The liquidity trap heralds fundamental change

This tweet from MacroResilience caught my eye today:
And he then expanded his argument in this post.

The first thing to note is that nearly all money is interest-bearing - and not because central banks are paying interest on reserves, although this is a contributory factor. It is because nearly all money now is held in bank accounts and other forms of investment, and nearly all bank accounts and investments carry interest. Actually this has been the case for a long time, but the change in the last decade has been the ease with which people can move money around between accounts, funds and investments. As MacroResilience points out in his post, there is no reason for anyone to leave significant amounts of money in a non-interest bearing account. And I would add that there is no reason for anyone in the Western world to keep large amounts of physical cash, either. So for the first time in history virtually all money bears interest.

The fact that money is interest bearing, and money can be readily exchanged with other safe assets - especially government debt - means that investors have no preference for safe assets over money. Any real difference between yields on safe assets and interest rates on government-insured deposit accounts will be immediately arbitraged away, so it is reasonable to assume that they are now equivalent for any given maturity (deposit accounts are not time-bounded) and liquidity (time deposits don't have immediate access). This is the liquidity trap, and as originally envisaged by Keynes and described more recently by (among others) Paul Krugman, it is a "temporary affliction" in a distressed economy.

Both Keynes and Krugman describe the liquidity trap as coming into play when interest rates are so low that the usual preference for holding interest-bearing investments instead of non-interest bearing cash doesn't apply any more. So for them, the liquidity trap is a phenomenon associated with very low nominal interest rates - an abnormal situation by any standard. And we have had very low nominal rates for five years now, so it would be reasonable to assume that the liquidity trap we now find ourselves in is due to interest rates being near-zero, and that once we have restored the economy to sufficient health to allow interest rates to rise to historic norms, normal service will be resumed.

But that's not actually the current situation. We have interest-bearing money. Yes, interest rates on money are very low at the moment. And therefore - as I explained above - so are yields on the investments which are near-substitutes for money. But if interest rates were to rise, would this change?

I can't see any reason why it should. Because interest-bearing money is freely exchangeable with government debt - and indeed the shadow banking system constantly performs that intermediation - the equivalence between government debt and interest-bearing money would hold at any level of interest rates. We are indeed in a liquidity trap, but it's not because of economic distress and near-zero interest rates. It is because the nature of money has fundamentally changed. Money is no longer just "cash". Money is any financial asset that flows freely and is  readily exchangeable for currency.

MacroResilience then goes on to discuss whether targeting real interest rate stability rather than price stability would be a better framework for monetary policy. I don't propose to discuss that here, though I recommend reading his thoughts on this subject. What interests me is the effect of negative interest rates in an environment where government debt and money are near-perfect substitutes.

In this post, Izabella Kaminska noted that yields on US Treasuries are now entirely negative except for the 30-year. But that's where they seem to be stuck - a choke point. And there is also a choke point on interest-bearing commercial deposits, whose rates cannot fall very far below zero because non-interest bearing physical cash is an alternative. Perhaps the problem with the UST yield curve is that it has hit its equivalent of the choke point for negative deposit rates and cannot fall further because investors can switch into cash? In which case, if the Fed wishes to depress yields further the next stage will be to restrict cash issuance and impose negative interest rates on reserves.

But what would happen if the UST yield curve were entirely negative? To understand this we need to break with conventional macroeconomic thinking. Conventional thinking says "so what", more-or-less: it assumes that the shape of the curve would still remain the same even if all points were negative. I don't think so. As I've noted before, the negative interest rate world is a very strange place. It is a distorted mirror image of the normal world. I say distorted, because negative interest rates affect the relationship of the public and private sectors in a way that has serious implications for the ordering of society. I shall come back to this shortly. What is important at this point is the mirror image. When an entire yield curve is negative, I think it will invert. Yields on longer maturities will be lower than yields on shorter ones. This should make sense if you interpret negative yields as indicating that investors are primarily interested in safety rather than yield, and are prepared to pay for it. A 30-year Treasury is the safe asset equivalent of a 30-year fixed rate mortgage - its refinancing date is so far away you don't have to worry about it, so there is effectively no duration risk. It's gold-plated. It would be expensive. Of course, I may be wrong.....but I can't think of any good reason why investors who want yield would invest in government debt at negative yields. They would look for positive returns on higher-risk assets.

