The problem with negative real interest rates

The “Taylor rule” is representative of a large school of macroeconomic thought which takes the view that monetary policy-makers should set the policy rate as a function of the inflation rate and the unemployment rate (or an alternate measure of economic slack).  Those who have been schooled in this framework have difficulty understanding why anyone would recommend raising the policy rate when inflation is extremely low and the economy is weak.

Monetary policy is viewed as a “neutral” policy because it works through interest rates.  As long as the big banks pass changes in the policy rate on to borrowers, then all participants in the economy are able to benefit from any decreases in the policy rate and to face the costs of any increases.  Fiscal policy by contrast will always favor some beneficiaries of the government’s largess over others, and thus cannot be considered “neutral”.  It should be noted, however, that the neutrality of monetary policy depends on the competitive structure of the monetary transmission mechanism and if the banks that trade in the federal funds market, where policy rates are set, do not always pass on changes in the policy rate, monetary policy will act as a subsidy to the big banks.  In fact, it is my view that when the policy rate approaches the zero lower bound — and real interest rates are negative — the incentive for financial intermediaries to arbitrage their negative cost of funds distorts lending markets and the monetary transmission mechanism.

Models that support the use of a Taylor rule rarely specify the structure of the financial system explicitly.  And I think that the best way to understand them is that they express a very simple view of financial intermediation along these lines:  A vast number of the transactions that underlie economic activity are dependent on the extension of credit — many firms depend on short-term credit to finance working capital and on long-term finance to make large scale projects possible and most consumers are dependent on credit to finance large purchases like homes and automobiles and other consumer durables.  For this reason a decrease in the interest rate tends to reduce the cost of financing transactions and by reducing their cost increase the number of transactions — and it is of course these transactions that are used to calculate GDP.  The role of financial intermediaries in this process is to hold as deposits the income received by the consumers (who also staff the firms) and sales receipts of the firms and recycle those deposits into the loans — at an interest rate sensitive to the policy rate — that allow this economic activity to take place.  In short, the model is based on old-fashioned banks that (i) hold loans on their balance sheet — and because they carry long-term exposure to these loans underwrite them very carefully and (ii) set interest rates on the loans they offer in a competitive market.

There are many historical time periods in which this simple model of financial intermediation is accurate enough.  However, the drive towards profitability in the financial system has a tendency to generate a process of financialization in the economy.  A multi-tiered financial system is created in which banks lend to other financial intermediaries who in turn lend to other financial intermediaries or the real economy.  One of the most common consequences of this process is a reduction in the capital supporting the issue of loans.  In fact the profitability of the multi-tiered system is generally driven by the fact that more loans can be issued with a given capital base.  (It is precisely because there are norms for bank capital requirements that a new kind of intermediary has to be created.)

Some examples of this process are the bill-brokers of mid-19th century England, who are discussed in detail by Walter Bagehot, and whose role in the financial system was greatly reduced after the failure of Overend and Gurney in 1866.  In the early 20th c US, trust companies and investment trusts were important vehicles for financialization — until the reforms of the ’30s forced a return to “plain vanilla” banking.

Of course another wave of financialization has taken place over the past few decades and it is this multi-tiered financial structure that interferes with the simple operation of the Taylor Rule.  Modern banks don’t hold the loans they originate, but instead either sell them off — to for example an asset backed commercial paper conduit — or finance them on the repo market.
(i)  Because the loans are not carried on the balance sheet, but instead have their value realized at the date of origination, the immediate value of the loan becomes more important than the life-long value of the loan.  This is an environment which is primed to issue as many loans as possible.  Furthermore,
(ii) Each tier of the financial system is profiting from an interest rate spread and when nominal interest rates are below the rate of inflation, economic incentives push these intermediaries to borrow as much as possible and finance as many loans as possible.  While, in theory, these should all be “good” loans with little risk of credit loss, (i) ensures that the incentives are not necessarily aligned to guarantee the quality of the loans.

Another aspect of modern financialization is that financial intermediaries are able to use their borrowed funds to trade on secondary markets — an act that has traditionally been prohibited for banks.  Thus, the unlimited demand for funds created by negative real interest rates is easily channeled into purchases on secondary markets.  The natural consequence of this process is that negative real interest rates tend to drive up the value of risk assets like stocks and junk bonds.  Of course, to the degree that the demand for these assets is driven by the negative cost of borrowing, normalization of interest rate policy will necessarily have the effect of reducing demand for these assets and the value of risk assets.  Thus, negative real interest rates will tend to create increases in the prices of risk assets that are unsustainable over the long-run.

