On penalty cash rates

Scott Fullwiler from New Economic Perspectives (ht Economists View) describes some issues he has with the “negative interest rate” idea being put forward by Willem Buiter , Greg Mankiw , and Scott Sumner

Now I have previously put my foot forward and said I agree with this idea (here and here) and I still feel the same, let me describe why with reference to Dr Fullwiler’s post.

In short, the proposal assumes that banks either need the reserve balances (if you tax all reserve balances) for the actual act of creating the loan or (as appears to be the case in Sumner’s proposal to tax only excess balances) they need the reserve balances because of reserve requirements

It is true that in order to set up a penalty interest system we need a good idea of what constitutes “reserves”. In New Zealand the RBNZ actually does financial regulation so I feel that we do. In this case we could set “reserves” as cash that is not lent out or in bonds – and we can charge banks on the basis of these “reserves”.

Now as Fullwiler says this has a negative income effect, which is problematic. However, the reverse side of this is to have a positive rate of interest on bank borrowing from the central bank (although at a lower rate than the charge on reserves). If we set a cash rate of -1.75% this could denote a penalty rate of interest of 2% and a writedown on bank borrowing from the central bank of 1.5%. In this case we definitely promote bank lending.

Remember given that we are working on the presumption that “effective demand” is too low – in this case we want to promote lending, and such a scheme would definitely do that. Of course, we might disagree with that, we might say that we don’t want to increase effective demand and we certainly don’t want to push money towards “risky lending”. If that is the case then we are simply saying that we think the central bank is cutting the cash rate too far – not that this type of monetary stimulus is ineffective in its given role!

On a slightly different point, I also have to discuss this:

The problem IS NOT that people have idle balances and aren’t spending them (and it almost never is the problem in a recession). The problem IS that people don’t have enough income (or don’t have the certainty that their current income will be sustained) and/or savings to make them comfortable to spend or to borrow to spend

Given the presumption that we face “insufficient demand” I would say that the problem is a lack of spending. In macroeconomics income is in itself an unclear topic – but ultimately income should stem from the production function, and the production of goods in the economy.  This is the supply side of the economy.

Now, because prices aren’t properly aligned we (are assuming that we) have a situation where a lack of demand is leading to a situation where markets don’t clear – if we could increase spending we could increase income and this would lead to a superior outcome. This is our paradox of thrift.

Even though we do have a balance sheet problem, if we are facing a paradox of thrift additional savings actually makes the balance sheet worse – not better.  As a result, cutting interest rates to encourage borrowing could be a good “short-term” way to go.

Note: Again I am not saying we are in this situation, just that this is the prevailing assumption that holds when people assume that we should push for further monetary easing.  In the NZ example this type of easing would be HIGHLY unnecessary and damaging – I am definitely not suggesting it for our country in the current situation.

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  • Mario Sanchez

    I am still trying to determine how negative nominal rates are not deflationary (at least from the perspective of narrow money supply, if not from the perspective of the multiplier & velocity). Every actual example of negative nominal interest policy described seems to require money destruction (expiration of currency based on serial number or lack of timely stamps, paying cash back to the central bank) or fiscal contraction (paying taxes for various failures to act as desired).

  • Why is New Zealand in a depression state? Are we not coming out of a recession.

  • @Mario Sanchez

    Hi Mario,

    Negative nominal interest rates are an insane concept – I don’t know if it would really work at all 😛

    Ultimately, the goal of the penalty interest rate isn’t to make nominal interest rates negative – it is too change the opportunity cost associated with the banks decision to lend/buy bonds. By making “hording” less attractive a penalty rate of interest (and positive interest on borrowing from a central bank) can increase the money supply by either getting banks to make riskier loans or too buy up bonds.

  • No they can’t. Think about this, if there was a bank offering a loan with a negative nominal rate of interest then the amount I pay back in the future would be less than the loan amount.