Over at Econlog I have a new post pointing out that negative IOR has had an unquestionably positive impact on asset prices, and yet much of the business press claims exactly the opposite.  This confused thinking makes it more likely that central banks will adopt bad policies in the future.

A similar problem occurred in late 2007 and early 2008, when the media adopted a Keynesian approach to monetary analysis, instead of a monetarist approach.

From August 2007 to May 2008, the Fed repeatedly cut interest rates, from 5.25% to 2.0%. The media treated this as an expansionary monetary policy, even though it was clearly exactly the opposite.  The monetary base did not change, and falling interest rates are actually contractionary when the money supply is stable.  Indeed it’s a miracle the economy didn’t do even worse.  NGDP growth slowed sharply, and I surprised there wasn’t an outright decline.

Here’s the monetarist approach:

NGDP = MB*(Base velocity), where V is positively related to nominal interest rates.

Thus if you cut interest rates without increasing the money supply, then V falls and policy becomes more contractionary. It’s monetary economics 101, but almost everyone seems to have forgotten this simple point.  Market’s responded favorably to larger than expected rate cuts, because they implied a bigger than expected boost to the monetary base, on that day.  But over time the base did not increase at all; the rate cuts were merely enough to keep it from falling.  So do more!!

Because the media wrongly thought money was getting easier, they became (wrongly) pessimistic about the efficacy of monetary policy, which led to President Bush’s failed fiscal stimulus of May 2008.  There is no economic model where Bush’s policy would be effective.  Interest rates were above zero, so monetary offset was fully applicable.  The Fed responded by putting rate cuts on hold, which drove the economy right off the cliff after June 2008.  By September the tight money caused Lehman to fail, as its balance sheet was highly leveraged, and exposed to asset price declines triggered by falling NGDP expectations.  Yet even Ben Bernanke inexplicably endorsed Bush’s tax rebates, even though there is no logical reason for him to have done so.  If more stimulus was needed in May, then the stance of monetary policy should have been more expansionary.  So do more!!

Bush’s policy was a lump sum tax rebate, which doesn’t even work on the supply-side.  And unlike more government spending, there isn’t even a New Keynesian argument that fiscal stimulus might boost aggregate supply by making people work harder.  It was really dumb policy, there’s nothing more to say.

So because the media and many economists wrongly though money was loose, we ended up with really bad macro policy. The recent backing away from additional negative IOR is more of the same.  Just as markets responded to unexpected rate cuts in late 2007 as if they were highly expansionary, markets responded to negative IOR in Europe and Japan as if it is expansionary.  But over longer periods of time the markets were more negative, because investors rightly perceived that central banks would not do enough.  So do more!!  In 2007-08 investors were pessimistic because they thought the Fed wasn’t cutting rates fast enough.  The Fed needed faster rate cuts to enable the monetary base to increase.  So do more!! Similarly, in recent months, markets in places like Japan have become pessimistic because the BOJ is not cutting rates fast enough, or is suggesting it may give up. But the media thinks the market is pessimistic because the BOJ is doing negative IOR, even though asset markets respond positively to negative IOR.

In both cases, people wrongly assumed that the problem was that the measures that were taken were not effective.  Instead of, “So do more!” it became perceived as, “So stop doing that, it’s not working.”  They ignored the fact that markets clearly indicated it was working, but that much more needed to be done.  Did I say, “So do more”?

Sometimes I think I’m going crazy—maybe everything I believe is wrong.  After all, almost everything I read is diametrically opposed to what clearly seems to be happening, or to what our textbooks teach us about monetary policy.  But then I look at the asset markets, and am reassured.  I’m not really losing my mind. Monetary stimulus is effective, and it’s needed in Japan and Europe, and was needed in 2007-08 in America.  No matter how many times the press tells us that the markets hate negative IOR, each new IOR news shock confirms once again that the markets prefer even more negative IOR in Europe and Japan.  I don’t have my head in the sand, it’s the business press that does.

The ECB moved more aggressively than expected to cut IOR and increase QE. Today I will explore the effects, beginning with the banks.  Recall how negative IOR was supposed to be so bad for bank profits.  It seems those theories were wrong:

Banks have warned that negative interest rates are eroding their profitability. The rates cut into banks’ net interest margins as lenders have been reluctant to pass on the cost of negative rates to all but the biggest retail customers.

