From ZIRP to NIRP?


ZIRP is the acronym for the Federal Reserve Board’s nearly 90-months of “zero interest rate policy.” For seven-plus years, the federal funds rate (what the Fed charges its member banks for short-term, overnight loans) has been at the “zero bound” (that’s Fed-speak for almost zero) in order to stimulate economic growth through more borrowing, corporate investment, and consumer spending. It hasn’t worked.

As Mervyn King, a former Bank of England governor general, explains in his tremendous new book, The End of Alchemy: Money, Banking, and the Future of the Global Economy, maintaining extremely low interest rates for extended periods boosts asset prices (like housing and equities) as investors seek higher yields. Aggressive fiscal and monetary policies were appropriate responses to the Great Recession, but their prolonged use has created serious distortions.

According to King, “[m]aintaining interest rates at extraordinarily low levels for years on end has contributed to the rise in asset prices and the increase in debt. Debt has now reached a level where it is a drag on the willingness to spend and likely to be the trigger for a future crisis.”

There’s a vicious cycle here. With rising debt levels, the Republican-led Congress won’t provide more deficit spending. Many economists and policymakers favor aggressive macroeconomic policies to stimulate Keynesian “aggregate demand,” and yet low interest rates aren’t stimulating demand either. King warns us that “[s]hort-term stimulus reinforces the misallocation of investment between sectors of the economy, and its impact on spending peters out when households and businesses come to realize that the pattern of spending is unsustainable.”

Money plays a vital role in every economy: it facilitates transactions and represents a store of value. Money’s value, however, is clearly not zero. Under ZIRP, the Fed has been setting the market price for money in ways that impede honest price discovery elsewhere in economy.

Given ZIRP’s ineffectiveness, some central banks are now experimenting with another monetary stimulus: NIRP, or “negative interest rate policy.” That’s right: under NIRP, the price of money isn’t zero: it’s less than zero. Central banks in Denmark, the European Union, Japan, and Sweden have embraced NIRP, which means that almost 25 percent of the global economy has central-bank-imposed negative interest rates.

How does a negative interest rate work? If you have a savings account with your bank, you will pay the bank for holding your money. Those central banks currently pursuing NIRP have only imposed it on commercial banks. It is unclear whether those banks will swallow the NIRP costs internally or pass them on to their retail customers.

NIRP is not working in Japan, and it is unlikely to work anywhere for two reasons: consumers will revolt, and the policy is counterintuitive. Consumers will shift into cash and purchase home safes before accepting a negative return on their liquid assets. NIRP is counterintuitive because it ignores the fact that as a store of value, money represents future purchasing power. Here’s how NIRP would affect consumers.

If you put $5,000 into a one-year certificate of deposit at 1% interest, you have a binding contract that at the end of that year, you will earn $50 of additional purchasing power. If you put $5,000 into a one-year certificate of deposit at a negative 1% interest rate, at the end of that year, your initial deposit will be worth only $4,950. You would be contracting today for a lower future standard of living. Try explaining that to the American public.

The economic theory behind NIRP is that negative interest rates will encourage banks to push money out the door rather than hold it. Corporations will start investing again, and consumers will spend sooner rather than pay a negative interest rate for holding cash in their banks. As a result, overall aggregate demand will rise, and bingo: the post-2009 stagnation and low growth will be reversed!

Mervyn King suggests a different perspective: “The ‘headwinds’ that the major economies are facing today are not the result of a temporary downward shock to aggregate demand, but of an underlying weakness caused by the earlier bringing forward of spending.” Translation: we have a structural problem called too much debt. And when a nation goes heavily into debt (through deficit spending or through sustained low-interest-rate monetary policy plus Quantitative Easing that has added some $4 trillion to the Fed’s balance sheet to keep long-term interest rates low), there comes a point when the ability to bring forward spending reaches a limit — for individuals, companies, and countries. Tomorrow suddenly becomes today.

In her June 21, 2016, testimony before the Senate Banking, Housing, and Urban Affairs Committee, Fed chair Janet Yellin announced that the Fed had the legal authority to impose NIRP but had no plans to do so now. Her statement was somewhat reassuring, but we also need a laser-like focus on the deep, underlying, structural causes of anemic economic growth.

For eight years, we have pursued fiscal and monetary policies that have not generated robust economic growth. These policies have now reached their limits, and hoping that consumers will somehow – miraculously – return to excessive spending, thereby boosting aggregate demand, is more wishful thinking.

According to Mervyn King, the source of today’s economic problems is a long-running global imbalance — a disequilibrium in the pattern of demand that remains impervious to low interest rates. He points to the major “imbalance between high-and low-saving countries” in which the resulting “disequilibrium has morphed into an internal imbalance of even greater significance between saving and spending within economies.” What this means, for example, is that China needs to consume more domestically and save less. In the United States, the opposite is needed: we need to save more and consume less. He is emphatic that “[l]ow interest rates cannot correct the disequilibrium in the pattern of demand.”

As long as we ignore the underlying causes of these global imbalances, we will experience low economic growth and recurring economic crises. Since 2008, we have addressed symptoms, not causes. Another traumatic reckoning is certain unless we are bold enough to implement policies now that will establish a new equilibrium. Those policies, says King, will require boosting productivity, promoting trade, and restoring floating exchange rates. In the United States, I would add major tax and regulatory reform. Do you think our next president is listening?

Charles Kolb served as Deputy Assistant to the President for Domestic Policy from 1990-1992 in the George H.W. Bush White House. He was president of the French-American Foundation – United States from 2012-2014 and president of the Committee for Economic Development from 1997-2012.

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