[Pen-l] Mankiw's bright (though borrowed) idea

[Jim Devine <jdevine03@xxxxxxxxx>]

The New York Times / April 19, 2009

Economic View
It May Be Time for the Fed to Go Negative
By N. GREGORY MANKIW
(Copyright 2009 The New York Times Company)

... 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.

The problem today, it seems, is that the Federal Reserve has done just
about as much interest rate cutting as it can. Its target for the
federal funds rate is about zero, so it has turned to other tools,
such as buying longer-term debt securities, to get the economy going
again. But the efficacy of those tools is uncertain, and there are
risks associated with them.

In many ways today, the Fed is in uncharted waters.

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.

That move would free the Fed to cut interest rates below zero. People
would be delighted to lend money at negative 3 percent, since losing 3
percent is better than losing 10.

Of course, some people might decide that at those rates, they would
rather spend the money — for example, by buying a new car. But because
expanding aggregate demand is precisely the goal of the interest rate
cut, such an incentive isn’t a flaw — it’s a benefit.

[Wait a sec, Greg! most money -- as usually defined -- is not
currency. Most of it is entries in account books representing
obligations of banks, i.e., their promises to allow us to access our
checking accounts at a moment's notice and our savings accounts after
a small delay. This program only encourages people to shun currency,
not money. It encourages banks to shun vault cash, but not other
reserves (deposits in the Fed) or quasi-reserves (T-bills). I'm quite
surprised that a Harvard economist could fall for this confusion. ]

The idea of making money earn a negative return is not entirely new.
In the late 19th century, the German economist Silvio Gesell argued
for a tax on holding money. He was concerned that during times of
financial stress, people hoard money rather than lend it. John Maynard
Keynes approvingly cited the idea of a carrying tax on money. With
banks now holding substantial excess reserves, Gesell’s concern about
cash hoarding suddenly seems very modern.

[We could impose a tax on holding of _all_ money including the
bookkeeping money discussed above.]

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.

Having the central bank embrace inflation would shock economists and
Fed watchers who view price stability as the foremost goal of monetary
policy. But there are worse things than inflation. And guess what? We
have them today. A little more inflation might be preferable to rising
unemployment or a series of fiscal measures that pile on debt
bequeathed to future generations....

[By the way, this is _exactly_ what Krugman proposed for Japan during
the 1990s. Did Mankiw ever hear about that?

[It's interesting that Mankiw is ignoring the foreign exchange-rate
impact of this policy. It may have made sense to drive the Yen down
relative to other currencies during the 1990s, but does Mankiw want to
do the same to the US$ now? Might not the greenback find its
international reserve status undermined? If Mankiw's Krugmaniac policy
is instituted, it would work best if major US trading partners pursue
a similar policy.]

[In the end, the fact that a conservative like Mankiw is going pretty
radical is a sign of how much trouble capitalism is in.]


-- 
Jim Devine / "Segui il tuo corso, e lascia dir le genti." (Go your own
way and let people talk.) -- Karl, paraphrasing Dante.
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