Keynes was wrong!

No reader responded, but I found, in today’s Financial Times, an intelligent argument debunking yesterday’s post “Keynes was right!“.

Does monetary policy become ineffective once interest rates reach zero? With negative interest rates, monetary policy can continue to work, regardless of how low interest rates go. Real negative rates are certainly possible, and often observed, when the rate of inflation is greater than the interest rate. But the relevant question is: Are negative nominal interest rates possible? Martin Sandbu, writing in the Financial Times, thinks so.

In liquidity trap models of the economy, the central bank is impotent. Although it can create money at will, this power no longer provides influence over interest rates or the ability to give the economy a boost.

The reason this is said to happen is a supposed “zero lower bound” on interest rates. Central banks stimulate spending and investment by increasing the money supply. With more liquidity in the economy than people want to hold, they try to buy profitable assets for their cash. This drives market interest rates down. But when nominal rates are (near) zero, investors can hold all the liquidity the central bank throws at them without missing out on returns elsewhere, so money printing loses its power to pull market rates further down – even if that is what the economy needs fully to employ its resources. ….

But it is wrong to think interest rates cannot fall below zero. The rate most immediately under central banks’ control – the deposit rate on reserves – can be made as negative as one wishes. There are technical questions involving incentives to hoard physical cash, but these are solvable. And with the rate on reserves sufficiently negative, the rate on other assets can be made negative as well. The only zero lower bound is one central banks impose on themselves. (Emphasis added.)

Martin Sandbu, “Central bankers are caught in their own trap“, Financial Times, 3 November 2014 (metered paywall).

Mr Sandbu is the economics editorial writer at the Financial Times. For details on how to prevent savers from hoarding cash to avoid negative interest charges, Mr Sandu links to a five-year-old blog post of Willem Buiter. Mr Buiter describes three ways a central bank can set negative, short-term interest rates without encouraging savers to hoard currency:

(1) Abolish currency

(2) Tax currency holdings

(3) De-couple the numéraire/unit of account from the currency/medium of exchange/means of payment by introducing a new currency (the rallod) and abolishing the dollar currency.  The dollar would remain the numéraire.  The authorities would set the exchange rate between the dollar and the rallod.  There would no longer be a zero lower bound on dollar nominal interest rates because there is no longer any dollar currency.


As regards proposal (1) – the abolition of government-issued currency – other private means of payment (cheques drawn on bank accounts, credit cards, debit cards, cash-on-a-chip and other forms of e-money) could perform most of the legitimate/legal transactions role of currency. ….

As regards proposal (2), taxing the holding of money balances, the key issue is, if the desired interest rate on currency is negative, to get the holder (bearer) to come forward to pay the interest due (the tax) to the central bank.  If currency notes have an issue date on them, as most do, it would be very easy to announce an expiry date for currency as legal tender.  The holder of the currency note would have to come forward to pay the interest due to the central bank before the expiry date.  The currency would be stamped or marked in some way, to show it is current on interest due. ….

Under none of the proposals would people switch into currency if the nominal rate of interest were negative.  Under proposal 1, there is no currency.  Under proposal 2, currency has a negative nominal interest rate; under proposal 3, rallod currency has a zero interest rate but is not a better store of value than negative interest dollar bonds because the dollar appreciates vis-a-vis the rallod.  There is no dollar currency. …. (Emphasis added.)

Banks could still make money – that depends not on the level of interest rates but on the spreads between their borrowing and lending rates.  If a bank borrows from the central bank at minus five percent and lends at minus two percent, it will make the same amount of profit on a loan of a give size as it would if it borrowed at 5 percent and lent at 8 percent.

How would people living off their savings manage with negative nominal interest rates?  First check what real interest rates are.  If deflation were strong enough, savers could still be making out like bandits, even with negative nominal rates.  If real rates are negative, you live by consuming your capital.  If that means poverty for some and creates social problems, go to the Treasury or the Ministry of Social Affairs.  Don’t bother the central bank.

Willem Buiter, “The Wonderful World of Negative Nominal Interest Rates, Again“, maverecon, 19 May 2009 (free access).

Willem Hendrik Buiter (born 1949, in The Netherlands) is a US economist who is currently the Chief Economist at Citigroup. His FT maverecon blog has been archived, though it is no longer active. Access to FT blogs (unlike op-eds and articles!) is unlimited, subject to free registration.

Who is right, Kaletsky or Sandbu (and Buiter)? All this is puzzling, but fascinating. I am a microeconomist, and confess that I never understood macroeconomics. As soon as I find the time, I will visit Nick Rowe’s posts at WCI to search for a clear explanation.

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One Response to “Keynes was wrong!”

  1. […] Martin believes that economic imbalances are now so severe that monetary medicine will have dangerous side effects, and explains why negative interest rates, though possible, may not be a good idea. For a more optimistic  view, see my earlier TdJ on Martin Sandbu and Willem Hendrik. […]