A fully negative yield curve would force deposit rates below zero. I've noted that the existence of cash as an alternative would make it difficult for banks actually to charge negative rates, so I would expect them to show up as fees and charges rather than interest rates. However, holding physical cash does have risk, as does holding physical cash substitutes such as gold. Investors may prefer to pay what amount to safe deposit charges. And if holdings of physical assets such as cash and gold were limited or even outlawed, then deposit rates could go deeply into negative territory. This is not as crazy as it sounds: in 1933 the US banned private holdings of gold. Admittedly that was to ensure a plentiful supply of gold to settle its international trade debts, but coercive techniques of this kind could well form part of the armoury of an increasingly desperate government trying to kick-start its economy and fast running out of ideas.

When yields and deposit rates are both negative we are, of course, in the realms of financial repression. But perhaps more importantly, we are also facing fundamental changes to financial institutions and their relationships. When interest rates are fully negative, the normal sequence of maturity transformation reverses. Lenders (depositors) have to pay to lend, so they won't want to lend for very long if at all, while borrowers are paid to borrow so are happy to take out very long-term loans. Borrowing long, lending short.....the normal flows of funds would be reversed.  And the effect on banks would be horrible. They would find it difficult to raise funds except from government insured deposits and the central bank, because everyone would be charged for lending to them, and they would be paying people and businesses to borrow from them. This is clearly not a viable model.  Private banking as we know it could not possibly continue. But there is something that can borrow long and lend short, and in fact does so at the moment. It is, of course, government.

By "government" in this case I mean both the fiscal authorities and the central bank. I regard the distinction between the two as entirely spurious when money and government debt are near-perfect substitutes and freely exchangeable. Fiscal authorities borrow long - very long, actually. Maturities of 30 years or more are common for government debt, and some debt is perpetual (the UK still has perpetual debt from the Napoleonic Wars). No private institution can borrow at these sorts of maturities, and negative rates pose little threat to the market for safe government debt: investors seeking safety will buy government debt even at deeply negative yields. Conversely, central banks lend short - very short, in fact, typically overnight although they also do term lending and short-term borrowing. So in the negative rate universe, the entity best able to provide banking services would be government.

This is once again consistent with the distorted looking-glass nature of the negative rate world. Things that are private become public: the private sector becomes dependent on the public sector. So banking - currently a private operation - would become a public function, or at least very dependent on public sector support. But we are already a long way down this road, actually. To what extent are banks that rely on central bank funding "private"? If a bank is so large and systemically important that it cannot be allowed to fail, so must be rescued by government if it gets into difficulties, is it really "private" - or is it actually a public utility? And if bank runs can only be prevented by government guaranteeing to reimburse depositors in the event of bank failure, how can insured deposit accounts be regarded as anything other than public liabilities?

Actually, we have been going down this path ever since money started to become interest-bearing and people had alternatives to bank deposit accounts for their savings. So although negative rates would precipitate a private banking crisis and force governments to take over borrowing and lending functions, all that really does is speed up the process. The fact is that the distinction between "private" and "public" has been getting increasingly blurred for a long time now. Every new piece of regulation and every intervention to improve the safety of banks increases their dependence on government, however much we might like to think it does not. The more reliant people and businesses are on banks, the greater the likelihood that government would have to intervene to resolve failures of major banks. Yet banks are becoming more and more fragile, as the nature of money expands to include financial assets that aren't under bank control and people take advantage of non-bank opportunities for saving and borrowing. And as we strip away the layers of mispriced and mis-sold products, rigged rates and crazy lending, what lies underneath - core banking - looks less and less like a viable business proposition.

Negative rates do indeed create weird distortions. But perhaps the end of private banking as we know it is not a distortion. Perhaps it is the inevitable consequence of the fundamental change in the nature of money.

Related links:
Macroresilience        On the folly of inflation targeting in a world of interest bearing money
FTAlphaville            The end of Ro-Ro, or is it
Coppola Comment  The strange world of negative interest rates
                               When governments become banks
                               The nature of money

I am indebted to scepticus on the FT Alphaville post for a most interesting and informative discussion, much of which has fed into the second half of this post. The discussion itself can be found by clicking the link above and scrolling down to the comments, though I do recommend reading Kaminska's post too. In the discussion, I am Cat in a Box.


  1. A "fundamental change in the nature of money"? Prey tell, what is the nature of money? Can you answer us that, please.

