The Nuttiness of Negative Interest Rates
In his April 18 New York Times op-ed, Harvard professor (and Bush adviser) Greg Mankiw calls on the Federal Reserve to promise future inflation, in order to fix the economy. Mankiw's article beautifully illustrates what is wrong with today's economics profession: it consists of very sharp guys (and gals) who can develop interesting models that spit out policy recommendations that would destroy the economy.
Mankiw's Case for Inflation
Mankiw's op-ed is chock-full of faulty analysis — though in fairness to Mankiw, my argument is with mainstream economics itself, not with his personal exposition. It will be most economical to quote Mankiw at length, and then proceed step by step through the flaws:
Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend…
The problem today … is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero…
So why shouldn't the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?
At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.
The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.
Unless, that is, we figure out a way to make holding money less attractive.
At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that…. Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.
That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10. …
If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.
Interest Rates Do More Than Regulate "Spending"
I don't want to make anyone cry, but I must report that Mankiw's analysis is simply crazy. In a better world, where the economists were serious thinkers who thought through the full consequences of their recommendations and whose models were very accurate, Mankiw's analysis would be akin to a brain teaser. Professors would ask their students in Econ 101, "I can give you an argument that says the government should promise massive inflation. Who can spot the fallacy?"
Perhaps the single biggest mistake in Mankiw's worldview is his treatment of the interest rate as merely a brake or governor on "spending." In this standard yet woefully simplistic approach, "the" interest rate serves to either stimulate or suppress how much money people spend today. So if businesses are laying people off, why, the answer is obvious: cut the interest rate to induce more spending, so businesses hire those workers back.
But in reality, interest rates coordinate production and consumption decisions over time. They do a lot more than simply regulate how much people spend in the present. In particular, certain sectors are much more sensitive to interest rates than others. For example, if interest rates fall, it's not merely that consumers and businesses spend more, but that they spend more on particular items such as houses, cars, and factories. When interest rates fall, the share price of General Motors might rise, but not General Mills, because breakfast cereal is not a durable good (at least not in my household).
Mankiw Doesn't Explain Why We're in Recession
A related problem is that Mankiw doesn't explain why we just so happen to be in "the worst recession since World War II." His article gives the impression that golly gee, consumers just decided to stop spending money, and so the Federal Reserve has to hit Ctrl-Alt-Delete.
In reality, what happened is that the Federal Reserve — under the leadership of the "maestro" Alan Greenspan — slashed the Fed's target rate down to 1% and held it there for a year from June 2003 to June 2004. More and more analysts are realizing that this caused or at least exacerbated the unsustainable boom in housing.
Now why in the world would Greenspan have done something so reckless? Well, he was operating under the belief that the way to get out of a recession — caused by the dot-com crash at the time — was to slash interest rates to get businesses and consumers to spend more. In other words, we are in our current mess because of the very same "medicine" that Mankiw proposes.
Because the Federal Reserve pushed down interest rates below their free-market levels, the complex capital structure of the economy was steered into an unsustainable configuration. Mankiw relies on a very simplistic model where there is one good in the economy, and a lone "representative agent" takes the interest rate and perhaps two other variables into account when deciding how to maximize his utility function. But if you make the effort to study the Mises-Hayek approach to capital, you will see all that Mankiw's simplistic analysis leaves out. You will understand why the boom period is actually wasteful and unsustainable, and the bust period is the market economy's attempt to salvage the best of a bad situation.
After a Fed-induced boom, workers and other resources need to shift from the bloated sectors into the industries that were starved during the boom. Remember, the Fed's printing of new money doesn't create more physical resources; it simply gives the big banks more dibs on bidding those resources away from other potential users. Unemployment rates rise during a recession because it takes time for the market economy to steer those workers back into useful, sustainable niches where their labor meshes with the rest of the economy.
It would have been impossible for the world economy to continue operating the way it was during the boom years of 2002–2005, because these years saw Asian and other countries sending Americans consumption goods in exchange for claims on a growing stock of empty houses. The only way to truly solve this problem and get on with life is to allow the market to liquidate these boneheaded investments. Yet that is precisely the cleansing process that Mankiw wants to short-circuit.
The Market Doesn't Need Help to Reach Equilibrium
What is really infuriating about Mankiw's analysis is the suggestion that the Fed needs to inflate in order to give households the ability to save! (He says this more explicitly on his blog.) On the contrary, the Fed has been doing everything in its power to promote consumption and dissaving.
Even though it flies in the face of everything you will hear from Nobel laureates, Harvard professors, and CNBC commentators, in the onset of a financial panic — where liquidity is at a premium — short-term interest rates need to rise dramatically. It is analogous to the prices of flashlights and canned food during a hurricane that knocks down power lines. The price needs to shoot up in order to ration the available units to those who need them the most.
By the very same token, when investment banks realize that their assets aren't worth nearly as much as they had thought, and the supply of "loanable funds" shifts way to the left, then market interest rates need to rise. The price of renting a generator goes up during a hurricane, and the price of renting cash ought to go up during a financial panic.
Even on his own terms, Mankiw overlooks a very elementary point. Let's stipulate for the sake of argument that the "equilibrium real interest rate" is negative, and that the nominal interest rate goes all the way down to zero. But oh no! Given the current array of prices and the expected array of prices next year, the implied real interest rate is too high for the market to clear. What to do?
Mankiw's suggestion is that the Fed should credibly promise to dump gobs of new dollars into the economy in twelve months, thus raising the future price "level" and giving people an incentive to unload their dollars today, while they have some purchasing power.
But there is another alternative, and that is for market prices today to fall very steeply until the market clears. The short-term collapse in prices during the present month, say, will then allow for a rapid price inflation back up to "normal" prices a year from now.
This is exactly what would have happened over the last year, had Bernanke not flooded the market with new money — and I'm talking about M1 here, not just the monetary base. Prices of not just gasoline and houses, but all sorts of items, would have fallen significantly. Consumers and investors would have gotten off the sidelines, as it were, and the economy would have resumed operations in light of the malinvestments made during the housing boom.
Destroying the Currency
It is no coincidence that Mankiw's worldview leads him to literally propose destroying the currency in order to fix the economy. That alone should have set off warning bells. As a general rule, if your economic model pops out the result "Randomly burn a tenth of the cash every year," then you should think some more about the model rather than fire off an article to the New York Times.
"Mish" has done a good job ridiculing the idea, but let's point out some more problems. For one thing, the proposal wouldn't actually yield a uniform interest rate, but would instead set up an absurd environment where things are going along smoothly and then poof 10 percent of the cash becomes worthless.
Another problem is that holders of currency would have to waste time analyzing the digits in order to diversify their cash holdings. For example, no grocery store would want to be stuck with a large proportion of its bills having any particular digit in their tills, because that would be an unnecessary gamble.
The grad student's proposal, if actually implemented, would spawn new markets in derivatives that would allow currency users to hedge against this new (and completely arbitrary) risk. In fact, the government-run AIG would probably make a small fortune selling credit-default swaps that would make whole anyone stuck holding the bag of the neutered bills.
Greg Mankiw is a very clever guy and a great writer (at least for an economist). Yet because he subscribes to the basic Keynesian aggregate-demand framework shared by all mainstream economists — whether at MIT or Chicago — he doesn't recognize the horrible implications of his proposals. It is fine for a grad student to toy with crazy ideas like randomly destroying a tenth of the currency. But a serious economist who actually influences policy debates at the national level ought to know better.