To offset some of the pain to banks, the ECB will provide cheap loans through targeted longer-term refinancing operations, each with a maturity of four years, starting in June 2016. These loans could potentially be provided at rates as low as minus 0.4 per cent, in effect paying banks to borrow money. Banks will also benefit from a refinancing rate of 0 per cent.

Shares in eurozone banks rallied sharply after the ECB announcement with Deutsche Bank up 6.5 per cent, Commerzbank up 4.9 per cent, Société Générale up 5.4 per cent and UniCredit up 8.2 per cent.

Over the years I’ve pointed out that there are things that central banks could do to offset the hit to bank profits. For instance, they could raise IOR on infra-marginal reserve holdings, while they lowered IOR at the margin. I did not propose the exact offset discussed above, but it seems that the general concept is workable. Negative IOR need not be a problem for banks, if done correctly.

European stocks rose sharply on the more aggressive than expected announcement and the euro fell in the forex markets. Oddly, however, for the 347th consecutive time the “beggar-thy-neighbor” theory was falsified by the market reaction.  Not only did Europe’s actions not hurt the US, our stocks soared higher on the news:

Dow futures added more than 150 points after the ECB cut the deposit rate to negative 0.4 percent from minus 0.3 percent, charging banks more to keep their money with the central bank. The refinancing rate was also cut, down 5 basis points to 0.00 percent.

I warned people to be careful after the Japan announcement; the EMH is not a theory to be trifled with.  As you recall, Japanese stocks soared and the yen fall sharply when negative IOR was announced in Japan.  But then a few days later both markets went into reverse (probably for unrelated reasons).  Many people assumed it was a delayed reaction to the negative IOR.  That’s possible, but markets generally respond immediately to news.  With the European moves today we see yet another confirmation of market monetarism:

1.  Policy is not ineffective at the zero bound.  So do more!!

2.  Reducing the demand for the medium of account (negative IOR) is expansionary.

3.  Increasing in the supply of the medium of account (QE) is expansionary.  I.e. the supply and demand theory is true.

4.  There is no beggar-thy-neighbor effect from monetary stimulus.

Market monetarists were the first to propose negative IOR.  It’s our idea.  When your ideas are correct, they help to explain how the world evolves over time. Things make sense.  In contrast, people with a more “finance view” of monetary policy have been consistently caught flat-footed.  Note that these people are represented on both the right and the left, and they have been consistently wrong in their views of monetary policy at the zero bound.

BTW, James Alexander has a post showing that eurozone growth has nearly caught up with the US:

Notice that at the beginning of 2012, NGDP growth in Europe had been running at less than 1% over the previous 12 months.  That’s the horrific situation that Draghi inherited from Trichet.  Draghi did move much too slowly at first, but at least things are beginning to look a bit better for the eurozone.  Still, Draghi needs to do more, as the eurozone is likely to fall short of its 1.9% inflation target.

Even better, the ECB needs to change its target, and set a new one high enough so that the markets are not expecting near-zero interest rates for the rest of the 21st century:

Take overnight interest rate swaps. They imply European Central Bank policy rates won’t get back above 0.5 percent for around 13 years and aren’t even expected to be much above 1 percent for at least 60 years.

Update:  The euro later reversed its fall.  But note that US stocks soared even after the initial plunge in the euro.  It’s interesting to think about why the euro reversed its losses–perhaps a view that the ECB action will make the Fed less likely to raise rates?  Or because it was expected that the action would lead to stronger eurozone growth?  What do you think?

Update#2:  Commenters HL and GF pointed out that the euro rose in value after Draghi indicated (in a press conference) that the ECB would probably not push rates any lower.

Tyler Cowen linked to a post by Frances Coppola:

But one thing seems clear. How negative rates would work in practice is no clearer than how QE works in practice. They are experimental, and their effects are complex. Hydraulic monetarist arguments (“if you can get rates low enough the economy will rebound”) are simplistic.

