Smiles on a summer night

Nothing new today, just some facts about Sweden:

1.  The Riksbank, which is Sweden’s central bank, sponsors and funds the Nobel Prize in economics.

2.  According to Claes Berg and Lars Jonung, in the 1930s economists were held in higher esteem in Sweden than in any other country in the world.

3.  During the interwar years, the best economists in the world tended to favor price level targeting.  These included Fisher, Keynes, Wicksell, Cassel, and many other names that I can’t recall.

4.  In 1931 Sweden became the first country to officially adopt a stable price level target for monetary policy.  Berg and Jonung claim that the Riksbank remains the only central bank to have ever explicitly targeted the price level.

5.  In late 2008 I began advocating a policy of negative interest rates on bank reserves.

6.  A few days ago the Riksbank adopted a policy of negative interest rates on bank reserves.

7.  In the spring of 2009, Gregory Mankiw and Willem Buiter discussed the idea of negative interest rates on all currency, not just bank reserves.

8.  As this article in the distinguished newsmagazine The New Republic indicates, Mankiw and Buiter are being widely credited with the idea of negative rates on reserves.  And this is despite the fact that I tried to sell Mankiw on my reserves-only idea, and (as far as I know) failed.

9.  Am I bitter?  Just the opposite.  The TNR article mentions four economists;  Krugman, Mankiw, Buiter and yours truly.  And the context is the most important issue of our time, how to spring the liquidity trap.  Just as the basketball team from my alma mater (Wisconsin) must have felt on reaching the Final Four in 2000, I’m just happy to be there.

10.  Commenters should also feel happy.  Your comments advance this blog by constantly forcing me to amend and revise my views when they are clearly inadequate.  It’s a collaborative effort.  So let’s all enjoy a moment in the sun.

PS.  No snide remarks on my use of the adjective “distinguished” before TNR.  Any magazine that quotes me is distinguished.  If they were to give me a favorable plug, you’d hear me refer to “the august National Enquirer, newspaper of record.”  (Well who would you trust on the John Edwards story?)


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28 Responses to “Smiles on a summer night”

  1. Gravatar of Gary Gary
    6. July 2009 at 19:06

    I’m curious as to how the negative interest rate policy will work for people who deposit money in banks. Will the banks in Sweden be taking money periodically from people’s savings? Thanks

  2. Gravatar of Alan Alan
    6. July 2009 at 19:47

    That’s just reward for your tireless efforts, Scott. Now all we need is for another Princeton economist at a larger central bank to imitate the actions of Svensson.

  3. Gravatar of Riksbank lowers deposit rates to negative! « Mostly Economics Riksbank lowers deposit rates to negative! « Mostly Economics
    6. July 2009 at 21:20

    […] -o.25%. Thanks to Scott Sumner for pointing this in his very wise blog. TNR Blog points this could perhaps be the first tome a central bank targets negative int […]

  4. Gravatar of Current Current
    7. July 2009 at 01:41

    I don’t agree with this policy.

    What a negative interest rate amounts to is paying people to borrow. Individuals and businesses hold money because doing so confers a benefit on them. It helps to manage uncertainty, this is why people hold it rather than getting rid of it as soon as possible.

    In my view this is the valid argument for easy money in a recession. Many agents wish to hold money because the recession makes them more uncertain. So, it is preferable to allow this by creating money.

    But, what is the argument for negative interest rates? Why pay people to take money away?

  5. Gravatar of anon anon
    7. July 2009 at 02:49

    You certainly deserve some acknowledgement for the idea for being specific about reserve treatment.

    I hope there’s a way of following the Swedish data to try and gauge the effect of this.

  6. Gravatar of Van Van
    7. July 2009 at 03:13

    Prof Sumner, that is certainly great affirmation of your efforts! Congratulations.

    Here is one thing to consider in case it has not been mentioned: These same banks that are getting paid int on their reserves (and holding rather than lending) are the same ones trying to shore up their balance sheets and re-build capital. And regulators are pressing them to do so. What is their incentive to lend reserves right now, given they are wards of the state currently? Seems that for once the various gov agencies actually have policies pointing in the same direction-shore up bank balance sheets, whether the policy is correct or not.

    While i agree negative rates would ratchet lending on the margin, what is the demand for loanable funds right now? Are businesses and individuals comfortable enough to “relever” themselves? what would be the net consequence of neg rates to these banks?

