The experimental monetary policy of recent years has shattered many conventions and core beliefs. Central banks have shamelessly ‘printed money,’ but inflation has nonetheless declined. In particular, central banks ‘monetarised’ sovereign debt: inflation has merrily declined. Since the summer of 2014, the ECB and some other central banks in Europe reduced their interest rates (and thus the short-term money market rates) below zero. They did this because inflation constantly continued to fall. Economic theory actually considered this for practically impossible. Even so, economic reality has led to a further very interesting surprise. The BIZ also noticed it in its latest quarterly publication. It turns out that, at least for what concerns the money market, monetary policy works even below the zero threshold. Whether this policy will achieve its stated objectives, increase inflation and strengthen the recovery, or whether instead side effects within the financial system will undermine these objectives of the remains uncertain until further notice.
My own preliminary ruling on the subject, and especially on the recent ECB measures, is mixed. One has to remain realistic about what can überhaupt be achieved by monetary policies and what cannot. Specifically, negative interest rates certainly do not provide a monetary silver bullet.
Keynes has asked himself the same question in his General Theory. He also took the role of banknotes in determining the interest rate floor into account. He basically agreed with Silvio Gesell, who wrote that it is necessary to add a fee to the use of cash money as a kind of negative interest in order to continue to lower interest rates towards zero. However, Keynes only saw these developments occurring at the final stage of a capitalist economy in the context of its reflections on the ‘euthanasia of the rentier.’ Here Keynes followed the classical idea of a stationary equilibrium in which (net) capital accumulation comes to an end.
For Keynes, such a ‘final stage,’ in which the capital stock no longer continues to grow and current production is completely consumed (aside from depreciation) means that the risk-free interest rate must fall to zero. In other words, the risk-free rate must drop to zero (or be able to do so) to reach the final stage and to allow the end of the accumulation of capital. Failing that, the economy remains permanently in a state of under-utilisation and the ‘final stage’ cannot become a reality, precisely because capital is kept ‘artificially’ scarce.
Another connection can be seen in Keynes’s essay ‘The Economic Possibilities for our Grandchildren.’ In the midst of the Great Depression, Keynes looked with optimism towards the future and predicted that ongoing technological progress would allow humanity to eliminate the economic problem of scarcity within the next 100 years. If we would get population growth under control, another century of rapid capital accumulation and sustained technological progress would lead to an altogether new situation for humanity. The main question would no longer be how to sustain ourselves, but how we could use our time to live a wise and fulfilling life, given that we could enjoy much more leisure time. The world would not stand still: technological advances and ongoing economic change would continue unabated, but (net) capital accumulation would collapse. People would have to work progressively less while prosperity would progressively rise. In this ‘final stage,’ the rentier would become extinct and the ‘morality’ of capitalism would become obsolete. The love of money would no longer be regarded with admiration; instead it would be understood for what it is: a pathological defect.
These are indeed interesting ideas of a man who has often been vilified by his opponents for never have considered longer term evolutions (we all know the cliché about all of us being dead in the long run).
In fact, in Western Europe and North America, Keynes’s prophecies became much closer to being realised since the 1930s. Keynes forecasts about the development of technological progress and productivity were impressively accurate. But Keynes clearly failed to recognise the tendency of increasing commodification and senseless consumption. The ‘rest of the world’ stayed of course very far away from this target and was not able to catch up with the rich West. Continued high population growth should be mentioned here as a factor. The fact that the latest technologies (which enable productivity gains) are not equally available everywhere is another objection. For the world as a whole, the capital stock will therefore remain tight for some time. The rentier probably did not become obsolete yet. In a world in which financial capital can move freely, a zero interest rate or less will remain a temporary phenomenon for the time being – which is exactly the reason why Keynes rejected footloose financial capital.
Here then, arises the real problem of practical monetary policy: the expectation of the financial markets that interest rates will eventually rise again and ‘return to normal’ at a certain point. This expectation is justified as long as the final stage of a stationary state global economy is not in sight.
In the literature, this possibility (or certain variations thereof) is known as the ‘liquidity trap.’ It refers to a situation in which the open market purchases of the central bank, aimed at reducing long-term interest rates, fail because market actors take refuge in liquidity and repel bonds en masse. As a theoretical limit, one must therefore imagine here that the central bank might ultimately acquire all non-monetary debts while pushing their prices to a level that convinces all other market participants of the superior advantages of the liquidity thereby created.
