Sunday, 22 April 2018

The argument for a permanent zero interest rate.


If you like simple original economics ideas like E=MC2, then the permanent zero interest rate idea might interest you. So let’s run thru the arguments for this idea. As with Einstein’s famous equation, while the end result is simple, the arguments leading to it are not quite as simple. However, you don’t need to be a genius to understand the arguments for a permanent zero interest rate. 

That idea amounts to saying that government and central bank (I’ll refer to that pair of entities as “the state”) should issue a form of money, i.e. base money, but should not pay interest to anyone for holding that money: i.e. it’s the idea that there should be no government debt.

Milton Friedman briefly suggested the idea in 1948*. See his para starting “Operation of the proposal…”.

The idea was also advocated by Warren Mosler** in 2005, and Bill Mitchell*** in 2011.

Needless to say I think I can explain the reasons for a permanent zero rates better than the above three individuals – else I wouldn’t bother writing this article! So here goes.

Demand and the stock of base money.

It is reasonable to assume that aggregate demand will vary with the size of the stock of base money held by the private sector. That is, all else equal, when a household is given more money, its weekly spending rises, ergo give more money to every household, and demand will rise.

Note that is not the same as saying that demand is related to the total stock of money: the bulk of the money supply is created by commercial banks, and for each dollar of money they issue, there is a corresponding dollar of debt. Thus a rise in the stock of that type of money probably has little effect on demand: indeed, a rise in that stock is probably the RESULT of a rise in the private sector’s desire to do business (e.g. a desire to borrow and invest in machinery or in a larger stock of finished goods for sale).

It follows that the optimum stock of base money to issue is the amount that keeps the economy operating as near capacity as possible, without causing excess inflation.

Now government can of course issue more than that stock of base money, but if it does, demand will probably become excessive, which means government will need to offer interest to “money holders” with a view to persuading them not to try to spend away their excess stock of base money.

But the effect is an entirely artificial rise in interest rates! And that’s an important defect in the latter “excess stock of base money” scenario. The defect is that it is widely accepted in economics that the GDP maximising price for anything is the free market price, and that presumably goes for interest rates. Ergo, the above “excess stock of base money” scenario will not maximise GDP. (There are of course exceptions to the latter “free market is best” idea: that is we overrule market forces where it is clear that social considerations should  overrule the free market. E.g. kid’s education is available for free. But in the absence of obvious social considerations, the normal rule is: “the free market price is best”.)

Having hopefully established that a zero government borrowing regime is best, there are numerous matters arising from that claim  and apparent problems with the claim. Some of those problems will now be considered.

A permanent zero rates rules out interest rate adjustments.

The answer to that criticism is that demand can perfectly well be regulated by fiscal means as well as monetary means (e.g. interest rate adjustments). Plus it is clear that neither method of adjusting demand works in quick or predictable way, thus abandoning one of those methods of demand adjustment would do not harm at all, at least in principle.

Also abandoning interest rate adjustments does not mean ruling out monetary instruments altogether: that is, it would be perfectly possible to abandon interest rate adjustments, while implementing stimulus by having the state print base money and spend it (and/or cut taxes) as necessary, and that would clearly increase the private sector’s stock of base money, which is monetary policy of a sort.

Government should borrow so as to invest.

The popular idea that government should borrow so as to invest in infrastructure and the like obviously clashes with the above claim that government should borrow nothing.  In fact the arguments for the latter “popular” idea don’t stand inspection.

First, the average small business proprietor would fall about laughing at the idea that investment justifies borrowing: for example if a taxi driver wants a new taxi and happens to have enough spare cash to buy it, why would he or she borrow?  That is, why pay interest to someone when you don’t need to? And the state has a near inexhaustible supply of cash: first the taxpayer, and second, government or “the state” can print money (though clearly money printing cannot be take too far).

Second, education is one huge investment, but for some bizarre reason, while the idea that borrowing should fund infrastructure investment is popular, no one ever suggests the entire education budget should be funded via borrowing.

Third, the lack of any sort of logical relationship between borrowing and investment is further underlined by the fact that it can make sense to borrow to fund consumption. For example there are doubtless thousands of married couples whose children have left home and who plan to move into a smaller home but don’t want to do so quite yet. If some of those couples want to borrow money this year to go on a world cruise, then pay the money back out of the proceeds of sale of their existing house in a couple of years’ time, that would make sense.

The conclusion of this section is that the idea that investment justifies borrowing is nonsense.  The real justification for borrowing is a shortage of cash.

Giving politicians the right to borrow is risky.

