Should our government borrow more at negative real interest rates?

You’ll see a number of posts about financial repression on Credit Writedowns. What I am referring to is the negative real interest rates that are prevalent not just in the US but everywhere we see for higher-rated sovereign borrowers. In my mind, Bill Gross and Mohamed El-Erian of Pimco, the world’s largest bond fund, have done the most to push talk about financial repression.

This talk began in February with Bill Gross’ monthly post “Devil’s Bargain”. I reviewed it, writing:

What Gross is saying is a version of Michael Pettis’ story of how crises get resolved. The real cost of non-performing loans is some form of loss socialisation, whether overt or through surreptitious means. In the case of bond holders like Gross, the Fed (and the Bank of England) is taking money away from investors by reducing the real yields that they can earn. It’s as if Ben Bernanke (and Mervyn King) reached into Bill Gross’ pocket. That’s what zero rates are about.

Bill Gross: Devil’s Bargain

As Gross puts it, ‘Low policy rates represent an immediate threat to investment portfolios’ everywhere. I am an ex-credit guy, so my knee-jerk thinking will probably always be bonds first. So I do see something very pernicious in this effort to rob savers and bondholders. I know some people argue that bondholders are rent seekers and are not guaranteed a return on their investment. Tell your grandmother she’s a rent-seeker! More than that, if real returns remain low, it will skew capital investment. When recession hits, debtors backing those losing investments will be caught out and forced to delever aggressively as resource misallocation becomes evident. That’s the result of bad economic policy.

As Mises put it:

The projects which owe their existence to the fact that they once appeared "profitable" in the artificial conditions created on the market by the extension of credit and the increase in prices which resulted from it, have ceased to be "profitable." The capital invested in these enterprises is lost to the extent that it is locked in. The economy must adapt itself to these losses and to the situation that they bring about.

Easy money will not create sustainable growth.

Here’s the question though: if the free money is there, shouldn’t governments take it? As Tyler Cowen puts it: Should our government spend (and borrow) more at negative real interest rates? He writes:

Let’s say I could borrow money at negative two percent real, but my seven cousins, three of whom are crazy, would get together and decide how to spend it. I would get a vote too and they would agree to spend it on me. I would have to pay it back.

That’s the right question and the right reasoning… except for the last sentence, “I would have to pay it back.” This introduces a constraint that just doesn’t exist.

Here’s a question for you: in history, when was the last time the United States paid off its national debt? Since the Europeans have a longer history than the US, let’s ask the same question about Germany, Britain and France: when did they last expunge the national debt? To my knowledge, the answer in each case is never. Why is that?

Here’s my answer:

In the corporate world, the average Treasurer of a multinational corporation would tell you they never think about expunging their debt entirely because the cost of debt capital is cheaper than the cost of equity capital and they would much rather fund their capital expenditures with debt capital than equity capital.

But for sovereigns, the situation is even more stark. Even during the gold standard when governments made self-imposed constraints to prevent the government from spending out of control (mainly to fund wars), governments did not expunge their debt entirely. Governments create money.

In today’s world, if you go to the government with your paper IOU with $100 printed on it to claim your ‘money’, the government would hand you another paper IOU with the exact same amount printed on it. The concept of “solvency” is not applicable to a sovereign government like the U.S. since it can simply manufacture an infinite supply of liabilities with which to expunge present liabilities. Why would you pay off your debt then? The question is not solvency but about political choices, resource allocation, currency depreciation and inflation.

But you might say that’s why we have had self-imposed constraints like the gold standard. Yes, governments in the past have simply spent on wars until they had inflated the value of money away and/or been overthrown. The same is most surely true today. Nevertheless, Randy Wray makes a good case that even gold-backed money has always operated via “nominalism” by which the nominal value of money is determined by government. The point for me is that government money is coercive. One of two situations always exists. Either A, you must accept government money and/or B, you need government’s money to expunge your tax liability. Either way government tells you how you must pay. If you don’t, you suffer the consequences. Government does not have the same constraint.

My point? if you have constraints that don’t exist, the thought experiment that results, doesn’t work. In fact, if those constraints are important like this one, it could lead one to very wrong answers. I point this out because government actors are not equivalent to actors in the private sector. Household or company budgetary constraints are not the same as government budgetary constraints. Households are users of the currency issued by the sovereign government. Governments are creators of currency.

Stephanie Kelton correctly stated,

“debates about "affordability" become inapplicable. As this becomes more widely understood, we can begin to have a completely different — and vastly more important — debate about the size and role of government…

And, no, it does not follow that because the US government "can" do something that it "should" do it. It has the ability to purchase anything for sale in terms of its own currency. Let us accept that point and then debate whether, when, and to what extent it should exercise this power.

