Negative interest rates are not sufficient

In a post published last month, we saw Tom Palley and this blogger getting it mostly right about how pre-Keynesian thinking was impairing policymakers’ ability to see beyond interest-rate policy when dealing with less-than-perfect growth and job creation. (Yields on many government bonds are now below zero.) Those who read Palley’s article will remember that John Maynard Keynes thought of the following model. (I have used parentheses as symbols for functions. For example, the expression “aggregate demand(employment)” can be read as one would read the notation “f(x).” I apologize to nonmathematical readers.):

aggregate demand(employment) = aggregate supply(employment) (KEYNES’S THEORY OF EFFECTIVE DEMAND)

On the other hand, Keynes rejected models like this one:

saving(interest rate) = investment(interest rate) (SOME PRE-KEYNESIAN NEOCLASSICALS)

(I have simplified both models; see chapter 3 of Keynes’s General Theory if you wish to see his original argument for the theory of effective demand.) Only the second model offers the hope that the problem with employment is due to an interest rate mechanism that is “stuck” in some way, preventing investment from rising when households are in the mood to save. One example is “floors” on interest rates thought to prevent them from falling much below zero percent.

In today’s post, I quote a recent working paper by Richard Koo, who brilliantly skewers some of the same preconceptions about interest rate cuts as a reliable way to achieve full employment. He argues that one cannot presume

“that all saved funds are borrowed and spent, with interest rates moving higher when there are too many borrowers relative to savers and lower when there are too few. It is because of this assumed automaticity that most macroeconomic theories and models developed prior to 2008 contained no financial sector.

However, the advent of the Great Recession in 1990 for Japan and in 2008 for the West demonstrated that private-sector borrowers can disappear altogether in spite of zero or negative interest rates when faced with daunting financial problems after the bursting of a debt-financed bubble. In both post-1990 Japan and the post-2008 Western economies, borrowers disappeared completely due to the specific sequence of events described below.

First, people tend to leverage themselves up in an asset price bubble in the hope of getting rich quickly. But when the bubble bursts and asset prices collapse, these people are left with huge debts and no assets to show for them. With their balance sheets underwater, these people have no choice but to pay down debt or rebuild savings to restore their financial health.

For businesses, negative equity or insolvency implies the potential loss of access to all forms of financing, including trade credit. In the worst case, all transactions must be settled in cash, since no supplier or creditor wants to extend credit to an entity that may seek bankruptcy protection at any time. In order to safeguard depositors’ money, many depository institutions such as banks are also prohibited by government regulations from extending or rolling over loans to insolvent borrowers. For households, negative equity means savings they thought they had for retirement or a rainy day are no longer there.

Since these conditions are very dangerous, both businesses and households will focus on restoring their financial health regardless of the level of interest rates until they feel safe again. With survival at stake, businesses and households are in no position to borrow even if interest rates are brought down to zero. There will not be many lenders either, especially when the lenders themselves have balance sheet problems. That means these households, businesses and financial institutions are effectively in debt minimization mode instead of the usual profit maximization mode.”

Koo’s article leads off a recent edition of the Real World Economics Review, a publication of the World Economics Association. As in the case of Tom’s article, I am not in 100 percent agreement everywhere. I’ll mention some flaws in Koo’s argument related to his seeming assumption that state money is exogenous in a future post. But his paper, designed to be read by economists and non-economists alike, makes a strong case that deficient aggregate demand is the issue. In the wake of weak GDP numbers for the US in the second quarter, I hope to get to some other interesting theories about what is and is not going wrong in the economy soon.

Finally, for those who might need it, here is the New York Times’s Neil Irwin from February with a Q&A on some of the basics of negative interest rates.