An amusing retort by Robert Murphy, at the Mises Institute, arguing against Mankiw’s proposal favoring negative interest rates.
First, Mankiw’s proposal:
Let’s start with the basics: What is the best way for an economy to escape a recession?
Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.
Assumption #1 that will anger Austrians everywhere — lower interest rates encourage consumption and borrowing, which is good for the economy.
How to do it though?
So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?
At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.
The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.
Unless, that is, we figure out a way to make holding money less attractive.
At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won’t help.)
Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent
Ridiculous, you say?
If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.
This is all straight from Mankiw. Now, there is one majorly faulty assumption with this argument, as noted above. Mankiw is referring to the interest rate as a tool to regulate spending, as Murphy notes, but he fails to mention it’s role in regulating saving.
Perhaps the single biggest mistake in Mankiw’s worldview is his treatment of the interest rate as merely a brake or governor on “spending.” In this standard yet woefully simplistic approach, “the” interest rate serves to either stimulate or suppress how much money people spend today. So if businesses are laying people off, why, the answer is obvious: cut the interest rate to induce more spending, so businesses hire those workers back.
But in reality, interest rates coordinate production and consumption decisions over time. They do a lot more than simply regulate how much people spend in the present. In particular, certain sectors are much more sensitive to interest rates than others. For example, if interest rates fall, it’s not merely that consumers and businesses spend more, but that they spend more on particular items such as houses, cars, and factories. When interest rates fall, the share price of General Motors might rise, but not General Mills, because breakfast cereal is not a durable good (at least not in my household).
The key question which Mankiw and Murphy disagree on is this: is it better to postpone the pain associated with paying off your debts, deflating them over time with a weakened currency, or is it better to swallow the bitter pill today, in one massive, painful deflationary swallow? Get personal savings rates back to 10%, let the savers among us who have capital to lend charge egregious interest rates on this capital because there is simply none available.
Mankiw assumes (without telling the reader) that encouraging spending and smoothing consumption is a good thing, well worth the (quite hefty) costs. Murphy focuses on the costs, of which are there are many. For example, what would an extended bout of inflation do the dollar’s status as an international reserve currency? What might that cost us in terms of cost of future borrowing? Just one example.
I don’t know which is correct. But it’s always good to question assumptions.