So, I do agree with the thrust of Tyler Cowen’s post, that government must use resources well and that means negative real rates are not an invitation for government to load up on liabilities. But, we need to frame the debate as one of resource allocation and not of affordability.

  1. Richard Rosso says

    The question is not solvency but about political choices, resource allocation, currency depreciation and inflation – excellent. It’s this poor resource allocation incredibly evident

    1. Edward Harrison says

      Agree, Richard. The elephant in the room is resource misallocation.

  2. wh10 says

    What interest rate do you think would be healthy? As a part of this conversation, there is that r < g consideration in terms of debt interest growth.

    1. Edward Harrison says

      The easy but flippant response is “I don’t know “. The Fed controls rates and it has moved to not just controlling overnight rates but also to controlling the rates further out to two years.

      People like Scott Sumner argue rates should be negative in real terms because of the Taylor rule. But the fact is rates are not market determined now so the price signal is defective.

      My view is rates should be positive in real terms and the Fed should provide liquidity as needed for liquidity constraints because low rates are more about solvency than liquidity. Bagehot said liquidity at a penalty rate.

      If government wants to prevent debt deflation, it can always manufacture more net financial assets via deficits without propping up bankrupt enterprises and promoting resource misallocation.

      1. wh10 says

        Right. And another follow-up- Are low rates right now actually stoking credit creation and investment, such that we should be worried about a boom in resource misallocation?

        1. Edward Harrison says

          You have to divide that question in two. The right question is not about the level of credit but the allocation of credit – meaning resources can still be misallocated even when not in a credit bubble.

          We do know there is a serious social media bubble going on. But that’s not a huge segment of allocated capital investment – and it is all equity capital. I would argue that housing and financial services are still receiving interest rate subsidies that have prevented those areas of the economy from collapsing. That’s certainly a misallocation of capital even if it has stopped a debt deflation. In the area I used to work in, high yield bonds had its BEST year ever in 2010 due to the Bernanke put and the allocation of capital that favoured marginal debtors. Now that the Bernanke put has been withdrawn that market is getting absolutely hammered. Issuance has fallen off a cliff.

          In each of the three cases I presented in the paragraph above, a self-interested investor in those three areas could make intelligent counterfactual arguments based on the microeconomics of their individual companies or sectors. Sure, fine. Wait until the next recession. Then we’ll talk again. The reality is longer-term rates are being increasingly driven by financial repression and this does have consequences. Prudent investors make investments based on these factors.The miisallocation is real.

          1. David Lazarus says

            Low interest rates make misallocation a certainty. Even with the economy so bad right now I would prefer a higher base rate of 2 or 3%. This would mean that asset prices would struggle to stay inflated and they would find their floor much quicker. It also encourages corporates to rate arbitrage for overseas investment.

  3. fresno dan says

    Interesting article.
    I would ask, “Can the average person borrow at negative interest rates?” If not, why not?
    The questions practically answer themselves.

    I read once that in the 1800’s when one retired (for those able to do so, which were damn few) that interest was not necessary, as a general deflation meant that the money one held became more valuable.

    To me, I see a government that appears in every way to construct policies that defacto reduce the income of average people, as well as their assets (turning the housing market into a casino, where the bank is the “house”). These same policy makers than scratch their collective heads, muttering how after providing trillions to banks, ungrateful and obstinate consumers refuse to borrow, and unemployed people refuse to sell their own organs to generate cash to spend.

    For going on two years, there has been no cost of living increase for social security.
    So how much inflation has there really been?

    In my life, I never imagined I would see explicit policies designed to save Goldman Sachs by taking interest income from little old ladies… (Oh, and being a sarcastic bast*rd, I can’t help but notice that the low increase in the price of Ipads doesn’t make up for the high increases in the cost of medicine….)

  4. David Lazarus says

    Two answers. While real interest rates are negative then the government should borrow that money for infrastructure projects. If they invested it into windfarms, that would create jobs in construction and power supply. Then as the investment matures they could sell that investment either as an enterprise or bonds so recoup the investment in future years. That would be stimulative and have benefits across the economy. Lower imports of energy, less oil dependant.

  5. Dan Lemnaru says

    “I read once that in the 1800’s when one retired (for those able to do so, which were damn few) that interest was not necessary, as a general deflation meant that the money one held became more valuable.”

