Latest posts by Richard Ebeling (see all)
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The recent gyrations in the stock market and the uncertainties surrounding American trade policies with China and other parts of the world have raised the question of when the next recession will inevitably follow the current economic recovery from the 2008-9 financial crisis. In the face of a future economic downturn, some economic policy analysts are already making the case for central banks to use negative interest rates to dampen and shorten the impact of any economy-wide decline in output and employment that may be ahead.
Not surprisingly, much of the speculation concerning the power of government to mitigate, if not prevent, an economic downturn surrounds the usual debates over the potentials of monetary and fiscal policy. Harvard University economist Kenneth Rogoff, in a recent article, “Central Bankers’ Fiscal Constraints” (January 4, 2019), downplays the efficacy of taxing and spending tools, and highlights, instead, the continuing crucial role of monetary policy and interest rate manipulation.
The Limits on Implementing Fiscal Policy
With nominal interest rates in the United States and some other places around the world still at historical lows (even in the face of recent Federal Reserve rate increases), Rogoff points out that many central bankers hope that more direct fiscal policy will carry the weight of countercyclical activities in the face of any serious recession that may come.
But he points out that in the American system of government, there is little immediate flexibility to enable agreement upon and introduction of tax cuts or spending increases that might be effective in holding back the recessionary trends in a timely fashion. Fiscal changes must work their way through and be passed by Congress, then signed by the president, and finally implemented by various government agencies. The entire process normally can take a long time, during which a recession could get increasingly worse.
Besides, the political and ideological conflicts and controversies among Democrats and Republicans have become even more divisive in recent years. Thus, Rogoff says, any agreement about who should benefit from any tax cuts and on what programs increased government spending should be directed would not be easily or quickly resolved. All this would prevent fiscal policy from taking the lead in fighting the next recession.
Monetary Policy With Zero Interest Rates
This means that the primary burden of recession fighting continues to fall on the shoulders of the Federal Reserve. The question is, How shall America’s central bank do the job when its primary policy tool in the face of an economic downturn, the lowering of interest rates through monetary expansion, has little room for manipulation because key interest rates are, nominally, so near to zero already?
In Rogoff’s view, this calls for new monetary policy strategies in the uncharted waters of negative interest rates. “Central bankers who are serious about preparing for future recessions,” he states, “should be looking hard at proposals for how to pay interest on money, both positive and negative, which is by far the most elegant solution.”
What shall a central bank do when price inflation rates remain low (say, 2 percent or less) and nominal interest rates are at or near zero? Where is the policy room to lower interest rates in an attempt to stimulate borrowing for investment and other purposes during a recession in a setting in which nominal interest rates are already so low?
Negative Real Interest Rates Under Inflation and Deflation
It is common knowledge that the real rate of interest on borrowed money can be negative. If the nominal interest rate at which a sum of money has been lent for a year is, for instance, 3 percent, and if during that year price inflation has been, say, 4 percent, then when the loan is repaid 12 months later, not only will the lender not have received any real interest gain over their principle, but they will not even get back a sum in real buying power equal to the original purchasing power they lent.
If the lender lent $100 with the promise from the borrower to pay back $103 a year from now; and if, because of the 4 percent price inflation, a basket of goods that cost $100 at the beginning of the year now costs, therefore, $104 at the end of the year; then the lender has not received back a large enough nominal sum ($103) even to acquire the same original $100 basket of goods that now costs $104. Thus, in real purchasing power, the lender has earned a negative return on their lending.
But how do you get anyone to lend if the central bank attempts to push nominal rates into a negative range? For instance, suppose that Federal Reserve policy succeeds in lowering nominal interest rates to −1 percent. That is, if you lend $100 today, a year from now you will receive back a nominal sum of $99. Even if price inflation is zero, and a basket of goods costs $100 both today and in a year, you, the lender, are worse off by $1. You’d be better off simply holding the $100 until that year has passed to buy that $100 basket of goods, if there are no more profitable ways of utilizing that sum of money over that period of time.
Now, of course, if it was expected that price deflation was going to occur during the coming year such that a basket of goods that cost $100 in the present would only cost $95 in a year, accepting a − percent nominal rate of interest would still leave the lender better off, since they would receive $99 at the end of the year and thus be able to buy a larger basket of goods than at the start of the year. But they would be still better off just holding on to their $100 and experiencing a greater real increase in their buying power than if they only got back $99 at the end of the loan period to buy that basket of goods for $95,
The Keynesian Case for Fiscal Policy
We could imagine a situation in which the Federal Reserve bought government and other securities in the financial markets and created money in the process as the means by which to purchase these financial assets. This would swell the loanable-reserves position of commercial banks and the cash balances of individuals who had owned those securities. But if, in doing so, the Federal Reserve pushed nominal interest rates into the negative range, commercial banks and these individuals might very well find it more profitable to hold excess reserves or larger-than-usual average cash balances, respectively, rather than to lend any or all of that increase to add to the general supply of money in the economy.