    Forgive me if htese items have already been discussed

  7. Gravatar of ateve fom virginia ateve fom virginia
    7. July 2009 at 05:18

    If I were you, I’d keep quiet about this. It’s kind of like taking credit for a perpetual motion machine.

    a) It won’t work and,

    b) it’s a fraud.

    I’m not surprised the ‘Big 3’ are favorable to negative interest rates. Krugman is the Keynesian’s Keynesian, Buiter hates currencies and Mankiw doesn’t seem to care …

    Time will tell how many Swedes take their hard- earned money out of thieving banks and bury it in cans in their back yards. I know if some bank was going to charge me interest to lend it to them, I would close my account in a heartbeat.

    You economists think there is an expedient money solution to problems that have little or nothing to do with money. Hate to break it to you, but there is no easy way out of our current mess which is caused by overdevelopment.

    Like trying to save a drowning man by pouring water down his throat …

  8. Gravatar of ssumner ssumner
    7. July 2009 at 05:19

    I’ll take the last comments first:

    Van, If you have the time, this post discusses the issue in detail, and answers your question. The short answer is that there is a way to set this up without hurting banks profits, or their capital position.

    http://blogsandwikis.bentley.edu/themoneyillusion/?p=1032

    Van and Current, The idea isn’t so much to get banks “lending” in the normal sense of the term, but rather to get them to stop hoarding so much base money, so that it can go out into the economy. (This is also discussed in the link above.) Maybe banks will just buy Treasury bonds, which would avoid a deterioration of their capital position. But even that would get the reserves out into circulation, although it might not be “lending” in the commonsense meaning of the word. (Obviously in a technical sense it would be lending to the Treasury.) This is about reducing the demand for base money to reflate the economy, it is not about encouraging borrowing–although more borrowing may occur.

    Gary, The link above answers your question in detail. It could lead to service charges in bank accounts.

    Alan, Thanks. And that’s a clever line I wish I had thought up.

    Anon, I don’t think the focus should be on Sweden, although I understand why it will be. Remember that small countries can easily escape liquidity traps anytime they wish, merely by depreciating their currencies. So it will all come down to the same question it always has, is the central bank determined to reflate, or not? It is not a good sign that Svensson was outvoted on his preference to reduce the lending rate to zero. Obviously the other members of the Rikbank are more hawkish than Svensson. On the other hand the krona did fall over 1% on the news, so the market didn’t completely discount its importance. I hope Sweden does well, as it will boost the prestige of the idea, although it will be for the wrong reason. Sweden could easily reflate even without this gimmick. My guess is that the Riksbank would need to drive the krona even lower, to get any major reflation.

    Sweden’s action is important because it offers a model to the US. For the US I am recommending a negative rate on ERs, but the sine qua non of effective policy is getting the TIPS inflation indicators up over 2%. And there are lots of ways of doing that, with or without negative rates on reserves.

  9. Gravatar of Alex Golubev Alex Golubev
    7. July 2009 at 05:52

    It’s probably true that the benefit of less bank hoarding will outweight the flight of lending capital. (And I get that they can always print more money, but so can anyone. That last resort is always available under any policy) I think the best solution to Mish’s argument would be to NOT allow banks to charge rates on deposits. I don’t know if any Central bank has that power (but if they don’t, I think that’s pretty dumb).

  10. Gravatar of Alex Golubev Alex Golubev
    7. July 2009 at 06:10

    And as far as Swedish economists go. They’ve definitely embraced economics and have been on the forefront of experimental policies over the last 3,000 years at least. But isn’t it true that the Riksbank didn’t start cutting rates until fall of ’92, after their financial index has declined by 80% and a year of bank nationalizations. Thankfully it looks like those “captains” went down with the Knarr. I don’t really know why it took a year though. and do give them credit that it only took another month or so to devalue. (in the sense that they found A solution, not necessarily the best, but better than Japan).

    Speaking of captains, I wonder if Bernanke knows that “devaluation” is the only quick fix besides mass liquidations. Not that i want to argue for one or the other at this point. I just wonder if he understands and chooses to buy time or doesnt’ even understand. I’m guessing he’s fully aware of the reality of the situation, but the political game complicates things much more.

  11. Gravatar of Current Current
    7. July 2009 at 06:50

    Scott,

    What I don’t get is why it is supposedly necessary to get banks “to stop hoarding so much base money”?