    1. I did give a very brief definition in the post. But if you look down to the links at the bottom, you will see a post called "The nature of money". I recommend you read it.

  2. You do realise that you're accepting the logic of Nazi economist Werner Daitz, don't you? Nice work!

    1. No I'm not. I've never heard of him. These are my own thoughts based upon the evidence that I see.

    2. Heh. I'm a trusting soul....but actually that might be about to change. I've had a few too many anonymous trolls recently. Oh, the price of fame!

  3. Frances, You say “Private banking as we know it could not possibly continue.” I don’t see the problem for banks.
    Re the idea that they would “find it difficult to raise funds”, I don’t agree, and for the simple reason that a negative interest rate scenario is a scenario where by definition people are prepared to hold money (in a bank or wherever) despite getting a negative rate of interest. Indeed, we are in that scenario right now in that people get a negative real rate on current accounts and some deposit accounts.
    You then say that banks “would be paying people and businesses to borrow from them..” Yes, of course. But banks would charge a higher real rate of interest (or less of a negative rate) to borrowers than to depositors. That way banks would still make a living.

    1. Umm. They would be paying borrowers to borrow, actually. So any return they were able to make would come from the spread between the charge on deposits and the interest paid TO borrowers. It's not going to be large, exactly, is it?

      The references throughout the post are to nominal rates, not real. I accept that there are people who will accept negative real returns even when cash and physical assets are an alternative. But I doubt if they would accept nominal rates that were significantly negative. People are far more sensitive to nominal rates than real ones. They would switch to cash and physical assets.

  4. I am confused. Don't you mix up nominal and real negative rates? Banks live in the nominal world. I think that any claims about the world which real economy lives have to be substantiated. Some parts of the real economy do live in the nominal world as well and some part live in the real. The balance is far from clear but I have to admit that I never spent much time thinking about this.

    1. No. I am talking about nominal rates. Real rates are already well below zero both for deposits and in many cases for loans too. My mortgage has been at 1.5% for the last 5 years, and for nearly all of that time that has been a negative real rate. The argument is whether NOMINAL rates should be below zero.

    2. I have re-read your post and remain confused (as a by-side note "interest-bearing" does not mean interest rate sensitive which I believe is an important distinction). Part of the reason for my confusion is your reference to the real yields of UST curve and only 30y point there being negative.

      But ignoring this and sticking to the nominal curve, why should the whole curve turn negative? It is equivalent to giving an unconditional commitment to keep short term negative nominal rates forever. And even in such case there is a) always a possibility that this commitment will be broken and short-term rates will be positive again and b) uncertainty about future *negative* nominal rates which is risk which demands *positive* term premium. So given these two factors and your assumption of inverted negative yield curve you need to have unconditional expectations of *progressively* negative forward interest rates.

      Or is the mechanics of negative interest rates so different that this requirement will not hold?

    3. And by the way there are only two alternatives to bank deposits: cash and bank bonds. Nothing else qualifies and saying that the interest bearing accounts or whatever other assets or shadow banking save the world is wrong. All money either stays in the banking system or leaves it. Shadow banking or whatever still needs bank accounts.

    4. There are two points here: 1) whether the nominal curve would turn negative 2) if it does, whether it would be inverted. I'd take the second first: if the real curve is inverted, surely the nominal one must be too? In which case all that is needed for the nominal curve to invert is the 30-year real yield to drop below zero.

      It would clearly be far more extreme for the entire nominal curve to turn negative. But then this whole post is about extremes, really. As was my previous post about negative interest rates, which considered the effect of a negative policy rate - that would be pretty extreme monetary policy, yes? However, if nominal rates on insured deposits dropped below zero, then I'd expect the nominal yield curve to follow suit, at least at the short end. The driver for this would, as I suggested in the post, be negative interest on excess reserves and repression of cash - possibly coupled with restrictions on holdings of gold and silver, too. All of this is pretty extreme stuff.

      The problem with the long end of the yield curve is that in an interest rate environment as abnormal as this, investors would have no basis on which to form expectations of future interest rates. So the curve might just flatten, rather than invert. Or it might not invert at all if investors' inability to predict the future course of interest rates led them to prefer shorter maturities. Or we could get all manner of weirdness, depending on what signals the central banks gave regarding the likely course of interest rate policy and other measures. It's a very distorted mirror!