Monetarist?  Don’t they focus on the money supply and/or NGDP expectations?  Most people would consider Milton Friedman a monetarist, and here’s what he had to say about low rates:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.   .   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

In a monetarist model, lower market interest rates are contractionary for any given monetary base, because they reduce velocity.  It’s the Keynesians who are likely to claim that lower rates are expansionary.  Now of course Friedman was talking about market interest rates, not IOR. Lower IOR is theoretically expansionary, and so far markets have reacted to negative IOR announcements as if they are expansionary.

Will that be true in the future?  Nothing is certain, as monetary policy is very complex, and concrete action A can always be interpreted as a signal of future concrete action B.  Anything is possible.  A $1 billion increase in the base can have a contractionary impact if a $2 billion increase was expected.  But any monetary analysis should start from the presumption that reducing the demand for an asset will reduce its value.  A reduction in the value of base money is expansionary.  That means lower IOR has a direct expansionary impact on NGDP.  (Secondary effects are complex, as Coppola suggests.)

Indeed, individual banks can avoid paying negative rates on excess reserves. They can discourage customers from making deposits; they can choose to hold reserves in the form of physical cash; or they can increase new lending (not refinancing), since the balance sheet result of new lending is replacement of reserves with loan assets.*

But of course the reserves do not disappear from the system. They simply move to another bank, which then incurs the tax. The banking system AS A WHOLE cannot avoid negative rates on reserves. The reserves are in the system, so someone has to pay the negative rate. If banks increase lending to avoid the negative rate, the velocity of reserves increases. It’s rather like a game of pass-the-parcel.

This is a common misconception, which I see all the time.  If individual banks don’t want to hold a lot of excess reserves, they can simply buy other assets with them.  If the banking system as a whole wants to reduce its holding of excess reserves, it can reduce the attractiveness of deposits until the excess reserves flow out into currency held by the public.  The central bank controls the monetary base, not bank reserves. The composition of the base is determined by banks and the public.

It seems reasonable to suppose that negative interest rates might increase loan demand. Negative interest rates on reserves put downwards pressure on benchmark rates and thus on bank lending rates, attracting those who would otherwise be priced out of borrowing. But typically those are riskier borrowers. We have just spent eight years forcing banks to reduce their balance sheet risk. Do we really want to force banks to lend to riskier borrowers? Of course, tight underwriting standards could be used to deny those people or businesses loans: but doesn’t that rather defeat the purpose of negative rates? It’s something of a double bind.

We need an easier money policy and, if banks are taking excessive risks, a tighter credit policy.  It’s best not to mix up monetary and credit issues.  Negative IOR is about reducing the demand for base money, which is inflationary; it’s not about increasing bank loans.  Central banks should not be trying to encourage more debt creation—unless you want to end up like China (where the policies are unfortunately linked together.)

In the end I agree with those who are skeptical of negative interest rates.  These ultra-low interest rates are a sign that monetary policy is too contractionary. The developed world needs much higher interest rates, but only if we get there with an expansionary monetary policy.  In December the Fed tried a short cut, raising rates without boosting NGDP growth. This is putting the cart before the horse.  You need to generate higher NGDP growth expectations first, and then you can achieve a permanently higher level of interest rates.

I find that when things go bad with the economy, the level of discourse seems to suffer.  Here are a few items I keep bumping up against:

1.  Why not do a helicopter drop?  Because there are no free lunches in economics, and any fiscal stimulus will have to be paid for with future distortionary taxes.  What if they promise to never remove the money injected in the helicopter drop? Then we either get hyperinflation or perma-deflation, neither of which is appealing.  Won’t it help to achieve the Fed’s inflation target?  The Fed already thinks it’s achieved its target, in the sense that expected future inflation is 2%, in the Fed’s view.  That’s why they raised rates in December.  You and I may not agree, but helicopter drops are a solution for a problem that the Fed doesn’t think exists.  If we can convince the Fed that market forecasts are superior to Philips curve forecasts, then the solution is not helicopter drops, it’s a more expansionary monetary policy.

2.  Are negative interest rates good for the economy?  That’s not even a question.  I don’t even know what that means.  For any given monetary base, lower levels of IOR are expansionary (for NGDP), and lower levels of long term bond yields are contractionary. So there is no point in even talking about whether negative rates are good or bad, unless you are clear as to what sort of interest rate you are discussing.