    I think we agree that precautionary money holding is sensible for individuals. How then is it not sensible for banks?

    If you think banks are guilty of hoarding, and that doing that is socially damaging, then why not other agents too? That leads to the Keynesian view.

  12. Gravatar of Bill Woolsey Bill Woolsey
    7. July 2009 at 08:14

    Current:

    The reason that the Fed (and Riksbank) should charge banks for holding reserve balances is that there is an excess demand for them. Now, the Fed (and the Risksbank) can increase the quantity of reserves to clear up that excess demand. However, that requires that the Fed (and Riksbank) to accumulate assets. These assets involve at the very least interest rate risk, and some of them have credit risk too. The Fed (and Riksbank) are bearing that risk and should be compensated. And so, as the quantity of reserves increases, and the risk level of the assets held by the Fed increases, the interest rate paid on reserves should decrease. At some point the interest rate on those reserves will be negative.

    Of course, there is an “excess demand” for reserves in the sense of what the demand to hold reserves would be if nominal income were on its previous growth path (or even a reduced growth path consistent with price level stability, or even the level it was at last year.)

    In a free banking system, it would be normal for an increase in the demand for money to result in banks paying lower interest rates on the money they issue while increasing the quantity. If this made the issue of currency unprofitable, then profit making banks would stop issuing currency and solely issue negative interest deposits.

    It is supply and demand.

    Look at it another way. Why should be people be able to save by accumulating low risk, short term assets? Real world investment projects take time and involve risk. Someone must be bearing the risk. With the Fed (and the Riksbank,) it is the taxpayer. Why? Why shouldn’t those who want to save by accumulating low (no) risk and short term (zero term) assets pay for the priviledge?

    Today, people can earn high yields if they want. Buy 30 year Baa corporate bonds. They are averaging 7%. Sure, there is that 30 year commitment (though you can sell when you want if you are willing to take a capital loss) and there is that default risk…

    Oh, but you want to save by holding short term, low risk assets. Isn’t that your birthright? Why?

    If someone wants to use current resources to produce goods and services, sell them, and earn an income, but not in order to use that income to consume currently produced goods and services, but rather to save, but the person doesn’t want to take the risk of purchasing capital goods for some project that will take time and carry risk, then, why shouldn’t they pay enough to compensate those who are taking the risk?

    The interest rate is a market price. The purpose of market prices is to coordiate. If there is a surplus of apples at a price of zero, then the remainder are garbage and people have to be paid to haul it away.

  13. Gravatar of Bill Woolsey Bill Woolsey
    7. July 2009 at 08:16

    Scott:

    You really need to think about the financial intermediation end of things and not focus so much on the money multiplier.

  14. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    7. July 2009 at 11:16

    You should also mention this post on The Economist’s Forum on the FT:

    “The case for negative interest rates now
    November 20, 2008 12:35pm
    by FT

    By Brendan Brown”

    I was already prone to support this idea because of Fisher’s views on Stamping. That book can be read here:

    http://userpage.fu-berlin.de/roehrigw/fisher/

  15. Gravatar of Current Current
    8. July 2009 at 03:48

    Bill, you reply makes perfect sense in terms of a Free-banking system, I agree entirely. Such a system would probably charge to draw up notes or for current accounts in a situation like the present, and may do so in normal times too. Reserve banks that held gold for other banks would obviously charge for the gold to be used as backing.

    That doesn’t mean though that it is sensible to do this in a central banking system.

    But, look at what Scott has written. It is very different to your view.

  16. Gravatar of anon anon
    8. July 2009 at 04:08

    “The reason that the Fed (and Riksbank) should charge banks for holding reserve balances is that there is an excess demand for them.”

    Excess demand, or excess supply? Or both?

  17. Gravatar of ssumner ssumner
    8. July 2009 at 05:44

    Alex, I’m not concerned if banks put a small service charge on deposits, but again, the Fed can avoid that problem with a subsidy to required reserves.

    Thanks for the history of Sweden. Bernanke knows a devaluation would work, but he is a cautious guy, and that’s the nuclear option.

    Current, I agree with Bill’s reply. Another way of looking at it is the “fallacy of composition”–what’s good for the individual isn’t necessarily good for society. Hoarding helps me, but depresses the price level causing unemployment. And no, it doesn’t lead to “Keynesianism,” which today means roughly “fiscal stimulus.”

