Maybe We Shouldn't Be So Positive About Negative Rates
My doctoral adviser, Miles Kimball, recently said some very kind things about me on his blog, Confessions of a Supply-Side Liberal. As Miles says, my views on most issues are very similar to his. So in the spirit of friendly debate, I thought I would try to highlight one of the few areas where we do disagree -- the idea of very negative interest rates.
Negative interest rates are a new phenomenon, and they’re spreading. Japan is the leader, with 10-year government bond yields that are now in negative territory:
The German five-year bund is there too:
Low interest rates are supposed to help the economy by boosting consumption and investment. Consumption goes up, in theory, because when interest rates are low people have less of an incentive to save for the future, so they spend more today. Investment goes up because companies can borrow more cheaply to finance business expansion. According to standard New Keynesian macroeconomic theory -- which Miles helped to develop -- this can alleviate a demand shortage without the need for fiscal stimulus.
QuickTake Negative Interest Rates
Miles has been a tireless advocate for negative interest rates. One of the main barriers to the policy is that it’s naturally very difficult for central banks to push rates into negative territory -- people can choose to hold cash, which naturally has an interest rate of zero, or they can save at a zero interest rate by prepaying bills. Thus, Miles has advocated for electronic money and a tax on cash to prevent people from getting around the negative interest rate by using paper money. Faced with no way to hoard cash, people will presumably have no choice but to go out and spend, spend, spend.
Miles is far from the only proponent of this policy. My Bloomberg View colleague Narayana Kocherlakota argues that negative rates will convince the public that a central bank is willing to take immediate, drastic action to boost the economy. That credibility will then become a self-fulfilling prophecy, causing businesses and consumers to increase economic activity because of their belief in the central bank’s power.
The policy isn’t without its share of critics. Birmingham University’s Tony Yates worries that an unprecedented step like electronic money could hurt central banks’ credibility, thus making monetary policy less effective in the long run. A more vehement critique came from legendary economist Joseph Stiglitz, who had a number of problems with the idea:
Negative interest rates hurt banks’ balance sheets, with the “wealth effect” on banks overwhelming the small increase in incentives to lend…There are three further problems. First, low interest rates encourage firms to invest in more capital-intensive technologies, resulting in demand for labor falling in the longer term, even as unemployment declines in the short term. Second, older people who depend on interest income, hurt further, cut their consumption more deeply than those who benefit – rich owners of equity – increase theirs, undermining aggregate demand today. Third, the perhaps irrational but widely documented search for yield implies that many investors will shift their portfolios toward riskier assets, exposing the economy to greater financial instability.
Miles has responded at length to these criticisms, and you can ponder the complex, multifaceted debate for yourself. But I have another, more general criticism of negative-rate policy.
Most proponents believe that rates would have to go far below zero in order to have a major stimulus effect. The slight swing into negative territory now seen in Europe and Japan has't had much of an effect on economic activity. But deeply negative interest rates are something that has never happened before. In particular, the New Keynesian models that are being used to guide policy were developed -- and tested -- during an era in which rates were comfortably positive.
By taking us outside the realms of known models, negative rates introduce risk. Research has already shown that macroeconomic models tend to break down outside of normal circumstances, and super-negative rates certainly qualify as abnormal.
In fact, standard models may already have broken down. Zero interest rates have failed to incentivize the kind of consumption and investment booms that we might have expected. Companies are hoarding their cash. Savings rates have actually risen, not fallen. It’s possible that this is due simply to a very long, persistent negative shock to demand, but it’s also possible that we’re just not in a New Keynesian world right now. Maybe some other theory, like Roger Farmer’s regime-switching model, or a Neo-Fisherian model, or a financial macro model, is in effect.
If the world isn’t in the comfortable, well-known New Keynesian territory, then policies designed to fit a New Keynesian model run the risk of backfiring. If Neo-Fisherism is right, very negative rates would cause damaging deflation. If financial frictions are now the driving force of the business cycle, negative rates could damage banks as Stiglitz and others have intimated.
That suggests that central banks should be cautious about negative rates. Other policies, such as higher inflation targets, might keep us in more familiar territory, so maybe we should try them first. I’m not saying that very negative rates are definitely bad, but the doubt surrounding them means they should be turned to only in financial emergencies. And the world’s major developed economies are no longer in an emergency.
So while Miles is an important and visionary thinker on monetary policy, and his ideas will be very useful if another crisis comes, I’m personally a bit wary about deploying them in relatively normal times.
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