Narayana Kocherlakota on free markets and recessions.

NK claims in a Bloomberg article entitled “Want a free market…” that given a recession in a totally free market, interest rates would go “deep into negative territory” which would be part of the free market’s cure for a recession.

To be exact, his second paragraph reads, “Imagine what would happen in a free market if everyone suddenly decided that future economic growth would be very slow. The price of safe assets such as U.S. government bonds -- assets that pay off even in a low-growth environment -- would rise sharply. As a result, the real (inflation-adjusted) interest rate, which always moves opposite to the price of safe assets, would fall. In principle, if the demand for safe assets was strong enough, the real interest rate could go deep into negative territory.”

Well starting with EXISTING government bonds as distinct from freshly issued bonds, I’m baffled as to how interest on existing government bonds can go negative. No doubt in a recession, as NK suggests, there is a flight to safety: i.e. demand for government bonds rises. So let’s say the price of those bonds DOUBLES. That means that yield on them will HALVE.

Or let’s suppose the price QUADRUPLES. In that case the yield drops to a quarter of its initial level. No doubt you’ll have worked out where this is leading: yield can never go negative!


Freshly issued bonds.

As distinct from EXISTING bonds, there are the bonds issued, or rolled over AFTER a recession has hit. In that scenario, government will realize it can issue bonds at a very low rate of interest. In fact the free market rate of interest on a risk free loan may drop to zero. But in that case, why do those with cash to spare bother buying bonds at all? That is, what’s the point in locking up your money, which is what is involved when you buy a bond, when the reward for doing so is zero? You might as well keep your money in the form of ready cash somehow or other. For example you could keep it under the proverbial mattress, which is risky: your teenage son or estranged partner might run off with it. Or you could store it in a safe deposit box.

But those running safe deposit box facilities charge for their services: perhaps about 1% pa of the value of items deposited. So in that case it would pay you to buy a government bond with a negative yield of between 0% and 1%. But the SIZE OF that negative yield will never exceed the above mentioned cost of storing cash in a safe deposit box (or lodging the money at a commercial bank).

So the conclusion so far is that yields on government bonds could go negative, but NK is mistaken in talking about “DEEP negative territory”.


Arthur Pigou.

So what is the free market’s solution to a recession? And make no mistake, there must be some sort of free market solution because in the 1800s and before, there were recessions, plus governments in those days made no attempt to deal with them. Yet economies did recover from recessions.

Well as it happens I set out the market’s solution just recently.

To repeat, in a totally free market and given a recession, wages and prices would fall (in terms of money). That in turn means rise in the REAL VALUE of money (most importantly base money). And that in turn represents a incentive to holders of that money to spend more. And that phenomenon is called the “Pigou effect” after the economist Arthur Pigou who presumably was the first to set out that effect.

Incidentally, the REAL VALUE of government debt also rises when the value of money rises, which enhances the Pigou effect. And if you’re in any way puzzled by that, then remember that (as Martin Wolf explained), base money and government debt are almost the same thing, particularly at low interest rates. (See Wolf’s paragraph starting “The purchase of equities..”)

Incidentally, MMTers were onto that point some time ago in that they sometimes lump base money and government debt together and refer to them collectively as “Private Sector Net Financial Assets”.