    Bill, I don’t follow you—I almost never mention the money multiplier in my blog. What are you referring to?

    Thanks Don, I did mention this idea in an earlier post, but it is not exactly what I am proposing. I favor a penalty rate on excess reserves, but don’t wish to drive nominal rates below zero by taxing all cash. BTW, Fisher got the idea from Gesell.

    anon, The demand is higher than the socially optimal demand. So you want to apply a penalty rate to reduce bank demand for ERs. So it is excess demand, although not in the sense of disequilibrium, but rather higher than socially optimal

  18. Gravatar of Bill Woolsey Bill Woolsey
    8. July 2009 at 07:12

    Perhaps I mistunderstand, but the paying a subsidy on required reserves raises the demand for them. If you are only interested in the supply and demand for base money, then paying a subsidy on required resreves is a factor raising the demand for base money.

    So, suppose the penalty on excess reserves causes them all to disappear. All base money is either currency or required reserves. Required reserves are now paying extra high bonus interest.

    If the quanity of base money is the same, then the result is that the demand for base money is higher (becuase of the interest on excess reserves.) And so this must be deflationary.

    Oh, but you say, when the banks get rid of all the excess reserves (to avoid the penalty) the money supply rose. M1, M2, or MZM (or whatever) has risen. And so it was expansionary.

    See.. money multiplier reasoning.

    If you stick with your base money only view–the base is the medium of account–and look at the quantity of base money and the demand to hold it, then the demand for base money has risen beause of the interest paid on excess reserves.

    Your argument depends on money multiplier reasoning. Checkable deposits have expanded to make the excess rserves into required reserves, and that is supposed to be expansionary.

    And that maybe correct, but you need to look at what is happening to the demand for checkable deposits. Banks are buying T-bills (to get rid of the excess reserves.) This drives down their rates. Why don’t those who were holding the Tbills just hold the money in checkable deposits?

    If the quantity of checkable deposits rises, but the assets purchased by the banks results in the sellers just holding the money in checkable deposits, then the increase in the quantity of checkable deposits is matched by an increase in the quantity of checkable deposits demanded. There is no expansionary effect.

    Of course, why would banks do this? When the interest rate on their earning assets drop, won’t they pay less interest on checkable deposits? Down to zero? Negative? But the subsidy for required reserves interfers with this market process!

    Your proposal raises the demand for base money (paying bonus interest on required reserves.) It is only expansionary to the degree that some other, broader “M” expands through a money multiplier process. But, the subsidy on required reserves just shifts the problem to checkable deposits.

    Just like foolish people are saying that base money has risen a huge amount, ignoring that the Fed is paying interest higher than the opportunity cost (short T-bills,) well, without even noting that the only expansionary impact of your proposal is that M1 or M2 or something rises, you are trying to keep the interest rates paid on M1 and M2 above the opportunity cost (T-bills) by subsidizing required reserves. (Protecting the profitability of the banks, how is that possible unless the subsidy is sufficient so that they can continue to pay the same interest on liabilities despite the fall in the earnings on their asset portfolio?)

    Of course, banks don’t have to only buy Tbills. But leaving asside capital requirements, they prime interest rate is well above the interest rate the Fed is paying the banks on reserves. Long T-bills pay better too. The problem is that the Fed is paying more than short term, low risk assets–short T-bills.

    The interest rates on reserves (both excess and required) should be slightly negative. And the interest rates on deposits should be slightly negative. And the limit is the storage cost of currency. And that is the lower bound. There is no getting around it.

    As ;pmg as redeemability in zero interest currency is maintained, if the interest rate is at the true lower bound reflecting the cost of that currency, then, the Fed is going to have to purchase higher risk and longer term assets, which will bring down their yields.

    If the banking system (Fed and the banks) just purchase a bunch of low risk, short term assets, and fund it by issuing low risk, short term assets (reserves or FDIC insured deposits) then those selling the bonds to the Fed are just going to hold the liabilities created by the banking system.

    I say, go for it. Buy all of the T-bills. But it will not work. The problem is an excess demand for short term, lower risk assets. Once the interest rate on those hits slightly less than zero, then any excess demand gets shifted to money. Having thing banking system hold more of those assets reduces the quantity of those assets and exacerbates the shortage of them which shifts to money.