Now, if the reason the Federal Reserve has undertaken such an activist monetary policy is precisely to stimulate borrowing and investment because of a perceived (Keynesian-style) deficiency of aggregate demand, the impact could be anything between small and none in the postulated situation. Thus, monetary policy would fail to bring the economy out of the recession.
John Maynard Keynes called this the “liquidity trap,” in which interest rates are too low for people to find it worthwhile to lend at all, and, instead, they hold any increases in the money supply as “idle” cash. The traditional Keynesian answer to this dilemma has been activist fiscal policy. If the private sector will not spend and invest enough to ensure “full employment,” then the government will run budget deficits and spend whatever amount it takes to do the job.
Taxing Banks and Abolishing Cash to Engage in Monetary Policy
But Kenneth Rogoff’s argument, as we saw, is that fiscal policy might not be adaptable enough in the current political environment to step in to do that job. So, his solution is to “tax” financial institutions or individuals who hold excess reserves or idle cash balances above a certain amount rather than lend or spend those sums of available money. This is an argument that he developed in his 2016 book, The Curse of Cash. (For a summary of Rogoff’s argument, see his article “Dealing With Monetary Paralysis at the Zero Bound.”)
How do you get commercial banks to not hold undesired and untimely excess reserves that otherwise they could lend to foster increased investment spending for greater economy-wide output and employment (with undesired and untimely, in this instance, being from the central bank’s point of view)? According to Rogoff, the Federal Reserve should charge a fee to banks on all central bank-defined excess reserves not lent to borrowers on the market — that is, a “tax” for not lending in the amounts and ways the central bank authorities consider necessary.
As for private individuals, Rogoff proposes for the central bank to withdraw all large-denomination bank notes from circulation — $100, $50, and even $20 bills — thus raising the costs of “hoarding” cash by reducing the only remaining forms to less convenient small-denomination bank notes and coins. In the limit, Rogoff would like to abolish all forms of actual cash holdings, thus restricting people to using credit or debit cards or checks.
All money holding would be pushed into the banking system, where paper trails could be maintained on virtually every dime and dollar any citizen in the country spent on anything at any time. Big Brother would be able to watch all your transactions with anyone, around the clock. Rogoff sees this as desirable, from a different perspective, in that it would assist the government in preventing illegal transactions of all sorts. The cashless society would serve the ends of a more coerced society in which nothing outside of the approved orbit of government could easily be undertaken.
But from the perspective of mainstream macroeconomic policy, it would place all money within the banking system for the central banking authority to more easily control and plan the use of the medium of exchange as part of its economic policy making. In Rogoff’s world, with all money captured within the banking system in this fashion, the monetary central planners could decide how much lending should be undertaken and at what nominal rates of interest (even negative ones) by raising (or lowering) the fee imposed on the banks for holding more (or less) than central bank-preferred levels of excess reserves. Thus, through this policy tool, the flow of loanable funds extended to investors and other borrowers could be more easily micromanaged for the asserted purpose of macroeconomic stabilization.
The Cashless Society and the Loss of Liberty
The first observation worth making about Rogoff’s and similar schemes is that they are designs for reducing the freedom of the individual from the prying and pursuing eyes of the political authority. Cash transactions provide people with an arena of interaction outside of the controlling and constraining hand of government.
The usual rationale for restricting the use of cash is that it facilitates criminal activity of various sorts, from gambling to prostitution to drug dealing and terrorist plotting. The classical liberal or libertarian would respond by observing that many of the activities currently labeled criminal should not be crimes in a freer society, and, therefore, would not be driven into a cash-using underworld. For the friend of freedom, there is a serious underappreciation that “vices are not crimes”, as Lysander Spooner argued long ago in a tract by that title (1875).
But cash is also a way for many an ordinary citizen to implicitly undertake acts of peaceful civil disobedience in the form of protest against the pervasiveness and degree of unwarranted tax burdens placed upon the honest industry and mutually agreed-upon exchanges of the members of society by an increasingly Leviathan-like government. Especially for the poor and the lower income segments of society, cash transactions are a way to retain a larger amount of their hard- and honestly earned income from the grasping hands of those in political power.