People often debate whether the problem is that interest rates are too high, or whether the problem is that interest rates are too low.  Neither.  The problem is that we are discussing interest rates, which means we are talking nonsense.  We need to talk about whether NGDP growth expectations are too high or too low.  We need to create a NGDP futures market (which I’m trying to do, but not getting much support) and focus on getting that variable right.

Tyler Cowen’s recent post on negative rates is not helpful, because it fails to distinguish between the fact that negative bond yields are bad and negative IOR is mildly helpful.  The eurozone has negative bond yields because it raised IOR in 2011.  That was a really bad move.

3.  If market monetarism is so smart, how come you guys can’t predict recessions?  The point of economics is not to predict recessions (which is impossible, at least for demand-side recessions) the point is to prevent recessions.

4.  What’s the optimal rate of NGDP growth, or the optimal rate of inflation?  It depends.  If the central bank plans to hit the target you can get by with a lower growth rate than if they plan to miss the target.  If they use level targeting then the optimal growth rate is lower than if they target the growth rate.  If capital income taxes are abolished then the optimal rate of inflation/NGDP growth is higher than otherwise. So I can’t give you a specific number, except to say “it depends.”

5.  What do we make of the fact that the yen depreciated when negative IOR was announced, and later appreciated?  The depreciation that occurred immediately after the announcement was caused by the negative IOR.  The later appreciation was caused by other factors.  The EMH says the market responds immediately to new information.  BTW, talk about a new headline not matching the accompanying article, check out this bizarre story from Bloomberg.

6.  Thomas Piketty recently claimed:

Whatever the case, however, the failures to make such [structural] reforms are not enough to explain the sudden plunge in GDP in the eurozone from 2011 to 2013, even as the US economy was in recovery. There can be no question now that the recovery in Europe was throttled by the attempt to cut deficits too quickly between 2011 and 2013—and particularly by tax hikes that were far too sharp in France. Such application of tight budgetary rules ensured that the eurozone’s GDP still, in 2015, hasn’t recovered to its 2007 levels.

No question?  Anyone making that claim has clearly paid no attention to the recent debate over fiscal and monetary policy. His claim is not just wrong, it’s patently absurd.  I question the claim.  Hence there is a question.  QED.

Seriously, Piketty himself points out that the US kept growing during 2011-13.  And the US did even more austerity than Europe.  And the only significant policy difference was that the US monetary policy was much more expansionary than the eurozone monetary policy.  The logical inference is that the eurozone recession was caused by tighter money in Europe. I’m tempted to say that there is “no question” that tight money in Europe caused the double-dip recession, as eurozone fiscal policy was more expansionary than in the US.  But I won’t, because Piketty clearly questions this claim.

Are there any Keynesians out there who are willing to debate me on this point?  I’d love to see the argument as to how fiscal austerity clearly caused a double dip recession in Europe, even though the US did even more austerity and kept growing. It seems to me as if Keynesians live in some sort of intellectual bubble, where they aren’t even aware of the arguments made by people on the other side.  That’s not helpful if you have to debate the other side.

Commenter SDOO sent me the following:

Kocherlakota quoted you on Twitter re: Fed, ECB, BoE and BOJ getting together next week.

That’s quite an honor.  Stephen Kirchner sent me a couple of FT articles.  The first contains some extremely interesting information on the zero lower bound, which is looking less and less like a lower bound:

But the Bank of Japan’s set-up for negative rates, which apparently follows the Swiss National Bank’s, casts doubt on the premise that the nominal cost of holding cash is zero. As we have explained, if a private Japanese bank wishes to exchange its central bank reserves for cash, the BoJ will adjust the portion of its reserves to which negative rates apply by the same amount. That means any extra cash that a bank wishes to hold will cost it as much as if it kept it on deposit at the central bank.

But what really matters is what the public wants to do. JP Koning nicely explains the “hot potato effect” of pushing central bank reserve rates below zero: banks will bid down rates on other assets in the financial system as they try to swap reserves for cash. Ultimately, they will be forced to lower rates on deposits below zero as well, so that customers will have to pay to keep their money on deposit. This is where the liquidity trap is really supposed to snap shut: will there not be a run for cash as depositors refuse to pay banks to hold their money?