    My view is that they should bring thr short term and low risk yields as low as possible. (slightly negative.) And only then start shrinking the market risk and liquidity premium by bearing credit and interest rate risk that others don’t want. The first best solution is to have negative interest on currency and have short term rates, low risk interest rates to be as negative as needed to clear markets with nominal income on target. And then the market can determine the premia for higher risk and longer term assets without the Fed bearing that risk.

    But negative interest on currency is difficult in practice.

    If we are stuck with zero interest currency issued by the Fed, and the interest rate on zero risk, short term assets is as low as the storage cost of currency. Then, the Fed is going to have to buy other assets.

    So, paying interest on reserves is a bad idea right now. A negative interest rate on reserves is appropriate, but not so low as to cause a currency drain. Fancy pants policies of targetted subsidies are pointless. Yes, they can raise the money multlplier and increase M something or other by more, but it is only “necessary” if it will prevent there from being an expansionary impact anyway.

    And then, QE is needed, which will mean purchasing higher risk, longer term assets.

    I fully agree that if the Fed would to target the level of nominal income (say 15 trillion by fourth quarter) and then say, yes, short rates as negative as we can and we will buy up what we need to, then, maybe they won’t have to buy all that much. Maybe the short rates won’t have to be negative.

  19. Gravatar of Current Current
    8. July 2009 at 07:13

    Scott: “Current, I agree with Bill’s reply.”

    I’m a bit surprised about that. A couple of weeks ago you were talking about tackling the recession King Henry VIII style. Compare that to what Bill has said above.

    http://blogsandwikis.bentley.edu/themoneyillusion/?p=1671

    Scott: “Another way of looking at it is the ‘fallacy of composition’-what’s good for the individual isn’t necessarily good for society. Hoarding helps me, but depresses the price level causing unemployment. And no, it doesn’t lead to ‘Keynesianism.'”

    I agree with you about fallacies of composition.

    The problem with “hoarding” is that it implies that a “hoard” can be distinguished. However an individual holds money as a hedge against subjectively-determined uncertainty. So, it is not really possible to divide the portion of money that they possess into a “needed” and “hoard” portion. As such I don’t think that it is useful for analyzing the problem.

    Here is Mises:
    “Every piece of money is owned by one of the members of the market economy. The transfer of money from the control of one actor into that of another is temporally immediate and continuous. There is no fraction of time in between in which the money is not a part of an individual’s or a firm’s cash holding, but just in “circulation.”[4] It is unsound to distinguish between circulating and idle money. It is no less faulty to distinguish between circulating money and hoarded money. What is called hoarding is a height of cash holding which–according to the personal opinion of an observer–exceeds what is deemed normal and adequate. However, hoarding is cash holding. Hoarded money is still money and it serves in the hoards the same purposes which it serves in cash holdings called normal. He who hoards money believes that some special conditions make it expedient to accumulate a cash holding which exceeds the amount he himself would keep under different conditions, or other people keep, or an economist censuring his action considers appropriate. That he acts in this way influences the configuration of the [p. 403] demand for money in the same way in which every ‘normal’ demand influences it.

    Others maintained that one should not speak of the demand for and supply of money because the aims of those demanding money differ from the aims of those demanding vendible commodities. Commodities, they say, are demanded ultimately for consumption, while money is demanded in order to be given away in further acts of exchange. This objection is no less invalid. The use which people make of a medium of exchange consists eventually in its being given away. But first of all they are eager to accumulate a certain amount of it in order to be ready for the moment in which a purchase may be accomplished. Precisely because people do not want to provide for their own needs right at the instant at which they give away the goods and services they themselves bring to the market, precisely because they want to wait or are forced to wait until propitious conditions for buying appear, they barter not directly but indirectly through the interposition of a medium of exchange. The fact that money is not worn out by the use one makes of it and that it can render its services practically for an unlimited length of time is an important factor in the configuration of its supply. But it does not alter the fact that the appraisement of money is to be explained in the same way as the appraisement of all other goods: by the demand on the part of those who are eager to acquire a definite quantity of it.”

    I think that Bill is taking this view too. He is not condemning hoarding but rather asking that those who benefit from it should pay the real cost.