When politicians have the right to borrow, it’s pretty obvious what they’ll tend to do: borrow now with a view to ingratiating themselves with voters, with the cost of that ploy being loaded onto future generations. David Hume writing almost 300 years ago spelled out that danger very clearly. As he put it:

It is very tempting to a minister to employ such an expedient, as enables him to make a great figure during his administration, without overburdening the people with taxes, or exciting any immediate clamours against himself. The practice, therefore, of contracting debt will almost infallibly be abused, in every government. It would scarcely be more imprudent to give a prodigal son a credit in every banker's shop in London, than to impower a statesman to draw bills, in this manner, upon posterity.”

Government borrowing spreads costs across generations?

An apparent merit of government borrowing for infrastructure is that it spreads the cost over the generations that benefit from the relevant investments. The flaw in that idea is that idea assumes time travel is possible: that is, it is not physically possible to build a bridge in 2018 using steel and concrete produced by the blood, sweat and tears of those living in 2030.

That point about time travel might seem to conflict with David Hume’s point above about people today borrowing from “posterity”, i.e. future generations. The explanation is that a country can only in fact succeed in imposing costs on future generations to the extent that it borrows from abroad.  Thus the extent to which David Hume’s point is valid is a bit limited.

To illustrate, a country clearly benefits in the short term if the steel for a bridge is supplied by another country. That steel production requires blood, sweat and tears to be expended in the other country in 2018 for example. But when that debt is paid back, real goods (perhaps steel) has to be shipped the other way, which imposes a “blood, sweat and tears” cost on the country where the bridge is build.

Exactly the same point applies to a household. If one member of a household lends to another, there is not net benefit for the household as a whole. But if the loan comes from OUTSIDE the household, the household can enjoy a temporary standard of living boost, which will have to be paid back at some point.

And there is another problem with the “spread across generations” idea, namely that the government of most countries invest in infrastructure and so on, thus if every country borrows from other countries to fund their investment, the latter benefits approximately all cancel out!!

Borrowing to smooth out receipts from income from tax.

One excuse for government borrowing is that allegedly government needs to borrow so as to smooth out receipts from tax. In fact if government is short of funds for a few months, there is nothing to stop it (assisted by the central bank) from simply printing money to make good the temporary shortfall.

It might seem that that would lead to the private sector having an excessive stock of base money at particular times of the year, which in turn could result in excess demand, which in turn needs to be damped down by government borrowing. The answer to that is that if a firm or individual knows they will have to pay about $X to the tax authorities in  six months’ time, they are unlikely to blow that money on consumer goodies! Thus there is little need for the latter “damping”.

The political problems of “fiscal policy only”.

Having suggested above that interest rate adjustments can be abandoned, that clearly implies that fiscal adjustments take more of the burden, which could involve political problems. E.g. if an economy is overheating, that  can be dealt with by rise in income tax plus an interest rate rise, whereas if it’s just the income tax rise that does the job, then clearly the tax increase will need to be larger, and that could prove unpopular.

The answer to that little problem is that a permanent zero rate does not need to be 100% permanent. That is, if there is no government debt, and a temporary interest rate rise is required in order to get round the latter sort of political problem, the central bank can always wade into the market and borrow at above the going rate. But certainly the objective should be to return the “no state borrowing” scenario as soon as possible. 

Government borrowing facilitates private borrowing.

A final possible justification for government borrowing is one which I have not seen anyone else spell out, but it’s a possibility. It goes like this.

Government borrowing actually facilitates lending by the cash rich to the cash poor. That’s because the rich are clearly the ones who tend to lend to government, while the fact of that lending enables the poor to pay less tax, although taxpayers in general have to fund interest on government debt, and the poor do pay significant amounts of tax. Thus in effect, government borrowing enables the rich to lend to the poor.

Of course the rich are free to lend directly to the poor and indeed they do so, big time. But an advantage of “borrowing via government” so to speak might seem to be that the process is relatively efficient: witness the low rates of interest earned from government debt.

Unfortunately there is a snag with that argument which is that the latter efficiency derives from governments coercive powers: that is, government’s powers when it comes to collecting tax are similar to the powers enjoyed by the Mafia. And if the state has any problems repaying its debts, it can always resort to printing money in excessive amounts. Thus that method whereby the rich can lend to the poor does not represent fair competition with more traditional methods of lending. So the conclusion is that there is not much to be said for the latter “government borrowing facilitates private borrowing” idea.


* “A Monetary and Fiscal Framework for Economic Stability”, American  Economic Review.
**  “The Natural Rate of Interest is Zero.” Journal of Economic Issues.
***  “The Natural Rate of Interest is Zero.” Modern Monetary Mechanics.

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