Can You Ever Lower Interest Rates Past Zero? (Redux)

Greg Mankiw at the New York Times gives us another option for reducing interest rates past zero. As I explained before, low interest rates incentivise borrowing; subzero ones would leverage that. We'd be doing it to correct a market distortion, which as I noted here is primarily demand inelasticity to price. Money shouldn't act like that. And when it does, our attempts at aggressive AD are effete. But how do we stimulate demand when consumers aren't keyed into price?! All money buys you is price. It's not like we want it to come with 24-hour customer service and a free latte.

We need this demand. We need it badly, because assuming debt comes with the motivation to seek out returns. If borrowing takes off, so does the drive to grow, expand, hire, and innovate. But we can't force people into borrowing; all we can do is reassure them they won't go bankrupt. That's basically what low interest does: it tells the debtor he's not going to end up underwater.

But money's never been cheaper–not in my lifetime. Yet, no one wants to buy it as a loan. Either no one sees the bargain to be had, or no one finds it worth the (non-existant) risk involved. (As I've noted before, people may be reluctant due to their last experience with debt.) But negative interest rates offer solutions to both problems: it'd be the boldest advertising campaign the Fed's ever adopted–like some weekend sale-a-ganza–and it'd be the ultimate guarantee against risk–why the fuck wouldn't you buy if you'd be taking a relative loss on non-purchase?

But, as Mankiw observes:

The problem with negative interest rates [is that] nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Which leads us to his alternate solution:

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won’t help.)

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

 Greg Mankiw, consider yourself an honorary idiosyn.cranomicist.