Any government attempt to restrict or abolish cash transactions along the lines suggested by Kenneth Rogoff will only serve to strengthen the hand of those who wish to narrow the arena of interpersonal and commercial freedom in society by the government having greater control over everything that anyone earns and spends in the affairs of everyday life.
As for actual criminal or terrorist activity, the idea that controlling the use of cash will succeed in ending such illegal activity ignores the fact that such individuals will merely find alternative ways for facilitating their endeavors. The medium of exchange is not a creation of the state. It originally arose through the free exchanges of multitudes of people over many hundreds of years to make the gains from trade easier to consummate. Those who are that determined to follow a criminal path will devise alternative mediums through which to transact their appropriately banned illegal enterprises.
Monetary Centralization and Nonmarket Interest Rates
But Rogoff insists that the real reason for proposing the cashless economy and a tax on bank reserves above those desired by the Federal Reserve is to have a new set of policy tools to continue the task of monetary central planning in a new environment of low nominal interest rates.
In his world, the idea that interest rates should be set by the market seems to be nonexistent. That interest rates are intertemporal prices connecting and coordinating the choices of income earners to save with the decision of potential investors to borrow never appears to enter his mind. Market-based interest rates are meant to reflect the availability of scarce, saved resources for time-consuming production activities the output from which will only be offered to consumers to buy at some point in the future. (See my article “Interest Rates Need to Tell the Truth.”)
For Rogoff, interest rates are simply manipulatable policy variables to influence the flow of investment spending for the purpose of influencing the total amount of economy-wide output and employment. He, like too many other modern-day macroeconomic and monetary economists, fails to appreciate that monetary expansion and the interest rate manipulations that can accompany it not only influence “aggregate” output and employment, but potentially distort the structure of relative prices and wages and the patterns of resource uses (including resulting malinvestment of capital and misdirection of labor employment). (See my articles “The Myth That Central Banks Assure Economic Stability” and “Macro Aggregates Hide the Real Market Processes at Work.”)
Thus are planted the seeds of an inevitable future economic downturn. The artificial boom in production, investment, and jobs that is induced by the monetary expansion and interest rate manipulations will only last for as long as the monetary expansion continues and the wrong interest rates persist in successfully distorting savings-investment relationships as well as capital, resource, and labor allocations among sectors of the economy.
Federal Reserve Policies Bring About Recessions
Thus the activist monetary and interest rate policies that are meant to restore or maintain “full employment” are the very instruments that bring about the outcome that economists like Kenneth Rogoff say they want to prevent: the occurrence and severities of recessions. Policies such as those championed by Rogoff are the cause of the very problem he wishes to prevent or mitigate.
Interest rate manipulations by central banks through monetary policy are similar to price controls on other goods. They prevent a central and crucial market signal from telling the truth. For a good part of the last decade, the Federal Reserve used its policy tools to lower and keep a number of key market interest rates nominally near to zero. When adjusted for inflation, some interest rates were zero or even negative.
This has meant financial markets have been functioning, even more than many other times in the past, without a meaningful structure of intertemporal prices connecting and coordinating the nexus of savings and investment in the U.S. economy. What have been reasonable and profit-oriented investments during this decade? What allocation of capital and labor reflects a proper balancing for them among competing uses in differing time-consuming production processes? What structure of relative prices and wages would be consistent with underlying real market supplies and demands in a setting uninfluenced by monetary and interest rate distortions?
The answer: We do not know, because Federal Reserve monetary and interest rate policies have prevented markets from fully and effectively functioning and expressing savings and investment choices through a market-based intertemporal pricing process and structure without which there are not and cannot be any reasonable judgments about all of this. What I would suggest is that it is not unreasonable to say that markets have been out of proper balance and at least partly discoordinated because of the Federal Reserve over the last 10 years. (See my article “Ten Years On: Recession, Recovery, and the Regulatory State.”)
Now along comes Kenneth Rogoff with his proposal to do away with cash as a policy tool to stop crime and reinforce central bank ability to control and manage money and interest rates in an anticipated future of needed negative nominal interest rates. Once the Federal Reserve begins operating below zero, along the lines Rogoff wants, it will be reasonable to say that monetary central planning will have replaced any functioning financial market, however imperfect it may be, since it will be a sector of the economy totally without a price mechanism and completely commanded by a central authority that is beyond supply and demand.
[Originally Published at AIER]