Sunday, May 31, 2015

On Negative Interest Rates

Reading Tuure Parkkinen's Fixing the Root Bug exposed me to a new idea: the notion that lowering interest rates actually can improve the economy, and that the only thing holding it back is the zero percent lower bound, that it is possible that a negative interest rate on risk free credit is necessary to bring the supply of and demand for labor into balance (that is, to bring the economy into a state of full desired employment). Initially, it seemed like an insane idea, my background favoring Austrian Business Cycle Theory, which proposes that it is excessively low interest rates that cause market crashes, and that more of the same can only set the market up for an even worse crash in the future. But I suspended my disbelief long enough to fully appreciate his argument. And further reflection on the idea made me realize that it's quite possible that, once risk factors are discounted out of the going rate, negative interest rates can and do exist, in the absence of government monetary and/or fiscal policy creating a "floor" on interest rates.

Imagine the following scenario. Parkkinen's argument takes hold, and a policy of pursuing negative interest rates (either through higher rates of inflation, or through nominally negative interest rates in a cashless currency system) is enacted. Maintaining cash balances may cease to be a method of preserving wealth. I am assuming here that the interest rate is stable; this is not a hyperinflation scenario. I am also assuming that gold is no longer taxed like an investment (people can buy and sell gold freely without having to report or pay taxes on it). Let us suppose certain people decide that, rather than holding their wealth as money, or buying a risk bearing real investment, they decide to preserve wealth as a stockpile of gold. Have they dodged the "inflation tax"?

That depends on the exact real interest rate, security costs, and so on. For the hoarder of gold is not without expenses. Gold can be stolen; it must be stored in a secure fashion. This cost must be discounted out of the benefit of evading the negative interest rate. And even with that cost covered, there is still a risk that security measures will fail; thus, the cost of insuring against such a loss must also be discounted out. Thus, holding one's wealth as gold has costs built into it, and these costs must be compared against the cost imposed by a negative interest rate in the government's money (and the opportunity cost of buying gold, as opposed to a real investment in productive activity, or even a desired consumer good).

It isn't necessary to include the government's money in this analysis. All this does is demonstrate that, in the absence of the government imposing a zero percent lower bound (through such measures as providing security for property and deposit insurance without corresponding user fees), "aggregate" negative interest rates can and will exist (even if it is borne unevenly by those who fail to secure their stockpiles against theft).

Additionally, costs of securing and insuring stocks of a commodity money are not fixed, but rather vary by circumstance. And one factor that should strongly influence the costs of security is the ratio between the potential rewards of larceny and the potential rewards of productivity. The more that can be had stealing from those who already have, relative to the rewards that can be had engaging in productive activity, the higher the costs of securing stockpiles of money. In other words, as the wealth gap grows, ceteris paribus, the lower the "aggregate" "risk free" interest rate becomes, potentially going well into the negatives.

Government credit with a negative interest rate can be seen as a competitive option, in this case. There are times when one is less worried about the return on one's money than the return of one's money. And I can't help but think it would be preferable, even for those who have money to save (and particularly those who lack the skills to provide their own security), for this negative interest rate to be expressed in a regular, central price, rather than being little more than the balance of successful and unsuccessful efforts to protect a stock of commodity money against theft. The former encourages people to "flee" into real investments; the latter, an ever spiraling cycle of envy and jealousy.

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