One possible outcome is that this policy eventually leads to success, that loans are taken out, that expenditures are being made and that the economy reboots. If subsequently interests also return to normalcy, the central bank will on its sale of interest-bearing securities probably obtain (and destroy) less money than they previously spent (and created) on their acquisition. Perhaps it is incorrect to speak about losses here. The future profits of the central bank would in any case be less, especially when it has to mop up excess liquidity in order to control interest in positive territory again by issuing its own interest-bearing securities. This is the bottom line of an inter-temporal transfer of seigniorage (profit made by a government by issuing currency).
One cannot completely rule out the possibility that the experimental monetary policies increase general uncertainty and lead to restraints on investments and consumption or that other factors have such an effect so that the economy ultimately does not reboot.
The practical experiences of recent years have been somewhere between these two extremes.
The Federal Reserve started at a very early stage with the massive purchase of government bonds and mortgage-backed bonds guaranteed by the government (‘QE’), but it never lowered the short-term interest rate below zero. This was done out of consideration for money market funds, which would be the first ones to go down. But the banks were also taken into account. Banks can hardly pass on negative interests to the mass of small depositors because of the competition from banknotes. The negative interest rate of the central bank on excess reserves therefore acts to the banks as a tax which diminishes their interest margin and profits. The Fed of course understood this. The Federal Reserve has, incidentally, even paid a small interest rate on excess reserves of banks, which indirectly supports their recapitalization. The Federal Reserve has to a certain extent dissipated the seignorage (much boosted owing to QE) towards the banks rather than to the Treasury.
Overall, the Federal Reserve has without doubt significantly contributed to the recovery of the US economy since 2009, especially as the fiscal policy in the years between 2011 and 2013 was restrictive. Interest rate levels remain extremely low by historical standards today. In my view, interest rates can only rise again from here very, very slowly. On the other hand, asset prices, both for equities and real estate, are now again very high and this is a major risk factor. Asset prices have risen considerably in the last five years. A decline in price of 30 percent is readily conceivable. Not too large an interest rate shock is needed to accomplish that.
The ECB designed its monetary policy quite differently from the Federal Reserve. The emphasis of their actions was always to encourage banks to lend and to purchase financial instruments (specifically government bonds) instead of acquiring bonds directly itself. The problem of the liquidity trap – the expectation of rising interest rates and falling prices – was for the ECB therefore a more limiting factor. A central bank that does not buy itself will generally find it more difficult to effectively push down interest rate expectations in a sustainable manner. Another problem occurs when financial titles that have been purchased by banks also suffer losses; for instance because the (state) debtor is regarded as an increased credit risk. (This is the infamous ‘doom loop,’ the fateful alliance between banks and their governmental sovereign, but this is a point that I will not further develope here). The background of all this is of course the high bank losses from the financial crisis and the subsequent recession. The attempt to re-regulate the banks after the crisis was basically correct. De facto, however, the sum of all these factors led to a credit crunch, which together with the counter-productive austerity and deflationary adjustment programs, pushed the euro zone into a deep crisis. The ECB continued to sleep deeply until 2014. By then, the alarm bells had reached deafening proportions.
In the subsequent period, the ECB implemented three policies in particular. First, they developed a new special liquidity program which was designed to stimulate bank lending to the economy. This idea was basically correct, but the implementation of the program proved not very effective. Perhaps this was also due to the fact that ECB, at the time, was the first central bank (although the Swedish central bank had flirted in 2009 with it already) to drive money market rates below zero. The problem is, as I have said, that this works as a tax on the banks which were already under pressure from several sides. Anyway, I have always suspected that the ECB’s foremost concern was the exchange rate. In this regard, its policy was also quite successful: the euro has depreciated sharply since the spring of 2014. However, from a global perspective, the policy was inappropriate and destabilizing: an economy with growing a current account surplus and very low inflation or even deflation should appreciate its currency rather than depreciate. Between these two measures existed in actuality a trade off or a contradiction: should the ECB authorities prefer to help the banks and stimulate domestic demand or should it concentrate upon the exchange rate and net exports? It will hardly be necessary to state my own preference here.
Thirdly, the ECB ultimately started to buy government bonds on a large scale. This was very important and it was also very effective. Interest rate levels as well as spreads significantly fell. The policy had the result that, among others, the government interest burden decreased and after many years of counterproductive austerity, fiscal policy was brought to a more neutral course.
