- Alasdair Macleod
24 September 2015
The sudden end of the Fed’s ambition to raise interest rates above the zero bound, coupled with the FOMC’s minutes, which expressed concerns about emerging market economies, has got financial scribblers writing about negative interest rate policies (NIRP).
Coincidentally, Andrew Haldane, the chief economist at the Bank of England, published a much commented-on speech giving us a window into the minds of central bankers, with zero interest rate policies (ZIRP) having failed in their objectives.
Of course, Haldane does not openly admit to ZIRP failing, but the fact that we are where we are is hardly an advertisement for successful monetary policies. The bare statistical recovery in the UK, Germany and possibly the US is slender evidence of some result, but whether or not that is solely due to interest rate policies cannot be convincingly proved. And now, exogenous factors, such as China’s deflating credit bubble and its knock-on effect on other emerging market economies, are being blamed for the deteriorating economic outlook faced by the welfare states, and the possible contribution of monetary policy to this failure is never discussed.
Anyway, the relative stability in the welfare economies appears to be coming to an end. Worryingly for central bankers, with interest rates at the zero bound, their conventional interest rate weapon is out of ammunition. They appear to now believe in only two broad options if a slump is to be avoided: more quantitative easing and NIRP. There is however a market problem with QE, not mentioned by Haldane, in that it is counterpart to a withdrawal of high quality financial collateral, which raises liquidity issues in the shadow banking system. This leaves NIRP, which central bankers hope will succeed where ZIRP failed.
Here is a brief summary of why, based on pure economic theory, NIRP is a preposterous concept. It contravenes the laws of time preference, commanding by diktat that cash is worth less than credit. It forces people into the practical discomfort of treating physical possession of money as worth less than not possessing it. Suddenly, we find ourselves riding the train of macroeconomic fallacies at high speed into the buffers at the end of the line. Of course, some central bankers may sense this, but they are still being compelled towards NIRP through lack of other options, in which case holding cash will have to be banned or taxed by one means or another. This would, Haldane argues, allow them to force interest rates well below the zero bound and presumably keep them there if necessary.
One objective of NIRP will be to stimulate price inflation, and Haldane also tells us that economic modelling posits a higher target of 4%, instead of the current 2%, might be more appropriate to kick-start rising prices and ensure there is no price deflation. But to achieve any inflation target where ZIRP has failed, NIRP can be expected to be imposed for as long as it takes, and all escape routes from it will have to be closed. This is behind the Bank of England’s interest in the block-chain technology developed for bitcoin, because government-issued digital cash would allow a negative interest rate to be imposed at will with no escape for the general public.
Fortunately for the general public this remedy cannot be implemented yet, so it can be ruled out as a response to today’s falling stock markets and China’s credit contraction. What is deeply worrying is the intention to pursue current interest rate policies even beyond a reductio ad absurdum, with or without the aid of technology.
In considering NIRP, Haldane’s paper fails to address an even greater potential problem, which could easily become cataclysmic. By forcing people into paying to maintain cash and bank deposits, central bankers are playing fast-and-loose with the public’s patient acceptance that state-issued money actually has any value at all. There is a tension between this cavalier macroeconomic attitude and what amounts to a prospective tax on personal liquidity. Furthermore, NIRP makes the hidden tax of monetary inflation, of which the public is generally unaware, suddenly very visible. Already ZIRP has created enormous unfunded pension liabilities in both private and public sectors, by requiring greater levels of capital to fund a given income stream. Savers are generally unaware of this problem. But how do you value pension liabilities with NIRP? Anyone with savings, which is the majority of consumers, is due for a very rude awakening.
We should be in no doubt that increasing public awareness of the true cost to ordinary people of monetary policies, by way of the debate that would be created by the introduction of NIRP, could have very dangerous consequences for the currency. And once alerted, the public will not quickly forget. So not only are the central banks embarking on a course into the unknown, they could also set off uncontrollable price inflation by creating widespread public aversion to maintaining any cash balances at all.
The only reason any particular form of money has exchange value is because people are prepared to exchange goods for it, which is why relative preferences between money and goods give money its value. Normally, people have a range of preferences about a mean, with some preferring money relative to goods more than others and some preferring less. The obvious utility of money means that the balance of these preferences rarely shifts noticeably, except in the event of a threat to a complacent view. For this reason, monetary inflation most of the time does not undermine the status as money of central bank issued currency.
The trouble comes when the balance of these preferences shifts decisively one way or the other. At an extreme, if no one wants to hold a particular form of money, it will quickly become valueless, irrespective of its quantity, just like any other unwanted commodity. This is the logical outcome of negative interest rates, and subsequent increases in interest rates sufficient to stabile the purchasing power of currencies is no longer an option, given the high levels of public and private debt everywhere.
Therefore, we need to watch closely how this debate over NIRP develops. If the Bank of England is looking at ways to overcome the zero bound on a permanent basis, it is a fair bet that it is being looked at by other central banks in private as well. And if NIRP gains traction at the Top Table, the life-expectancy of all fiat currencies could become dramatically shortened.
* How low can you go? – Speech given by Andrew Haldane at the Portadown Chamber of Commerce, Northern Ireland.