    5. Where have I said anything about shadow banking "saving the world"? All I said (on FTAV) was that there would be likely to be unregulated, unsupported institutions offering positive rates on deposits and making risk loans to generate that positive return. Of course those institutions would need bank accounts. Far from "saving the world", that would make them dangerous. Shadow banking always poses a risk to the supported banking sector because it depends on it for payments and liquidity.

    6. "if the real curve is inverted..."

      I am failing to grasp this and what follows. What is the real yield curve? Real yields are always ex-post. All fancy stuff like inflation expectations & co are just dreamed up concepts to keep some central bank and private sector economists employed.

      I am kind of ok with the rest though I clearly stick to the logic of central bank rate -> deposit rate rather than the reverse. The spread can be driven by many factors but the causality is always as above.

      And I also doubt that a government subsidized basis of expectation is a required condition to have expectations. In the worst case the term premium might increase but it does not mean that the private sector alone is incapable to establish collective expectations.

    7. ok, pls forgive me the "saving the world stuff" :)

      But my point still holds. The interest bearing deposits are the result of the increased *bank* competition, which increases the rate and severity of mistakes, which leads to counteractions like deposits guarantees etc. Shadow banking and other assets have nothing to do with it. Finally government issues bonds not for fun but to spend it back into the banking system. So all this interest bearing stuff is in a sense a collective stupidity of banks. Prisoners dilemma if you wish. We are stuck with banks no matter what they do to us. And this is a crucial differentiating feature of the banking sector compared to any other sector in the economy.

    8. Now I'm puzzled. Are you saying the real yield curve can't invert? I suppose the substitutability of interest-bearing money and gilts would prevent inversion, really. The term structure of interest rates on insured deposit accounts wouldn't reverse (rates on longer-term deposits would be less negative than on short-term ones), so I suppose that would imply that the yield curve couldn't invert either - in which case I am indeed wrong.... Or are you saying that an inverted real yield curve wouldn't influence nominal interest rates? If so I don't rates on new debt are determined by reference to market yields at the time of issue, after all.

      Re policy rates. Are you suggesting that the central bank rate would be higher than interest on excess reserves, as it is now? If so I disagree. In a negative rate world the policy rate must be lower than the deposit rate. You do want banks to lend, after all - so you want to pay them more for borrowing than you charge them for depositing. The direction of causality must therefore reverse. And similarly, in a negative rate world, the interest rates on commercial bank deposit accounts must be lower than interest on excess reserves. Banks must charge more for deposits than they pay for depositing them at the central bank - oh and since gilts would be a substitute for cash holdings at the central bank, rates on deposits must also be lower than gilt yields. Otherwise banks won't want commercial deposits. It's really hard to get your head round this rate inversion lark, isn't it!

      It's only possible to keep rates negative by means of constant government intervention - which is why I say that for a negative rate world to remain for any length of time implies complete state control of banking (apart from the shadow banking I mentioned above). Therefore the expected behaviour of central banks and government would be the only basis for predicting rates. The private sector would form a view as to when, or if, government intervention to hold down rates would end.

    9. Inversion is fine. I am saying that there is no such thing as real yield curve. Real yields can be calculated *ex post* but this is far away from saying that there is an ex ante thing called real yield curve.

      I do think that an inverted negative nominal yield curve does imply and require the assumptions I stated above. Progressively negative rates are clearly unsustainable from any practical economic perspective but we can still entertain such theoretical scenario.

      The central bank rate is typically higher than the rate paid on excess reserves. This is the basis of monetary policy in the corridor regime which was and still is the dominant regime in all developed countries.

      But we should not mix central bank operations and commercial bank operations. Central banks lend own liabilities and also choose to pay on them. This spread was and still is the major income source for, say, ECB. In countries with OMO central banks do not lend but forcefully inject reserves. The result is however the same.

      Commercial banks, on the other hand, live in a more complicated world. They compete for liabilities and can chose to pay and charge whatever they want. I.e. they can subsidize tenors / asset classes / liability types / whatever if they think it can bring them competitive advantage. This is where the prisoners dilemma can start or stop. If other banks follow then they all end up in the worst-worst solution. If other banks are half smart then we can hope for worst-smart solution (balance sheets have to balance regardless of competition; but this is altogether a different topic).