  20. Gravatar of Bill Woolsey Bill Woolsey
    8. July 2009 at 07:22

    anon:

    There is an excess demand for base money relative to what its level would be with nominal income at $14.7 trillion. This claim is based on the notion that the demand for base money is positively related to the level of nominal income, which is currently $14.1 trillion. Paradoxically, if nominal income were to rise to $14.7 trillion, I suspect that the demand for base money would drop off rapidly, and the quantity would need to fall as well.

    I can only assume that you think that there is an excess supply of reserves based upon the assumption that the quantity is higher than it was a year ago. The implicit assumption then, is that the demand for reserves is unchanging. Demands change.

  21. Gravatar of ssumner ssumner
    10. July 2009 at 11:18

    Bill, My point about RR was just a way of addressing the profit issue. I don’t think we actually need it, but I also don’t think it would do the harm you suggest. Suppose the subsidy was done differently. Suppose the Fed said there’d be a 2% penalty on ERs, and a small offseting subsidy to bank’s total assets. I have no idea how large, but one that would lead to roughly zero net tax on the average bank. Thus the subsidy % rate would be very low, because total assets would be much bigger than ERs. That mix of policies could still reduce ER demand, and hence base demand. But it would not have the objectionable characteristic of boosting base demand by subsidizing RRs.

    My micro theory is rusty, but it seems to me I have a valid argument. RRs are required, so the demand is very inelastic. The demand for ERs is very elastic, as T-bills are close substitutes. So I think a tax/subsidy system can reduce total reserve demand, and hence total MB demand, even if there is no net flow from banks to the Fed. It is all about the very different elasticities. If I am wrong I will gladly back off, as I don’t really think a RR subsidy is needed. But I also want to overcome any political factor that may be preventing policymakers from giving it serious thought.

    You said:

    “The interest rates on reserves (both excess and required) should be slightly negative. And the interest rates on deposits should be slightly negative. And the limit is the storage cost of currency. And that is the lower bound. There is no getting around it.”

    I am not trying to get around this. I am not trying to get even lower interest rates. I want the interest penalty to create inflation expectations and hence higher rates. I think if the Fed does so much QE that people have to go out and buy safes to store all the cash, then that creates inflation expectations, which leads to actual inflation and moves us up the SRAS curve. It shows the Fed means business. But they must carry through when things get a bit better, not tighten like the BOJ did. I have never viewed i-rates as an important transmission mechanism.

    I want higher nominal rates because prosperity is associated with higher nominal rates (and a lower monetary base I might add.) The very last paragraph is where you are closest to my point of view. But at least we have the same general view of what they have done wrong and what needs to be done. The interest penalty is key, and a RR subsidy is a trivial issue in my view.

    Current, I am not advocating high inflation, the King post was satire, I was saying how is it that modern central banks say they don’t how to create inflation, when medieval kings knew how? I actually only want about 2% inflation. As far as I know Bill thinks 0% inflation is best in the long run, but agrees with me that it was foolish to bring the rate down to zero in the midst of a financial crisis. So I don’t think Bill and I are far apart, maybe my rhetoric is more reckless than his–I know he has told me that a few times.

    I actually like the von Mises quotation, but have a slightly different take. I agree that there is no sharp line between transactions balances, and hoarding balances. But if the MB doubles and NGDP is unchanged, or even falls, then I think it is reasonable to say “hoarding increased” even if we can’t say precisely how many dollars are hoarded. If you prefer “the real demand for cash increased” or “velocity decreased,” I’m fine with that terminology instead. It shouldn’t affect he merits of any good argument.

  22. Gravatar of Bill Woolsey Bill Woolsey
    12. July 2009 at 15:19

    Scott:

    The theory that we just implement index futures targetting and everyone will believe it will work and so everyone will expect real inome to be higher, so everyone will want to borrow more (and lend less) and so the level of real interest rates that clear markets now will rise, and spending will rise, and the economy will recover…

    Well, the problem is that it requires that people think it will work. What if they don’t believe it? How will the system prove to them that it will work. How will it work despite their pessemistic expections?

    OK, so we charge a penality on reserves. (I support this, though it should not be so high as to cause a currency drain.) So, the banks buy T-bills. And, perhaps the Fed does too.

    Now, people have more money in checkable deposits. Basically, the people who did have T-bills now have money in checkable deposits.

    Your theory is that they will look at those large balances in checking and either consume or else purchase capital goods.