The most recent moves by the ECB last week must therefore be evaluated as positive. First, the QE program increased in volume and expanded so as to include corporate bonds. This should basically contribute to cheaper and more uniform financing conditions within the euro zone. Second, the ECB made a fresh start in terms of the special liquidity program to stimulate bank lending to the economy. For the banks, four-year re-financing is now available at the interest rate on the deposit facilty. This means that active banks have to ‘pay’ an interest of -0.4 percent. In other words, the former tax was reversed into a subsidy for the banks, which can indeed be interpreted as a sort of ‘helicopter money.’ If it is assume here that neither the courts nor the Brussels competition authority will act because no state funding is implied or a distortion of competition is taking place, this policy might turn out to constitute an effective incentive for the banks. With this, we already indicated the ECB’s third new policy: the interest rate on deposits was reduced by ten basis points to 0.4 percent. (And the other two key policy rates were cut by five basis points.) That the value of the euro rose despite of this rate cut may seem confusing at first. The point is that Mario Draghi hinted that with this reduction policy interest rates may have reached their lowest point. He thereby killed off a lot of raving fantasies and wild speculations. The markets had been wondering how deep into the negative the ECB intends to drive the money market interest rate. At least a provisional answer was given now. As a result, the monetary policy mix is now more reasonable and appropriate: the policy is less focused upon the exchange rate and net exports and more upon banks and domestic demand.
What does all of this mean with respect to the above remarks about Keynes and negative interest rates? The crucial difference is that Keynes was writing about achieving a stationary state equilibrium as a final stage of a capitalist economy. The negative interest rate policy of the ECB on the other hand is a part of a series of belated emergency measures aimed at stabilising a strikingly destabilised economy at the expense of the global economy (the question whether this was due to intent or gross negligence is besides the point here).
When it comes to the Keynesian question, negative short-term rates can, perhaps together with a fee on the use of banknotes, help to reduce the long-term interest rate to zero. When the expectation is that the long-term interest rates will remain permanently zero, the negative short-term interest rate becomes ultimately superfluous. Money (bank notes and deposits) and risk-free bonds turn into perfect substitutes at that point. But those who start from a position that foresees a subsequent ‘normalization’ of interest rates, implying that money market rates will only be reduced to zero or below temporarily, must also consider the possible side effects of this subsequent normalisation process. Interest rate fluctuations can in principle lead to serious distortions within the financial system. With negative interest rates, additional complications enter the system that can potentially undermine the business models of important financial institutions. If in such a situation the central bank itself buys at (ex post) inflated prices, this may not lead to actual ‘losses.’ What happens is, rather, that the seigniorage income of tomorrow is already being wasted today. But if private financial institutions suffer losses due to the policy of the central bank, the upswing which is hoped for can easily become a miscarriage.
The conclusions can therefore only be that, firstly, we should better not maneuver an economy into the situation which the euro zone finds itself in today and, secondly, that it is wrong to leave the necessary task of stabilisation solely in the hands of the central bank.
The second conclusion has meanwhile also been reached by the IMF and the OECD. Today both argue for a more expansive fiscal policy and especially for public infrastructure investments. The BIZ, on the other hand, also identifies important risks by continuing to overburden monetary policies, but it still stops short of discussing the implications of fiscal policies. In this regard, it gets dangerously close to the positions of the Bundesbank and the German Ministry of Finance. They both continue to believe in their uninformed fantasies about the benign effects of austerity, wage cuts and ‘structural reforms’ in ‘restoring trust.’
In this, the Bundesbank celebrates Wilhelm Vocke as the founding father of its ‘independence’ and veteran German stability policy. The bank cites Vocke’s dictum that monetary policy ‘is the policy of restoring and maintaining confidence’ (see here). Sitting at the independent confidence switch seems to offer a good life. I can only say that this is the kind of central bankers that the world can happily do without. Only mercantilists, habitually feeding on the sounder policies pursued by others while enriching themselves through growing net export, are able to believe such hollow formulae. The dust and the stench that comes out of the Reichsbank may adequately represent the economic wisdom of Herr Vocke, councilor of the German Secret Council, but it certainly does not represent the competency of a modern central bank.
The ECB and the man who steers it, Mario Draghi, are certainly to be congratulated because they do no longer support this irresponsibly policy – this is true, even if the ECB’s monetary policy alone will not be able to prevent the failure of the euro, especially not with negative interest rates. Negative interest rates are but a sign of despair and a factual non-starter for the policies that we really need.