In short, in an environment where new financial intermediaries have been created that attenuate the relationship between deposits and loans, negative real interest rates create an unlimited demand for funds by the financial sector which can easily flow into loans of dubious quality and markets for risky assets as intermediaries gamble on their ability to successfully arbitrage the negative cost of funds.  This view implies that in an economy with a multi-tiered financial system the Taylor rule needs to be adjusted for the additional economic costs created by a policy rate that falls below the rate of inflation — and that as we near the zero bound the optimal policy rate will be significantly higher than that implied by the Taylor rule.  On the other hand these concerns will not necessarily apply to an environment where a law like Glass-Steagall (i) restricts the activities of financial intermediaries in a way that protects the profitability of simple commercial banks, while at the same time allowing for interbank competition, and (ii) precludes the flow of funds borrowed by intermediaries into secondary markets.


5 thoughts on “The problem with negative real interest rates”

  1. The New ‘Das Kapital’.

    Too many people believe that FREE MARKET ECONOMY and CAPITALISM is one and the same thing, as opposed by COMMUNISM.

    Communism is nothing more than a philosophy originating from a study of the poor living conditions of workers during the industrial revolution.

    Capitalism is nothing more than a monetary system originating from the use of gold and later deposit slips for gold as a means of exchange.

    But Free Market Economy is a natural way of bringing offer and demand in balance that already existed in the time of barter trade.

    Capitalism exploits labour to create added value …. or so Karl Marx said.

    But let’s face it ….. The only real existing value in this world is LABOUR! Nothing can be achieved without it. No raw materials can be extracted from the earth without labour …… No food can be produced …… No added value can be created….. No profits can be achieved …… Nothing! On the other hand …… CAPITAL has no real value at all. You can’t eat it. In Mugabe’s Zimbabwe, they burn CAPITAL (paper money) because it is cheaper than firewood!

    Contrary to popular believe: Money is TIME! When you earn money, you have given your time in producing something … in rendering a service of some kind … in trading something ….. or whatever ….. and received money for that! This money allows you to buy TIME from somebody else. You can buy a product that someone created with his time … a service ….. you name it. It is always TIME that you buy! Part of the time that you can buy for your money has already been transferred into products. A car waiting to be sold ….. Food in the supermarket …… Tools of some kind …… A house…. But services still to be rendered ….. products not yet created …… are still in their basic form of available TIME! So when unemployment is skyrocketing we should be so happy! There is so much TIME available! What richness! What wealth for a nation! But are we happy with high unemployment?

    TIME when it is not consumed loses it’s value. At a rate of 100 % per day. We are used to transfer the time that we are owed into CAPITAL in order to be able to transfer it back into TIME when we want to buy something or invest it. CAPITAL keeps, but TIME doesn’t!

    In order to persuade someone to invest his capital he wants interest or profit of 4 % or more or he hangs on to his capital. In order to persuade someone to invest his time in a period of unemployment you can give that person less than what he needs to survive and he will still sell you his time. Something is better than nothing!

    And that is how capitalism is able to exploit labour to create added value. By transferring time owed into CAPITAL and only buying time back when it can make a profit, allowing TIME or LABOUR to be completely lost when it is thought that no added value can be created with it. High unemployment, poverty and crises are the flaws of CAPITALISM. Not of the FREE MARKET! Without transferring the time that we are owed into CAPITAL and having to consume that time without too much delay we would still have a FREE MARKET ECONOMY, but we would not have CAPITALISM!

    So how can we have a Free Market Economy without the flaws of Capitalism?

    Barter trade? Of course not! We live in the 3rd millennium! Even though we still use a money system from the 1st or 2nd millennium! If CAPITAL or MONEY is to be a means of exchange for TIME, then it should have the same property as TIME! Meaning … it should lose value when it is not consumed within a certain period, just as TIME does! But how to achieve that?

    Nothing is easier. Let’s look at one possibility: Substitute V(alue) A(dded) T(ax), which is a punishment for transferring labour into added value, by V(alue) D(iminished) T(ax) on money in possession as long as it is not used. A negative interest Tax on money. For that we would have to change cash money into digital money in our bank account. But hey! We pay with pin, credit card, chip, cheque, internet, mobile phone ….. We are in the 3rd millennium! Substituting VAT by VDT will certainly make us all a lot richer. As TIME or LABOUR is the only real value that exists we cannot accept a monetary system like CAPITALISM that allows it to go to waste.

  2. Det er også veldig sexy å ligge på ryggen, på en pute, og dra
    opp knærne til hver side. Siden har virkelig forandret livet mitt og jeg er
    veldig glad for det. Ingenting er forpliktende her på knull kontakt og alt du trenger er en
    pc og internett.

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