Think of low interest rates as an outcome, not a tool
Tyler Cowen has a Bloomberg column discussing negative interest rates in the Eurozone. As with virtually all discussion of negative rates, the article doesn’t quite get to the essence of the issue:
Most economists and central bankers view negative interest rates as an acceptable tool of macroeconomic management. Maybe so. But in an era when trust, including trust among nations, is much lower than previously thought, it probably isn’t a good idea to place a punishing new tax on the German national virtue of saving. Central bankers must also be sensitive to public relations.
Here Tyler is viewing negative rates as a policy tool. That’s not entirely unjustified, as negative interest on bank reserves (IOR) is in fact an important policy tool. But it also misses something important.
Think of the following scenario. A central bank enacts a contractionary monetary policy, setting interest rates above the Wicksellian equilibrium level. This describes ECB policy during 2008-13, when nominal short-term interest rates were consistently positive (well above the zero bound), and excessively high relative to the equilibrium rate. This tight money policy reduced NGDP growth, which drove the equilibrium rate into negative territory. Anxious to avoid a major depression, the ECB then pushes then policy rate into negative territory, and also adopted a program of “QE”.
Do you see the problem here? The negative rate is in one sense an equilibrium outcome of a longstanding tight money policy (think negative long term bond yields), and in another sense an expansionary policy aimed at boosting inflation (think negative IOR). It’s both. Most discussion of this issue focuses only on the role of negative rates as a policy tool, which is actually the least important dimension of the issue.
To his credit, Tyler goes beyond the usual analysis, and eventually does get to the essence of the issue:
So if a policy of negative interest rates is just a Band-Aid, it is one that should be ripped off. And if monetary policy is insufficiently expansionary, that is going to require an increase in the ECB’s inflation target, or a move to nominal GDP targeting, not a jerry-rigged tax on deposits.
Bingo! I wish Tyler had provided much more of this, a much deeper look at how the eurozone can exit from negative rates. The only solution available to the ECB is to adopt a more expansionary monetary policy regime. Tinkering with the tools is not enough. Negative IOR is not enough.
The article also needs more discussion of the irony that the same German savers who are outraged by negative rates are also the single most powerful political force in Europe against a more sensible (i.e. more expansionary) monetary policy. I’m not blaming them; if even economists are confused then how can I expect average people to figure all this out? Nonetheless, Germans tend to oppose a more expansionary policy target that would push the equilibrium rate above zero, and thus allow for the policy rate to also rise above zero.
BTW, even if you reject my “market monetarist” analysis, and take the standard Keynesian view that tight fiscal policy is the problem, it is still conservatives in Germany who are most opposed to a solution for low interest rates. More than any other country in Europe, Germany has created the monetary and fiscal policy environment that enables negative interest rates.
In fairness, other countries are not blame free. Bad supply side policies in southern Europe are a drag on eurozone RGDP growth, and this tends to reduce the equilibrium real interest rate in the eurozone. And part of the cause may be exogenous factors such as demographics, for which no one is to blame.
I would also quibble with Tyler’s use of the term “insufficiently expansionary”. I understand why he uses this term; my claim that eurozone policy is contractionary goes against common sense, and would turn off readers that might otherwise be persuadable. But at some point the economics profession needs to take a hard look in the mirror and confront the fact that 99% of what’s been written over the past 12 years about the “stance” of monetary policy in Europe, Japan and America is utter nonsense, with no theoretical basis at all. I know that sounds harsh, but it is unfortunately true. The emperor has no clothes.
Aug 6 2019 at 7:18pm
I wonder if the very intelligent Tyler Cowen has also missed on a more fundamental point: true savings is investment, that is resources put into business, plant and equipment or well-considered infrastructure. True savings is not gold bars in a bank, or the modern equivalent of blips on a computer-chip ledger.
Higher interest rates are actually a tax on true investment.
Beyond all that, I think there is a valid argument that there is a global glut of capital. The world does not need more capital. If you listen to conference calls of publicly held real estate companies, they invariably say they find it difficult to acquire assets at a profitable price. There is too much capital chasing real estate.
The world needs more aggregate demand.
Aug 6 2019 at 10:06pm
Relatively low nominal and real interest rates, and low inflation rates, are a sign of tight money, not EZ money. Tyler Cowen must know this!
You do not get to negative interest rates through decades of EZ money.
In the modern world of developed economies, a valid argument can be made the current predicament is the result of decades of chronically tight money. In fact, is that not the case? What is the alternative explanation?
Tyler Cowen should be calling for central banks to more-aggressive in stimulus programs.
And Cowen should ask if central banks have the tools they need to break-out of the current lowflation-stagnation.
The world’s largest bond manager just said the ECB is out of ammo. In theory that may not be true. But if markets believe central banks have pop-guns, then what?
