Friday, 14 February 2014

The ECB’s flawed negative interest rate policy bolsters the arguments for MMT.

As if there aren’t enough flaws in the Eurozone (Greece etc) the ECB is now considering negative interest rates according to the Wall Street Journal.
I gave some reasons for thinking negative rates were flawed here (e.g. the fact that negative rates can lead to negative output). But those flaws actually beg a more fundamental question namely: should interest rates be used to control demand at all?
And that is a very fundamental question for the EZ because the Euro is structured so that there is no alternative to interest rate adjustments (assuming the ECB keeps to its no Outright Monetary Transactions  (OMT) policy). That is, the Euro is what is sometimes called a “debt based” system. Put another way, the ECB behaves like a private bank in that the private non-bank sector cannot get hold of the money the relevant bank issues without going into debt to that bank (and normally paying interest or at least some sort of charge for the privilege of being supplied with money by the relevant bank).
In contrast, in the US, UK and elsewhere, central banks and governments regularly go in for OMT, that is, having the central bank print money and buy private sector assets (primarily government debt). And that means that the private non-bank sector ends up with money to which there is no corresponding debt – in particular, no debt owed to a bank. Or in MMT parlance, that money is a “private sector net financial asset”.
And that in turn means that in the US, UK etc, the QUANTITY of base money in the non-bank private sector’s hands can be used to influence demand, a policy that MMTers back. That is MMTers argue that adjusting the latter amount of base money is a good way of adjusting demand.
There are thus two fundamentally different ways of adjusting demand: interest rate adjustments and “stock of base money adjustments” (of which QE is an example). There are of course fiscal methods of influencing demand, but I’m concentrating just on monetary methods for the moment. Also when the stock of base money in the hands of the non-bank private sector is expanded, that is inevitably done in a fiscal manner, e.g. by raised public spending or reduced taxes. But to repeat, the argument here concentrates on monetary matters.
Now I’ll hazard a guess that one of the above two (OMT or no OMT) must be the better. So which is it?

Interest rate adjustments are defective.
Well interest rate adjustments are defective for several reasons. First they are distortionary. That is they influence (at least in the first instance) just investment spending. And there is no earthly logic, given a recession, for raising just investment spending any more than there is in raising just expenditure on cars and restaurant meals.
Second, as Mervyn King pointed out, there is a limit to the TIME for which interest rate cuts work, and for the following reason. Given an interest rate cut (and assuming interest rate adjustments have any effect at all), investment will rise. That is, investment will be pulled forward in time. But there is a limit to the amount of “pulling forward” that any firm or household will do. That is, interest rate cuts might work for perhaps two years or so. (King made his point at the bottom of p.3 here).
In contrast, raising the amount of base money in private sector non-bank hands has a PERMANENT effect on demand (via the hot potato effect). At least the effect is permanent all else equal.
You could perhaps argue that raising the amount of base money in private sector non-bank hands is not a permanent solution in that inflation whittles away the value of that base money. But that is easily dealt with by issuing more base money. In contrast, when interest rate cut runs out of steam after the above two year period (or whatever the period is), the only option may then be to go for the absurdity of negative interest rates.
Incidentally, it could be argued that base money is held by commercial banks, not private sector non-bank entities. The answer to that is that in effect, commercial banks simply act as agents at the central bank for those non-bank entities.
And a third reason for doubting the efficacy of interest rate adjustments is this recent Fed study plus another recent study, both of which found that there is not much relationship between interest rates and investment spending.
Ergo, demand should be adjusted in the way advocated by Positive Money and by MMTers, namely having government and central bank adjust the amount of base money created and spent into the economy, and/or adjusting taxes.
As to interest rates, they can be left to find their own level. Though there is perhaps no harm in using interest rate adjustments as a SUPPLEMENTARY tool to be used in emergencies.


  1. To offset economic stagnation, the objective is to increase aggregate demand. But unless you increase goods & services at the same pace, you end up shooting yourself in the foot.

    The money stock can never be managed by any attempt to control the cost of credit. Proper monetary policy would be just to get the commercial banks completely out of the savings business. This would redirect the flow of savings back through the non-bank lending/investing sector (where savings are matched with investment).

    1. If I’ve got you right, then I agree. Milton Friedman and Lawrence Kotlikoff advocated a system (which is a variation on Positive Money’s system) where real saving and investment (as opposed to storing up bits of paper called “pounds sterling”) is done by what are in effect unit trusts, rather than banks.


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