    The liquidity trap argument is that they will just hold it. That they were holding the T-bills before.. now they will hold the money in their checking accounts.

    What then? Well, the Fed just has to buy more and more T-bills until it has them all. What if people chose hold the checkable deposits in place of the T-bills?

    Now the Fed has to start purchasing other assets.

    Now… watch out.. Don’t go back to your optimistic scenario where everyone just believes it will work. No, they don’t believe it will work. So they aren’t going to start borrowing and spending and pulling up the level of real interest rates consistent with market clearing.

    So, the Fed is buying up risky and longer term assets. It is bidding up their prices and causing their yields to go down. They are lowering the real interest rates on these things, so that people will spend more despite their pessimism about the future.

    But, notice that the yield curve is less steep and market risk premia is shrinking. Because, of course, the Fed is taking the risk.

    This is bad. It would be better for the real interest rates on the short term assets to fall. And the obvious way to do that is negative nominal yields.

    Now, when short term, low risk yeilds are sufficiently negative and the real interest rates on risky and longer term assets are low enough, then spending will rise so that nominal income is on target.

    Now, as the economy starts to recover, presumably, people will start to believe it works, and the needed real interest rates and nominal interest rates will rise.

    But, unlike your approach, where “the market” will know it will work, and it is just economists and the Fed who doesn’t see the light, this approach works if the market doesn’t know and must be shown.

    And so, interest rates on T-bills, FDIC insured deposits and reserve balances at the Fed should all be negative, but no more negative that the cost of storing currency.

    The reason the Fed is paying interest on Reserves Balances is to keep all of these interest rates up. (They said it was too keep the Fed Funds rate up.) It is a mistake. All of these interest rates should drop. Negative for all of them is good.

    I have explained before that you are guilty of money multiplier thinking. The penalty rate of excess reserves impacts M1 (or something) and so people will have more cash balances, and so they will spend more, and so aggregate demand will rise. Maybe. But maybe not. When the banks get rid of the excess rserves by purchasing T-bills, this reduces the quantity of T-bills remaining to the nonbanking public. What if they shift to holding FDIC insured deposits instead? The increase in deposits created by the banks will be exactly matched by an increase in demand.

    Of course, sometimes you jump into the expected inflation thinking. Everyone knows that the increase in M1 (or whatever) will cause inflation. And that will turn real interest rates negative.

    Now, I for one, don’t want actual inflation and so I don’t favor policies that cause expected inflation.

    But, of course, it doesn’t matter. I do favor increasing spending. And we both agree that the desirable increase in output and the increase in prices are due to the increase in spending.

    My point is that it is obvious that there are lots of people who don’t believe that an increase in base money (or a reduction in the interest rate on reserves) will raise spending.

    It needs to increase enough to actually get spending to increase. And this implies that the Fed is buying a lot of assets. And that has implications for the prices and yields on them.

    Price floors cause problems. Having monetary instituions that puts a floor of zero on nominal interest rates are going to cause problems. Nominal income targetting may be inconsistent with having some real interest rates at market clearing levels with that price floor. Just because every episode you have studied in the past only has a negative real interest rate of more than 2% on any asset when nominal income is expected to grow less than target doesn’t cover all the possibliities.

  23. Gravatar of Current Current
    13. July 2009 at 02:06

    Scott: “I am not advocating high inflation, the King post was satire, I was saying how is it that modern central banks say they don’t how to create inflation, when medieval kings knew how?”

    Ah, I get it.

    Scott: “actually only want about 2% inflation. As far as I know Bill thinks 0% inflation is best in the long run, but agrees with me that it was foolish to bring the rate down to zero in the midst of a financial crisis.”

    I agree more with Bill than with you in the long term. I don’t think that right now though that it matter too much if the rate of inflation is higher than 0%, there are bigger fish to fry.

    Scott: “But if the MB doubles and NGDP is unchanged, or even falls, then I think it is reasonable to say “hoarding increased” even if we can’t say precisely how many dollars are hoarded. If you prefer “the real demand for cash increased” or “velocity decreased,” I’m fine with that terminology instead. It shouldn’t affect he merits of any good argument.”

    Yes. However, what we should remember is that there is both a social benefit and a social cost here. The spread out social cost is that of the depressed price level. However there is also an individual benefit in the security of money holding, that also leads to an overall social benefit. We are unable to tell which is greater. Mises’ words are targeted at Keynesians who failed to recognize the latter point. As most who talk about hoarding still seem to today.

