Friday, March 20, 2009

The proposal for negative interest on reserves that Bill Woolsey and I have been discussing for months

From The Money Illusion:

"Krugman on negative insider trading

If markets are efficient then the expected loss on Fed purchases of long term debt is roughly zero. On the other hand if the Fed has inside information about its future policy, then the Fed could use that information to make expected profits or losses. In a post today, Krugman argues that the Fed may be using the inside information in a perverse way, to generate expected losses. His argument (which is technically correct and which I discussed here in an earlier post) is that the Fed might actually persevere and produce more inflation (and I would add more real spending growth as well) than the markets currently expect. Because markets are skeptical about the ability or willingness (probably the latter) of the Fed to carry through on a reflationary policy, long bond yields do not currently price in the sort of inflation or nominal spending growth that the Fed presumably wants. What do we make of this?

1. My initial thought a few weeks ago was that the Fed should buy assets that are likely to appreciate if they are successful, which they would insure by announcing a nominal target and doing whatever was necessary to hit the target. Who cares if traders who doubted the Fed’s word lose money? It’s a good way to build credibility.

2. The Fed may think my idea is too risky, and they may be right. The markets may actually know the Fed better than it knows itself. I.e. the markets may be able to predict future Fed behavior better than the Fed. Think of the Fed as like a powerful but lumbering woolly mammoth, surrounded by agile saber-tooth tigers. The markets are very good at sensing which policy targets are credible. In Japan, the markets correctly sensed that the BOJ’s promise to end deflation was a sham, and deflation got priced into bond yields. And they were right; the BOJ tightened policy twice while deflation was still occurring.

3. Neither Krugman nor Bernanke seems to have noticed yet that we could get by with far less QE than is currently being discussed. The proposal for negative interest on reserves that Bill Woolsey and I have been discussing for months has finally been discovered by Harvard University (according to a recent post in Mankiw’s blog–and with a wacky idea for negative interest on cash that is not a part of our proposal here.) It would end the problem of excess reserve hoarding, which has been by far the biggest factor in boosting demand for base money (and hence limiting the effectiveness of QE.) Let’s see how long it takes for the idea to get to Princeton (Krugman and Bernanke’s University.)

4. On a serious note, I actually do agree with Krugman:

a. QE is worth trying.

b. By itself QE may not work (in my view due to positive interest on reserves.)

c. And if it does work it may expose the Fed to some capital losses.

The reason that I have been prodding people like Mankiw and Krugman in recent posts is to try to raise the visibility of the proposal for negative interest on excess reserves. I strongly believe this issue is important, and hope to attract the attention of someone who can publicize the issue much more effectively than I can."


  1. Don the libertarian DemocratYour comment is awaiting moderation.
    20. March 2009 at 19:22

    Back in November, we had this post in the FT which I endorsed:

    “The case for negative interest rates now
    November 20, 2008 12:35pm
    by FT

    By Brendan Brown

    A conundrum has long been known to monetary economists, but only comes into the open during the once in a quarter-of-a-century type of recession apparently plaguing the global economy.

    The quandary is how, in a conventional monetary economy, to bring interest rates down to the negative levels essential to speedy recovery during periods when there is a sharp decline in spending propensities.

    If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes.

    The interest rate under discussion is the risk-free nominal rate as quoted on short-maturity government bonds, most obviously US T-bills or short-dated German government bonds.

    Over the course of decades, particularly during the Japanese “lost decade” of asset deflation, suggestions have emerged as to how to solve the conundrum.

    These include the periodic stamping (for a small fee) of banknotes (without the stamp they would not be valid). The idea is that by imposing a running tax on banknote hoarding, nominal risk-free rates could fall to negative levels.

    In the age of the information technology revolution, surely the authorities could devise a simple and practical method of effective taxation of banknote hoards?

    There are two cues to a practical method of taxing notes. The first comes from what happened during US financial crises in the 19th century.

    Banks under stress of cash drains (depositors withdrawing funds) suspended temporarily the 1:1 link between cash and deposits, so their notes sold at varying discounts. The second comes from the launch of the euro; a conversion of old banknotes into new.

    These cues lead to the solution.

    The relevant government would announce that existing banknotes were to be converted into new notes at a fixed date, say three years from now, at a discount (for example 100 old dollar banknotes would be converted into 90 new)…..”

    I don’t remember anyone being interested in this at the time.

    “Then, Interfluidity offered this:

    Since the current Fed loves bold and unorthodox action, I thought I’d end this with a (sort of) constructive suggestion. As the composition of the monetary base changes from mostly currency in circulation to largely electronic reserves, the zero-bound on nominal interest rates can be made to disappear. How? Simple: Rather than paying interest on reserves, the Fed can tax them. If banks were taxed daily on their reserves, banks would compete to minimize their holdings, and interbank lending rates would go negative. With a high enough tax, banks could be made desperate to lend, even though in aggregate the banking system has no choice but to hold the reserves. Presumably, banks would pass costs to depositors by eliminating interest on deposits, increasing fees, and ceasing to offer term CDs. Money in the bank would go from what everyone wants to something nobody can afford to hold. People would strive to minimize transactional balances, and invest any savings in money markets or stocks or bonds, anything not subject to the tax. (This is similar in spirit to a suggestion by Arnold Kling.)”

    Then, I asked Nick Rowe this:

    “Nick, I might ask something else, but this puzzles me:

    “because the domestic and foreign central banks want to push interest rates lower, but can’t.’

    I don’t understand why the Fed couldn’t”
    1) Add a fee to these bonds
    2) Discount them over time

    In other words, add a disincentive to buy and hold them.

    Posted by: Don the libertarian Democrat | February 03, 2009 at 04:51 PM

    Hi Don: it’s technically possible. But people would just hold cash under the mattress, or in safety deposit boxes, and get zero interest rates that way. (There are various schemes always floated to tax cash, or make it expire, etc., but they always come across as a bit sci-fi.)

    Posted by: Nick Rowe | February 03, 2009 at 05:27 PM”

    Are you advocating the same thing, or are these ideas somewhat different?


Don, Thanks for the link, I need to link to that blog, as he has the same idea as I do. The FT idea of interest on cash, however, is probably a nonstarter. If I understand your idea, it is for negative rates on T-bills (once nominal rates had fallen to zero.) Is that right? If so, I am afraid that Nick Rowe is right, it wouldn’t work because of private currency hoarding. It is the same logic as my idea, and is a good idea, but here is the difference. The Fed cannot police the public and prevent them from hoarding cash as a way of avoiding negative rates. But the Fed can police commercial banks and prevent them from hoarding vault cash as a way of avoiding the tax on bank reserves.

No comments: