The Menace of Sub-Zero Interest-Rate Policy
Sub-zero interest rate policy as Europe and Japan have practiced for many years menaces global economic prosperity. Yet Congress and the White House are strangely silent on the issue; even a prophetic messenger would not arouse them.
Two monetary episodes – one historical and counterfactual, the other contemporary and real – highlight the nature of the danger.
First, history: throughout the heyday of the gold standard from the mid-1860s to 1914, short term money market rates in London rarely fell below 1-2% p.a. and then only briefly. Typically, these short rates were highly volatile day-to-day, but few cared.
The medium and long-term rates were much steadier, their level reflecting a massive amount of decentralized information in the market-place stemming from individual borrowing and lending decisions. Perceptions of the likely average short-term rate over the long-run set a floor to long-term rates (as speculators could borrow at the long rate and roll-over lending at the short).
Walter Bagehot famously observed that “John Bull can stand many things, but he cannot stand interest rates of 2 per cent” (meaning lower rates would make him mad – in today’s sense of irrational exuberance or desperate search for yield). The gold standard worked in a way which respected that wisdom.
If short-term rates fell towards zero, there would be a heavy “drain of gold” as the public converted deposits and notes into the yellow metal; a growing shortage of gold reserves (in the banking system) would force a tightening of monetary conditions. This mechanism depended on the natural scarcity of gold and its unique attractions. “High-powered money” under fiat money regimes has never enjoyed these properties.
The implicit floor to nominal interest rates was no barrier to the invisible hands achieving economic recovery from recession. This occurred in the context of stable prices in the very long run, not permanent inflation as preached by the architects and officials of today’s 2 per cent inflation standard. Crucially goods prices fell to a below-average level during the weak phase of the business cycle and were widely expected to rise back to normal or above in the expansion phase.
What do today’s central bankers think of Bagehot’s wisdom about John Bull?
They deny that asset inflation exists. And they would not request their research departments, filled up with neo-Keynesian economists, to conduct the following counterfactual analysis.
If central banks had all respected a 1-2% floor to interest rates through the last decade how would economic recovery have taken place and what would have been the nature of the expansion?
ECB Chief Draghi for one has never broached the topic of asset inflation. He has never had to answer a serious question on the topic at his tedious press conferences or hearings before the European Parliament. Even so the Chief has not been able to totally sidestep a public discussion which reveals indirectly some of the dangers of zero and negative rates in this present cycle. His fellow-officials have also commented.
The subject: a key difference between how the ECB on the one hand and the Bank of Japan (BoJ) plus the Swiss National Bank (SNB) on the other have been administering negative interest rate policy in this cycle.
The powerful bank lobby in Germany has been asking why the ECB does not copy the SNB and BoJ in only charging banks negative rates on a marginal slice of their deposits with the central bank rather than the entirety.
Chief Draghi has not provided a direct or frank answer but admits that the issue is “under review.” His reticence hints at some of the disturbing motives behind negative rate policies.
In puzzling out why the ECB is administering negative rate policy in harsh fashion as regards the banks which are plush with reserves let’s start by identifying what common purpose it could achieve with the BoJ and SNB by keeping to a lighter touch (imposing negative rates on only a small marginal slice of deposits placed with the central bank by its member banks).
This common aim is currency manipulation.
The national money (or union money in the case of the euro) depreciates as a flight of capital occurs out of negative rate assets. All are not equal in this flight. Banks seek to shelter their regular domestic clients from negative rates. They pass on the cost of the negative rate fee on their reserves only to wholesale and foreign depositors, also taking account of the squeezed rates of return obtainable on their other assets including loans and short-maturity government bonds.
In effect the negative rate regime operates partly like a system of exchange restrictions which imposes penalties on foreign inflows into the domestic money market.
German banks are more stressed in sheltering their depositors from negative rates than their Swiss and Japanese counterparts given the harsh treatment of the ECB. In consequence the shelter they offer is less broad and deep and bank shareholders have to pay more heavily for its provision via diminished profits.
Why doesn’t Chief Draghi relent? Because that would mean less subsidy to Italian banks, stupid! The ECB takes advantage of the negative rate fee it charges on deposits (and German banks are the main net creditor of the euro-system reflecting the huge German savings surplus) to make subsidized loans most of all to Italian banks.
If ECB Chief Draghi were just pursuing currency manipulation, yes, he could please the German bank lobby (and the Bundesbank which pleads on their behalf). But he has this second purpose in mind. Hence the prevarication.
Ultimately these transfer consequences of negative rates within Europe (mainly from Germany to Italy) are not a matter for anyone else, including the Trump Administration. German voters should have their say. The aspect of concern for the US is currency manipulation.
The most direct remedy would be for the US Treasury to add negative and zero rate policy to its list of tests as to whether a foreign government is pursuing currency manipulation. Further the US could use its considerable influence at the IMF, notwithstanding its French managing director, to make negative and zero rate policy a suspect activity inconsistent with the goal of stamping out beggar-your-neighbor policy.
There is absolutely no likelihood of the Trump administration taking either step. For banning negative rates in Japan and Europe could precipitate the passage of present asset inflation into its final phase of crisis ahead of the 2020 elections. Much better to concentrate on direct action to reduce the ill-effects on US trade of currency manipulation.