Tuesday, April 21, 2009

Real Interest Rates & Economic Growth

One of the more commonly accepted assumptions in modern economics is that nominal interest rates can't go below zero. The reason for this is that if interest rates are negative, then it will be more beneficial to have your money in cash, and so no one will lend if interest rates are below zero.

This, some argue, is a problem because this limits the ability of the central bank to lower interest rates.

Greg Mankiw now proposes to fix that alleged problem. He starts by quoting a suggestion from one of his students that a year from now, the Fed would randomly pick a number and make all dollar bills with that number as its last serial number worthless, creating a negative expected return of -10% on dollar bills. That way, people would prefer to have their money in deposits even if those deposits had a negative interest rate of say 3%.

There are numerous practical problems associated with such a scheme, but perhaps they can be resolved or limited. The same goes for the similar scheme by Silvio Gesell to tax cash holdings.

And the trouble of people moving to hold more gold and similar real assets could perhaps be resolved in the way FDR solved it: by banning people from investing in them.

Perhaps a more fundamental flaw in the scheme is that it presumes that lower real interest rates are always beneficial for the economy. That may be the assumption in the kind of New Keynesian models used by Mankiw, but in reality lower real interest rates is a symptom of the phenomena’s which are beneficial to the economy.

Lower real interest rates in a pure market economy, or simply an economy with a stable money supply, would be the result of lower time preferences, or in other words a higher willingness to save. That will boost investments and so also increase productive capacity.

If we instead assume that the decline in real interest rates was the result of monetary inflation, then it can too provide a short-term boost to the economy, provided certain assumptions specified in the Austrian business cycle theory holds true.

But under other circumstances, lower real interest rates will not boost the economy even in the short-term. If no entrepreneur is willing to invest despite negative real interest rates, then the decrease in money demand will simply lead to higher prices, something which causes money demand to simply fall further, which in turn leads to yet higher prices in a hyperinflationary spiral. Countries with hyperinflation have strongly negative real interest rates, and are thus the perfect example of what happens if such schemes are initiated.

This will do nothing to boost output even in the short-term and will have disastrous consequences later as there will either be a breakdown of the monetary system through hyperinflation like in Germany in 1923 or a severe contraction when monetary authorities in order to stop the hyperinflationary spiral must iniate a sudden, dramatic monetary contraction.


Blogger Kapitalist said...

Ha ha ha!

I would've thought that you work hard to find nut jobs to comment on, for comic effect. But this N. Gregory Mankiw is alledgedly "a professor of economics at Harvard. He was an adviser to President George W. Bush." I'm speechless! Mankiw might very well get the Swedish Central Bank's prize in economics "to the memory of Alrfred Nobel" for having invented the negative interest rates.

To give each and every bill a unique identity, even in a purely monetary sense... He's maybe the first one ever to think that thought? But what good does it do if paper bills are transformed to electronic money? In some countries, like Sweden, paper money (M0) has been decreasing inspite of M2 and M3 having increased by over 50% over the last 3-4 years. 10% of the paper bills is only a small fraction of 10% of all the money around.

No problem! Even bank accounts can be randomly cleansed in a similiar way. Just sum up the individual figures in the number which describes the amount money available on the bank account, and delete it if it ends with a lucky number 7! That is, if you have 3400 in your account, your lottery number would be 3+4+0+0 = 7 and you lost it. If you have 945, your lottery number is 9+4+5 = 18 i.e. 8, and you'll keep it.

This kind of concept can be brainstormed into fascinating levels of random destruction of property rights!

8:37 PM  

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