Aug 7 2019 at 1:27am
Ben, You said:
“The world’s largest bond manager just said the ECB is out of ammo. In theory that may not be true. But if markets believe central banks have pop-guns, then what?”
What does the belief of the world’s largest bond trader have to do with the belief of markets?
Aug 7 2019 at 7:03am
Pimco may not be the market, and of course, even monster financial behemoths are not the market.
I was using Pimco as an example of how even sophisticated, influential and large financial market-players view central banks.
No, I cannot cite an authoritative survey. And true, there may be other large financial institutions that say, “Oh, oh, oh-no the central banks are courting hyperinflation!”
But Pimco is exemplary of commentary lately from major bond houses. If we think market and public expectations drive inflation…then maybe we need improve the central-bank arsenal. The strong arm is never tested?
Aug 7 2019 at 9:43am
ECB does need “regime” (a target) that takes into consideration both real growth and enough average price inflation to compensate for sticky prices. As the Euro zone is still quite heterogeneous in its price behavior, my guess is that it needs a higher inflation target than the US (and 2% is arguably too low for the US). As for “fiscal policy” governments should invest in activities that have future benefits and present costs according to an NPV rule. One suspects that many more such activities exist than are being taken advantage of.
Aug 7 2019 at 11:46am
Excellent, Scott. German inflationphobia is really damaging to the EU.
Stateside, the entire yield curve (except, of course, the short-end) has fallen 0.45% in the past 9 business days, going back to the halcyon days before the July Fed meeting; about equal parts lower inflation expectations and lower real (TIPS) yields. That’s a cratering.
Can we wait until the next Fed meeting, even if Powell puts on the Chuck Norris costume?
Aug 7 2019 at 2:29pm
The Germans only want what we all want: high interest rates, low inflation, and a growing economy. If only they were independent variables!
Aug 7 2019 at 8:13pm
If we had a rapidly growing economy (e.g. like China) who would care if we had high inflation or low interest rates?
Aug 8 2019 at 12:05pm
Sure, a growing economy covers all sins.
Luis Pedro Coelho
Aug 7 2019 at 4:49pm
The opinion of market participants doesn’t matter, only the opinion of the market matters.
This may seem esoteric, but it’s not: it’s very easy to imagine situations where every single market participant believes X, but the market clearly signals “not X”. Scott will probably know better, but I think that, during the early 1930s, the Wall Street opinion was that leaving the gold standard was a bad idea, but the markets clearly wanted countries to leave the Gold Standard.
The Germans get a lot of (deserved) blame, but there is nobody on the other side, really. Southern European countries are not pressuring for NGDPLT, a higher inflation target, or any such fundamental measure.
When it comes to public opinion, there is almost as much inflation-phobia in Southern Europe as in Germany.
Aug 8 2019 at 10:07pm
Maybe so. I have sometimes noted how in recent decades the opinion of nearly all macroeconomic authority figures and the financial media was that the US was headed towards higher inflation, perhaps even hyper-inflation. It never happened, here or in Japan.
On the other hand, we keep hearing that “public expectations” and central bank “guidance” are very important.
I gather the relevant public, and large financial institutions, think central banks are weaklings. The markets says so too…how else do you get to $12 trillion in bonds offering negative interest rates?
The market is not impressed with the firepower central banks have.
Maybe the market is wrong. I suspect the market is right, and central banks are underpowered.
Aug 7 2019 at 5:41pm
Luis, Interesting. But I wonder if that’s true at the governmental level. Would the Italian government actually be opposed to faster NGDP growth? If so, why do they seem to favor fiscal stimulus, which would also boost inflation?
Aug 14 2019 at 3:54am
To all ,
I can only agree with Scott, when looking at the “performance” of the German economy :
€ 1912 Billions (2019) : German debt, i.e. less than 60% GDP, this factor only should push the Euro upward !
€ 58 Billions (2018) : positive Trade Balance mostly thanks to intra-europe trade surplus
despite a GDP Growth of 1.5% in 2018, much lower than previously in 2016-2017 (> 2% growth)
leading to a delay in infrastructure spending according to KfW institute , €159 Billions not spent by Lander and municipalities
The German decision makers for economic policy (influenced by the Conservative Party CDU-CSU) are basically creating the conditions that hamper most the savings of their citizens, with negative interests rates.
This originates in the German long time fear of the Weimar Rep. 1920’s hyperinflation, and in the mind of the German voters / public opinion, low inflation and negative interests rates are a minor pain to suffer than the high inflation…
So the Europeans will have to endure the situation for a while, and find better investment supports than the German Bonds …until the German economy needs a revival boost not any more based on trade surplus but an economic stimulus based on internal demand (consumption and investment..).
To get there, they also need a political change to occur…and find new political alliances to govern the country.
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