But consider two things. First, it is not as if depositors as a class actually have a legal right to convert all their money to cash as it is. You cannot present a debit card at the Bank of England and demand cash. Indeed, even your own bank limits how much cash you can withdraw, as Frances Coppola has pointed out. Just read the fine print of your account terms of service.

And how could private banks honour mass withdrawals of cash even if they wanted to? No law provides for the central bank to swap client deposits for cash; only central bank reserves. And despite the huge growth of reserves in recent years, these still amount to only a fraction (about one-fifth in the UK) of bank deposits. So, to honour customers’ demands, banks would have to borrow more reserves from the central bank, which could impose terms as onerous as it wished. Onerous enough that banks would try to pass the cost on to customers. As my colleague Richard Milne argues in an analysis of Danske Bank’s success — its market value now exceeds that of Deutsche Bank — Danske is thriving because it has adapted to Denmark’s negative rates, in part by indeed passing them on to customers.

Second, the BoJ’s and SNB’s set-ups to neutralise banks’ incentive to hold cash instead of reserves can be exactly duplicated by the banks themselves vis-à-vis their customers. You want to take cash out of your account? Be our guest, but we will keep track of your total balance of net cash withdrawn and charge you the same interest on that balance as we charge on your deposits. This can be implemented through one of the regular “updated terms and conditions” that our banks seem to impose on us unilaterally every so often.

Read the whole thing.  This article (by Martin Sandbu) confirms my claim back in 2009 that the central bank could impose negative IOR on vault cash, but it also provides lots of options that I never contemplated.  More evidence that central banks never really tried very hard, which is obvious now that the Fed is no longer at the zero bound (and should have been obvious during 2008-12 when the ECB was above the zero bound.)

The second FT article is an odd one, with some good stuff:

December 16 2015 may go down as the date of one of the most monumental policy errors in history. The financial markets were nervously anticipating that the US Federal Reserve would raise the interest rate for the first time in nearly a decade — but few grasped the inadequacy of the data driving the decision.

The Fed had never before initiated a tightening cycle when the manufacturing sector was shrinking. . . .

The bond market, meanwhile, sees no shades of grey in the data; it is shifting rapidly from pricing in one rate hike this year towards pricing in the possibility of the next move being a rate cut, all but ridiculing the Fed’s insistence that four rate hikes would come to pass in 2016.

Tellingly, Fed officials are softening their tone on the number of times the rate might rise this year. “Don’t fight the Fed” — the idea that markets ultimately benefit from the Fed’s decisions — has become a cliché. The truth is the Fed has never dared fight the markets.

There’s that term ‘dare’ again, which Tyler Cowen mentioned a few weeks back (and I quoted in a recent post.) Unfortunately this generally good article (by Danielle DiMartino Booth) is marred by one dubious claim:

With hindsight, few dispute that the Fed missed an opportunity to raise rates in 2014. No doubt, tightening policy at that stage would have created its own messy side-effects. That said, the benefits would have been significant.

First, for example, commodity prices might not have risen so high or so fast without the cheap money flowing from the US to emerging markets. Property prices worldwide might not be as frothy had investors not sought refuge in the sector from what they rightly recognised as risky valuations in equity and bond markets. And “fragile” would not now be the word for financial markets and economies worldwide.

Is it really true that “few” dispute this claim?  I certainly do.  I’m not saying it’s impossible, counterfactuals are always tricky, but it certainly should not represent the conventional wisdom at this point, unless I’m missing something.

BTW, Just to be clear I am currently much more worried about NGDP growth than jobs.  I still think a recession is unlikely for the US in 2016.  Rather I worry that if NGDP growth and long-term rates stay low, the Fed will be ill-prepared for the next recession—unless it shifts to NGDPLT.  And let’s face it; no one can predict recessions.

PS.  I have a new article in The Fiscal Times discussing my Depression book, and its implications for current policy debates.

PPS.  Over at Econlog I have a new post on a talk given by James Bullard.

PPPS.  I will be giving a couple talks at the Warwick Economics Summit this weekend, so my blogging may tail off for a few days.