Sunday, January 19, 2014

Can the natural rate of interest be negative?

I’m getting tired of talk about negative interest rates and in particular, talk about “natural negative interest rates”. The reason large numbers of economists think that the natural rate of interest can go negative seems to be as follows.

Cutting interest rates is a popular way of trying to impart stimulus in a recession (though a recent Fed study cast doubt on whether interest rate cuts actually have the desired effect). So it’s often assumed that that entirely ARTIFICIAL method of adjusting demand must be part of the free market’s cure for a recession, plus if the economy is still in recession at a zero interest rate, then the “natural” rate of interest must be negative. There are two basic flaws in that argument.

First, it’s not clear that interest rate cuts are a significant part of the free market’s cure for recessions. Of course, in a recession, there is less demand for borrowed funds, but then would-be potential lenders don’t feel over-burdened with surplus funds in a recession, so not only does demand for borrowed funds decline in a recession, but so too does the SUPPLY of relevant funds.

But (secondly) let’s assume that interest rate cuts ARE a significant part of the free market’s cure for recessions.

If the amount of money that savers want to lend grossly exceeds the amount that borrowers want to borrow for near risk free loans, then obviously the rate of interest will collapse to near nothing. But the moment it becomes negative, savers have a potential alternative, namely to store their savings in the form of gold, dollar bills etc in safe deposit boxes, or some other near 100% safe form, like a rented property that brings little net profit (or which is just left empty).

Now if for the sake of argument the chances of losing everything when making a near risk free loan is 0.5% and the cost of hiring a safe deposit box is 0.5% of the wealth that can be stored there, then interest rates will never go negative.

To be accurate, you’ll get 0.5% for making a loan, but that 0.5% is compensation for the risk. INTEREST, strictly speaking, is a reward for forgoing consumption. And in the latter example, that reward will be nothing.

Or in more general terms, if the risk on a near risk free loan is negligible, then the free market rate of interest will never go further into negative territory (in percentage per annum terms) than the cost of storing wealth “safe deposit box” style or “empty property” sytle (in percentage per annum terms).

And that raises the question as to how the free market DOES DEAL with recessions when the rate of interest has collapsed to near zero. The answer is first Says Law (although that arguably doesn’t work very well in real world complex economies) and second, the Pigou effect, which in the real world is equally ineffective.

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