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Backward thinking

16 July 2012 By Edward Hadas

What used to be outlandish may be on the way to becoming almost normal: governments are borrowing at negative interest rates. France has become the latest state to charge investors for the privilege of providing it with funds. The French nominal rate – 0.05 percent for 3-month funds – is only slightly negative, but it is not alone. Switzerland, Germany and Denmark are already members of the below-zero club and other relatively successful countries could join soon.

The immediate cause of these apparently uneconomic transactions is investors’ extreme desire for safety. They would rather accept a small but relatively sure loss than take their chances in riskier assets. For buyers of debt from non-euro countries, the safety is in the currency. The Swiss franc and Danish kroner are seen as refuges from the troubled euro. Inside the single currency, safety is sought in members with relatively trustworthy governments.

Why not just put money in safe banks? That was a viable approach in the euro zone until the most recent interest rate cut from the European Central Bank. The best banks could offer a low but positive interest rate, while earning a little bit more by depositing the cash overnight with the European Central Bank. Now that the ECB deposit rate is zero, government debt looks relatively attractive, even at minus-something.

It’s all a bit strange, but policymakers don’t mind negative rates. They should encourage investors and banks to take more risks, which in turn should lead to economic growth and job creation. But right now the ample supply of free money is basically sitting around, at a slight cost to whoever happens to own it. In the first week since the ECB’s rate cut, deposits with the central bank fell by a statistically insignificant 2 percent.

Negative nominal interest rates cause problems. Computer systems may have to be modified. Money market funds may have to close, because their short-term, low-risk investments won’t pay enough to cover their costs, let alone offer buyers a positive return. However, these are problems which the clever technicians of finance should be able to solve.

A more difficult issue is raised by negative real rates – interest rates which are below the rate of inflation. Those have been around for years in Europe and the United States. The U.S. Fed Funds rate has been below the last reported annual rate of consumer price inflation for 32 straight months, and for two-thirds of the last decade.

According to the standard economic model of finance, such negative-cost money is supposed to be a strong incentive to economic activity. It’s always hard to test a theory like that, but it certainly seems easy money has not actually stimulated either lending or spending. It has only led to what economists call a liquidity trap – lots of money that no one wants to spend or invest.

For monetary policymakers, the lack of response is a much bigger practical problem than negative nominal rates. The problem of finding effective policy, however, will be difficult to solve without a major revision to the standard theory of monetary finance.

According to a model first presented in the 1940s, the “natural” real risk-free interest rate (r) is the same as the long-term sustainable real growth rate (g). The equation “r=g” was sometimes referred to as a golden rule. When the economy was ticking along at a healthy pace, unnatural policy interest rates would create inflation, if they were too high, or discourage growth, if they were too low. If the economy veered off course, rates could be used to pull it back to a sustainable path – above-natural to slow it down and below-natural rates to speed it up.

The theory has been elaborated with many impressive equations, but it doesn’t seem to work. The problem is not limited to developed economies. Some developing economies have avoided high inflation despite negative real policy rates of close to 10 percent.

What is actually wrong with this golden rule? Well, like most of the intellectual infrastructure of finance, the model which generates the rule starts with some hugely unrealistic assumptions: perfect competition, a single product, complete knowledge of the future, no government and identical households. It is hardly surprising that the model fails in a world defined by fear, greed, ignorance, strong governments and complexity.

As yet, the professional response to monetary policy failure has been what historians of science refer to as “saving the appearances” – developing explanations and corollaries which allow modified versions of the theory to be reconciled with uncooperative data. It is almost inconceivable to a well trained theoretical economist that the basic assumption – that real interest rates and expected growth rates are the crucial variables in lending – is false.

Economists should reflect on history. Interest was charged on loans long before anyone thought to measure either inflation or growth. Indeed, these statistics came into vogue largely because of the then new economic theory which claimed that borrowers and lenders were unconsciously making estimates of r and g.

Perhaps it is time for what historians of science call a paradigm shift, a whole new way of looking at interest rates. If so, something positive could yet come out of negative rates.


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