Thursday, April 23, 2009

Negative idea?

In a recent article in the New York Times Havard Professor Gregory Mankiw proposes the US Federal Reserve cut interest rates below zero. In essence a -3% interest rate means that one could take out a loan of $100 and only have to pay back $97 dollars in a years time. I have some bad news to those rubbing their hands with glee at the prospect of getting "free" money - Prof. Mankiw also outlines a mechanism that ensures this won't happen. Take every dollar bill - in a years time the Fed pick a random number from 0-9 and if that number appears first on the note it would be made redundant.

The idea is purely tongue in cheek (and the kind of extraordinary outside the box thinking that we need in these extraordinary times), but it does raise the issue of why 0% is considered the lower bound for interest rates.

Personally speaking I'm quite concerned about the drive towards low (even negative interest rates). Do we (developed countries) really need to be stimulating short term spending in this way to get back to our former level of long-term growth rates? Under-capitalised banks have been a symptom of our the current global economic malaise. Long story short - people borrowed too much and didn't save enough. Banking simply doesn't work unless the lender has the capital (savings) to finance their lending practices. In summary, people need to borrow money from other people's savings. This has to happen in the long-term regardless, so why are policy makers trying to squeeze every last consumption drop out of their respective populations? Surely if there wasn't some kind of paradox of thrift effect then the banks would become fully capitalised and start lending again, enabling us to move away from bank guarantee schemes, government re-capitalisation and nationalisation.

Surely we've learned that encouraging people to spend money for instant gratification is not a good thing. I'm not sure the need for balance is being addressed properly.


Cathy Redmond said...

I suppose the reason why central bank's tend to restrict the fluctuation in interest rates is that they want to avoid unnecessary inflation and further uncertainty with respect to future input prices, labour prices and the price they will get for their goods and services. Uncertainty = lower investment = lower production.

Your point in relation to whether the central bank's should be intervening at all is interesting as it implies you are suggesting that the main role of the central bank - regulating the economy's boom and bust cycle to generate a smoother cycle - is defunct, and the economy should be self regulating and people should be made pay for their mistakes in order to learn not to make them in the future. However, I think that the intervention of the central bank and attempts at stimulating the economy can only be for the good - why leave an economy floundering if you can give it a helping hand to get back on track? Also, the people paying for these mistakes are not necessarily the people who generated them in the first place.

Alan Fernihough said...

My point is that there are a lot of downsides to slashing interest rates and discouraging saving in our current situation. If the banks are under capitalized then why is borrowing being discouraged? There is a balance between saving and lending that needs to be addressed if we ever want banks to function as viable private enterprises again.

Banks are only intermediaries between borrowers and savers. The savers fund the borrowers loans. This is the balance I am concerned that central banks are not addressing. If this balance is not going to be restored then we should just permanently nationalize all banks and let the tax payer fund borrowing because there's not enough savers to do so.

I'm not saying the role of the central bank is defunct. But there are limitations to their instruments for encouraging and fostering growth. Also, in times of desperation their actions may do more harm than good, Zimbabwe and the Wiemar Republic are testament to this.