    Makes perfect sense in a world where money represent a constant (a certain man hours value), and productivity rises constantly, or even in an accelerated way due to the Industrial revolution. Yes, technological and productivity progress should lead to higher purchasing power even for those who only have claims on future products and services (that’s what money really is).

    “(Oh, and being a sarcastic bast*rd, I can’t help but notice that the low increase in the price of Ipads doesn’t make up for the high increases in the cost of medicine….)”

    Stuff like the Ipads (electronics), where technological change is so rapid, has seen deflation for 50+ years now, despite the policy of “low constant inflation”. The industry still does just fine. The idea that people will defer spending is false. They will defer spending only for a while – none of us is immortal. ;)

    I recall years when we had 100%+ inflation here. People still saved, even though it made relatively little sense to. Still, how else could you ever afford high-ticket stuff? Similarly, in a constant deflation environment people would still spend their money.

    “My view is rates should be positive in real terms and the Fed should provide liquidity as needed for liquidity constraints because low rates are more about solvency than liquidity.”

    That’s my gut feeling as well. I could put up with negative rates for a short while (say a couple of years), but after that “stop loss” will be storming in my head. So, deposits will start being spent. One might think it’s a good thing, with the inflation eroding debt scenario. But do you really want a banking system with very few and small deposits?

    In the real world, it makes no sense to give someone your money only to get less of it back. It’s an impossible proposition for those saving for say retirement. You force them to buy stuff, real estate, gold, anything that at a time appears more likely to hold its real value than a savings account of mutual fund etc. Basically, with negative real rates you plant the seeds of future bubbles, and destroy the saving-investing natural relationship. Saving becomes mere consumption.

    1. David Lazarus says

      I agree deflation is only a problem for economists. People in the real world still need to eat, so cannot defer everything. As you said we have had decades of deflation in electronic goods yet the industry is still thriving. All that inflation does is guarantee easy capital gains. Whereas if we had stable asset prices or even falling asset prices businesses will still operate and expand to meet demand. The only losers will be those who have over extended themselves to buy assets and banks who speculated on creating asset bubbles.

  6. Dave Holden says

    I’m somewhat offline at the moment but yes I agree entirely with this. What I’ve found particularly frustrating throughout this crisis is the concentration on the fiscal and monetary role of government in solving this crisis when in reality for most countries the problem is only one of government “solvency” through choice. And I’m not talking about the choice that the US makes regarding it’s debt ceiling, I’m talking about the choice to not require bad *private* sector debts be restructured.

    This I suspect is a choice born of powerful vested interests and one I believe is unsustainable. Meanwhile the blogosphere echos to many and varied debates on the merits of different economic theories all the while ignoring the elephant in the room. MMTer’s use the terms vertical and horizontal monetary axis. Well in my view it’s the horizontal one that’s broken, the vertical one can be fixed another day.

  7. Warren Mosler says

    my take is govt should leave the nominal risk free rate at 0 where it would be if they didn’t intervene with their various support measures (interest on reserves, tsy secs, etc) and use fiscal balance to regulate aggregate demand.

  8. Buddy Rojek says

    Real negative interest rates are definitely causing the gold and commodity bubble ( as at 8 September 2011) and the stock market to be above where it should be. P/E ratios are definitely higher than they should be in a recessionary environment. There are many blogs promoting the benefits of dividend paying stocks. i.e. they are offering a yield higher than bank interest on savings accounts.

    This is what Bernanke is trying to achieve. A wealth increase effect via a supported stock market. Retirees are not going to spend if their life savings are devalued.

    There needs to be a nationalization directive for the banks and positive real rates to ensure savers are rewarded. That way, consumption (low interest rates discourage saving) will only occur in the most needed areas.

    The savings must be put to effective use on major infrastructure projects. When I mean nationalisation I mean, corporate principles of profitability with government direction, but instead of money being diverted into lower cost housing, it is mandated to be spent on infrastructure projects and a user pays “Toll system”. That way you won’t have bridges to nowhere and you will get long term unemployed reemployed.

  9. Warren Mosler says

    Or, conversely, higher nominal rates would suppress them to below where they would ‘naturally’ be. ;) And seems to me gold is being pushed up by central bank buying with what amounts to ‘off balance sheet deficit spending’ as they credit the account of the seller and account for the gold as an asset?

  10. David Lazarus says

    Boosting asset prices will not get people to sell some of their assets to live on. They need income and zero percent does not give them that. If interest rates were higher, and dividend yields higher still then people will spend that income, without having to break into that capital. Yet the complete opposite is being tried.

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