Monday, July 23, 2012

Bye Buy Zero Lower Bound on Nominal Interest Rates?

It sure looks like it, and with that goes an enormous literature on the consequences of an absolute zero bound on nominal interest rates.  In the 1990s we saw occasional episodes where some rates would go negative in Japan, with Japan curiously still in the positive range in the current situation, if just barely on all its bonds.  The US had a few brief episodes at certain points on certain bonds at times, first in 2004.  In 2009, the Swedish central bank actually set a target interest rate of negative 0.5% at the worst of the financial crisis as it engaged in a massive monetary stimulus, but I am not sure how negative rates actually got. 

However during the last few weeks and accelerating last week and into today, a raft of nations have been selling bonds at negative nominal yields.  The current list of recent ones includes the US, Switzerland, Germany, France, Finland, Austria, Denmark, and the Netherlands.  While most of these have been just barely below zero, the Swiss have sold two-year bonds as low as -0.45% recently.  The barrier has been broken, even as some other members of the Eurozone are experiencing record high interest rates.  For a week-old discussion see http;//www/ (not sure that is right) .

I think that the deeply entrenched refusal to admit that this can happen is part and parcel of the long and somewhat equivalent refusal by most economists to admit that prices can be negative.  Standard economic theory simply assumes that negative prices do not exist, and when we see someone paying to give something away, we define it as a "new good," such as water removal or garbage removal.  The problem is that sometimes we see the same good sold for both positive and negative prices within the same market at the same time, with this happening occasionally in real estate (notable example was in the former East Germany after the reunification and some properties were saddled with environmental cleanup costs).  A literally classic example is bridal markets from Babylon reported by Herodotus.  Potential brides would be reportedly lined up and auctioned off.  The most desirable would draw forth positive prices, but as one went down the line to the dogs, the prices would go negative.  As it is, we see this now, but it is usually in different societies, with some having "bride prices" and others "dowries" (groom prices), with some modern societies such as the US muddying up the picture thoroughly with an implicit market (mostly dowries effectively given the norm that bride's family pays for the wedding, but groom's side is supposed to cover rehearsal dinner).  In any case, this is now called the "Herodotus Paradox," and it is about time that economists got over their long entrenched prejudice about the limits on what prices can be.

Now, having stated that negative nominal interest rates make a mess of this massive literature based on the zero lower bound, I shall admit that I think that this literature remains somewhat relevant.  This is because what we are looking at is probably still a form of a lower bound, only that it has become fuzzy.  The old arguments against negative nominal interest rates still carry some weight, but must be noted to have their limits also, not that rigid or absolute.  So the old standby is that one can always hold cash.  Well, if it is in the form of demand deposits in a bank, well, there is always the issue of the riskiness of the bank, and what lies behind most banks ultimately are government bonds, which may be risky as well.  And as for literal cash itself, well, it is not risk free either, whether in a mattress or cookie jar.  There are dangers of theft or fire or whatever.   However, while such risks exist, they are not huge, which may be why we have not clearly seen negative rates below -0.5% to my knowledge, although we are close to that now in some places.  Maybe we can go lower, but I think it is unlikely that we will ever see sustained rates lower than say 1%.  In the past, such episodes of negative nominal interest rates have been fairly short-lived. 

But, whether such rates are good or bad (and that obviously that depends on whether one is a lender or a borrower), this supposed bound has been much more widely and substantially breached than ever before.  We are living in a new world in financial markets.


john c. halasz said...

So what's the mechanism by which negative interest rate bonds come about? Well, if cash is king and there is only a limited supply of actual cash currency and all prices are denominated in cash, then the only way in which the increased demand for cash can be articulated is through a rise in the price, thus lowering of yield, in the nearest cash equivalent, T-bills, through swapping longer-dated t-bonds for t-bills, which then is expressed as a lower, "negative" price for t-bills in currency terms, and the t-bills then serve as rough cash equivalents in collateralizing further financial transactions. That's not too hard to figure. But then add on deflation risk and the threat of the blowing apart of the Euro, (which looks all too likely), and a speculative flight into T-bonds from likely currency appreciators, (Germany and especially Denmark, which is only pegged to the Euro and so can more quickly adapt to a break-up) and there is little mystery involved. But whether this is a "new world of financial markets" rather than just a likely global deflationary depression, (and we've seen that movie before), I suppose depends on just what you might think the "monetary" solution might be.

Rob L said...

Really? "Dogs" in this day and age? For shame.

Barkley Rosser said...

Shame on me, Rob. Probably it was their mothers who were barking too loudly...

John, without doubt deflationary expectations are coming on strong in all of this. While I said it may be for good or bad, this is mostly a bad sign, even if some governments are getting to fund themselves on the cheap. Heck, it is not every day that one makes money by borrowing it.

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