    All this is why Bill advocates the traditional and wise route of charging for money at a price that is related to cost.

    I’m still not sure though if negative interest rates will do the same thing in a central banking system. I don’t know enough about the subject.

  24. Gravatar of ssumner ssumner
    13. July 2009 at 05:41

    Bill, You said:

    “Your theory is that they will look at those large balances in checking and either consume or else purchase capital goods.”

    No, this isn’t my theory at all. My theory is that increases in expected future NGDP will cause current AD to go up. And it is not just my theory, but it is standard, mainstream macro theory, both new classical and new Keynesian.

    You ask what if people don’t believe it will work. Then they will keep buying NGDP futures. I think it would be great if people didn’t think it would work, and didn’t react to that pessimism by buying NGDP futures–then I could get rich buying NGDP futures myself. But I don’t think that fantasy is likely to become true. My hunch is that people will buy NGDP futures until the money supply increases so much that expected future NGDP is close to 5% higher (not exactly, obviously.) I am not relying on standard old Keynesian and monetarist transmission mechanisms. I think the relevant mechanism is that the (monetarist) excess cash balance mechanism causes NGDP to rise in the long run. And the expectation that it will rise in the long run causes AD to increase today, pushing NGDP higher in the short run.

    You said:

    “Now, when short term, low risk yields are sufficiently negative and the real interest rates on risky and longer term assets are low enough, then spending will rise so that nominal income is on target.

    Now, as the economy starts to recover, presumably, people will start to believe it works, and the needed real interest rates and nominal interest rates will rise.

    But, unlike your approach, where “the market” will know it will work, and it is just economists and the Fed who doesn’t see the light, this approach works if the market doesn’t know and must be shown.”

    I’m not quite sure what you are trying to do here. If you are merely showing a counterfactual, i.e. that failure would lead to a contradiction, then I guess it is all right. But if you are saying these things would actually happen, then I strongly disagree. It would make no sense to say interest rates will fall very low, so that would create expectations of recovery, so then interest rates would go up. You need a Ratex equilibrium where interest rates immediately go to the position implied by your model of the economy. If the policy is expected to be successful, rates will go up. Alternatively, you need a model where the interest rate on 1 year T-bills is consistent with other market prices showing a 5% premium of future NGDP over the spot NGDP

    Regarding your multiplier comment, I am not assuming anything specific about the money multiplier. I do think it is likely that a penalty rate on ERs would raise the money multiplier, but the only multiplier I care about is the ratio of NGDP to the base.

    Current, You said:

    “I agree more with Bill than with you in the long term. I don’t think that right now though that it matter too much if the rate of inflation is higher than 0%, there are bigger fish to fry.”

    It may not matter much to you, but it does matter to the millions of people who are unemployed because the inflation rate fell into negative territory. I view the sharp fall in inflation as the cause of the recession, just as in 1982, 1938, 1930, 1921, and every other major recession we have ever had. The losses in jobs far outweigh any benefits we get from cash having a bit more purchasing power. It is not a zero sum game–when output falls sharply there is a net loss to the economy, because we produce less stuff.

  25. Gravatar of Current Current
    13. July 2009 at 06:38

    Scott: “It may not matter much to you, but it does matter to the millions of people who are unemployed because the inflation rate fell into negative territory.”

    I think you’re misunderstanding me. I’m not taking Robert Murphy’s position here.

    My point is that in a crisis like this any problems of future mis-allocation that inflation may cause are not particularly important.

    Still, I don’t fully agree with you. Growth and deflation have occurred simultaneously frequently in the past. It is the specific overall situation that prevails at present that is the problem. Downward wage-price stickiness is a problem, of course, but it is revealed and made significant because of all the other problems right now.

    We are in the “secondary recession”. I think that Bill Woolsey and yourself (to some extent) are right about the solution to this. Those who are holding money should pay at least some of the costs of doing that. I’m not sure how that will work in the current central banking system though.

  26. Gravatar of ssumner ssumner
    14. July 2009 at 06:48

    Current, I agree about the secondary recession–which is often much worse than the first one.

  27. Gravatar of TheMoneyIllusion » Sweden is suddenly in the news TheMoneyIllusion » Sweden is suddenly in the news
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