider the small Swedish bank to be rather bolshie in its actions.
Some economists predict that a negative interest rate would force deposit holders to flee into cash. But this ignores the storage costs of holding money outside the bank (hired guns) and these are probably greater than 1 per cent of the cash value. So a minus 0.25 will not invoke that sort of behaviour.
Münchau’s assessment of why there is a song and dance going on about this is as follows:
… first … central bankers are a risk-averse lot and do not like to tread where no one has gone before … [second] … central bankers have also argued that negative interest rates would kill … money market funds. While that may be true, it is astonishing that its advocates prioritise the welfare of individual fund managers and their clients over the general goal of price stability. This is the argument of central bankers whose function is reduced to financial centre lobbyists.
A third argument is that zero or negative interest rates might lure investors into purchasing risky assets, in the full knowledge that those policies will sooner or later have to be reversed once the economy recovers. The latter is really an argument for a non-activist monetary policy, the kind that is generally preferred in continental Europe. But if non-activist policies result in large swings in inflation rates, they, too, might produce financial instability and unfair wealth distribution. So it is generally best for central banks to set interest rates to stabilise inflation expectations around a desired level, even if that requires vigorous policy action at times.
There is a long history of banks refusing to lend even though they have reserves. Japan’s experience between 2001 to around 2006 is a notable example. Then the government chose to use Quantitative Easing (keeping rates at zero though rather than negative – probably reflecting how conservative the BOJ is) but it was only fiscal policy that got the economy growing again and underpinned the confidence for investors to start approaching the banks to seek loans again.
Anyway, in reaction to the daring Swedish move, the current feeling is that other central banks will follow suit given their own banking sectors are also still not lending. So blindness to how a modern monetary economy is universal.
A so-called expert (an English investment banker) was quoted by the Financial Times last week as saying:
The success of the UK’s quantitative easing experiment hinges a lot on whether the banks will use the extra money they are getting for lending to individuals and businesses … If there is no sign of this over the next few months, then the Bank of England might consider a negative interest rate. In essence, it is a fine on banks that refuse to lend.
When will they ever learn and jettison this money multiplier nonsense?
The FT article further notes that:
In the UK, for example, nearly £140bn has been injected into the economy through central bank purchases of government bonds and corporate assets, mainly from the commercial banks. However, since the QE project was launched on March 5, a lot of this money, which in theory should be used by the commercial banks for lending to businesses and individuals, has ended up at the Bank of England in reserves.
They go on to argue that this increase in bank reserves could be used to “step up their lending to the private sector” because the more reserves it has the more they can lend.
This is basically nothing at all to do with the banking system in the UK or anywhere else for that matter. Banks do not lend because they have reserves. They get reserves because they have lent! Loans create deposits and then reserves are added.
The problem is that most of these commentators and central bankers have studied economics at universities which use textbooks such as Mankiw’s macroeconomics. Mankiw has written in recent months himself about negative interest rates – here and here.
The arguments are all gold standard, fixed-exchange rate, money multiplier, loanable funds doctrine nonsense. That is, not applicable to a fiat monetary system.
For example, in his private blog Mankiw has this gem:
If we want to prop up aggregate demand to promote full employment, what is the alternative to monetary policy aimed at producing negative real interest rates? Fiscal policy. Essentially, the private sector is saying it wants to save. Fiscal policy can say, “No you don’t. If you try to save, we will dissave on your behalf via budget deficits.” That fiscal dissaving would push equilibrium interest rates upward. But is that policy really welfare-improving compared to allowing interest rates to fall into the negative region? If people are feeling poorer and want to save for the future, why should we stop them? Unless we think their additional saving is irrational, it seems best to try to funnel that saving into investment with the appropriate interest rate. And given the available investment opportunities, that interest rate might well be negative.
So students – here is the mantra to take out into the real world:
(a) Budget deficits are evil because they cause inflation and deny the private sector the capacity to save.
(b) It is better to have negative interest rates to push funds into the hands of investors via the loanable funds market.
He earlier said that “Most ec 10 students begin thinking about the interest rate in terms of the supply and demand for loanable funds … There is no reason to presume that the equilibrium interest rate consistent with full employment is necessarily in the upper right quadrant of the Cartesian plane.”
This is the old classical doctrine that I discussed in this blog – The natural rate is zero!. It has no relevance at a macroeconomic level to the economy we live in.
You will readily appreciate that budget deficits by stimulating output and income also generate the capacity to allow the private sector saving desires to be met. The non-government sector cannot save if the government sector is in surplus. Impossible. Mankiw doesn’t even understand the basic national income relations that govern a modern monetary economy.
Just in case you need some help translating Mankiw’s writing you may want to have a look at this video, which is entitled Mankiw’s Ten Principles of Economics Translated – it will do the trick.
Currently, Adbusters is running a campaign against Mankiw’s brainwashing. They said:
You might not have heard of N. Gregory Mankiw. The Harvard economics professor and former adviser to George W. Bush is … one of the most effective and talented propagandists of our times. His target: young economics students. His field of operation: the world’s universities. His weapon: the best selling textbook in the world. It includes 36 chapters and 800 pages of nice colors, graphs, cool stories and interesting asides. Don’t worry if you or your kids don’t speak English, Mankiw’s text surely exists in your language.
The rest of that article is good reading for the layperson. Here is another snippet relating to my own research obsession – unemployment:
For Mankiw, if unemployment exists, it is only because of human inventions such as unemployment benefits, trade unions and minimum wages. Without them, there cannot be unemployment. Mankiw presents this view as being consensual among economists.
And this to emphasise the scale of the problem:
While Mankiw’s text is easy for professors to use, it oversimplifies economic theory and leaves out the ways in which markets can degrade human well-being, undermine societies, and threaten the planet. Each year, tens of thousands of students go out into the world, with Mankiw’s biases as a roadmap to the future.
The banks will not lend if there are no credit-worthy customers lining up for loans. The logic surrounding the negative interest rate move is based on the erroneous belief that the banks need reserves before they can lend. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.
But bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
The point is that building bank reserves or penalising them for holding reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.
The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.
The major problem facing the economy at present is that there is not a willingness to spend by the private sector and the resulting spending gap, has to, initially, be filled by the government using its fiscal policy capacity.
By appropriately expanding the fiscal position the government will not only add directly to aggregate demand and increase employment but will also promote confidence in the private sector that a recovery is possible. In turn, this will have the private investors lining up with their credentials to their local bank offices seeking funds for working capital and larger projects.
Fiddling with the real interest rate when it is already rock-bottom is just wasting time.