Wednesday, 5 February 2014
Negative interest rates are daft.
Miles Kimball is one of the long list of economists advocating negative interest rates. And the idea has an obvious appeal, approximately as follows.
Interest rate adjustments are one of the conventional tools used to control demand, so if it seems that demand is deficient despite interest rates being reduced to zero, then the obvious next step is to go for negative rates.
Now the first flaw in that idea is that interest rate adjustments are an inherently defective way of adjusting demand because (assuming they work at all) they influence just one form of economic activity: borrowing, lending and investment. But whence the assumption that a recession is necessarily caused by a drop in investment? Recessions can be caused, partially or wholly by a drop in current as opposed to capital spending.
Next, according to a recent Fed study, there is little relationship between interest rates and investment spending. But that all pales by comparison to the defects in negative interest rates, which are as follows.
If I can borrow money at say minus 4%, it will pay me to do something that yields minus 2%: like say buying up 100 houses per year and knocking 2 of them and selling the remaining 98. Now that’s a really useful thing to do, isn't it?
Of course no one is going to do anything so blatantly pointless just because they can borrow money at a negative rate. But that’s near irrelevant because in most forms of economic activity, e.g. running a chemical plant, it’s impossible to tell simply from looking at the stuff consumed and the stuff produced whether you’re doing anything useful. E.g. a chemical plant might consume chemicals A and B and produce chemicals C and D. But how do you know that’s a useful thing to do? Why not put it all into reverse and consume C and D and produce A and B?
Well the conventional way of determining whether you’re doing something useful is the bog standard profit and loss account. That is, if the market price of stuff produced exceeds total costs (including interest payments) then you’ve made and profit and you’ve done something useful.
So returning to the above genius form of housing development, and replacing the 100 houses with say two chemicals W and X and replacing the 98 houses with two chemicals Y and Z, it’s possible to run a chemical plant in a negative interest rate scenario where wealth destruction takes place, that is the value of chemicals produced is less than the value off the stuff consumed (including chemicals, negative interest payments made to creditors, and so on).
There is of course a much better way of implementing stimulus. It’s the way favoured by most MMTers I think. And that’s simply to create new fiat currency and spend it and/or cut taxes.
An alternative (favoured by market monetarists) is to have the central bank create new fiat currency and buy assets. While that is better than negative interest rates, I don’t like it because it channels money into the pockets of a small section of the population: the asset rich. Plus it boosts (at least initially) only a narrow range of types of economic activity. That is, it just boosts just investment spending.