      But above all the choice of excess reserves is the choice of the central bank. For this reason alone we can ignore excess reserves altogether. Finally, if the rate on excess reserves/deposit facility is higher than the base rate, then this rate effectively becomes the base rate. I.e. interbank market will start working off the deposit facility rate. Which is actually also the case today but for reasons of over-liquidity.

      Nevertheless and surely banks will generally pay/charge clients less/more than they can get from central bank/interbank/government. This spread is justified simply because non-banks clearly do not have access to interbank/central bank.

      btw, one more reason why negative rates are not sustainable and yield curve cannot invert (persistently) is that negative rates would result in asset bubbles which would via wealth effects sooner or later spill over into consumer price inflation.

      And yes, this negative stuff is really tough to wrap one's head around. I definitely want to thank you for sticking your neck out and giving this and previous very stimulating discussion some scary life.

    10. I'm not suggesting that banks would disappear. I am saying that the inevitable end of the current policy path is a fully state supported banking system. That applies whether or not completely negative rates ever became reality. We are already halfway there. But state support doesn't equate to state control. I think that we will end up with things called banks that are supposedly private but in fact totally dependent on state support - even more so than at present. (I've said this on previous posts.) And that means there will be more opportunities to game the system, not less.

    11. ....and thank you too for sticking with it and challenging me. A really interesting and informative discussion.

    12. actually, thinking about it....yes, the deposit rate would become the policy rate in a negative rate world. Reserves would be a hot potato, with every bank trying to get rid of them (put rather than call) the interbank market would price off the depo rate not the lending rate. Interesting - especially as that is already happening.

      I agree with you about the unsustainability of negative rates and the likelihood of asset bubbles and rebound inflation. It's such an abnormal structure, it's certain to blow up.

    13. "And that means there will be more opportunities to game the system, not less"

      Ok, offtopic, but is it really so negative? Assuming we manage to more or less ban all outrageous ways to game the system and leave only the "eligible" ones, is it really so bad? I personally would define the function of banks exactly "to game the system" where the government defines the rules and banks try to find the most efficient way to "game" them for private profit. Our collective problem is rather with the rules and not with the banks.

      Lets take for instance those famous LCR/NSFR rules. The government effectively wants to define a preferred structure of banks' balance sheets. I interpret this structure as a "strategic" goal of the government for the structure of economy (i.e. that many mortgages and that many retail deposits within the bigger picture of the financial sector). And we leave it to the banking system to find the most efficient way to "fit" into this strategic goal of the government.

      We can surely define some arbitrary (and honestly quite meaningless) goals as LCR/NSFR but this just highlights the shortsightedness of BCBS and national regulators/lawmakers. No big news here. And looking into the past and Basel 2 risk weights for mortgages what could we have expected? In reality and if we are honest to ourselves banks did an excellent job and deserve a bonus! :)

      However following this line of reasoning the government does use its banking system to implement its (government) macroeconomic objectives hoping that the financial structure will impact the structure of the real economy which is a reasonable safe assumption. So fine for me. Actually in my opinion it is very very good. Because the government gets a (hopefully) very efficient tool to implement its own strategic decisions. Which it subsidizes with regulation.

      The only thing which is open is setting proper public goals. Unfortunately here we have big issues. Which is no big surprise given our history of the last 20-30-40 years.

    14. Interesting. All of which supports the argument that banks are not really separate from government - they are agents of the state.

    15. Banks are agents of their customers, creditors and shareholders. Let's name this constellation of interests "wider society".

      Government are agents of the voting public. AKA "wider society".

      Not so surprising government and banks seem to so often be pulling in the same direction. The surprise is wider society so often complaining about the actions of both government and banks.

  5. I don't think banks would go away. In fact, thinking about it, banks originally appeared in an environment where people were quite willing to pay for the privilege of somebody holding their cash, as long as they could provide convincing assurances that their cash would be safe with them.

    The business of banks is matching savers and borrowers. In the current world, savers get paid for being savers and borrowers lose money for being borrowers. In the negative interest rate world, savers lose money for being savers and borrowers get paid for being borrowers. You can still do the matching and get all the accounts to add up, and make a profit from the difference. However, I'd expect the profile of your average saver and average borrower to change significantly.

    Nowadays, the alternative for a common person to borrow from a bank is to borrow from family and friends. Family and friends are often willing to lend at zero or low interest rates. And if you don't have family or friends willing or able to lend you at zero or low interest rates, you go to a bank. We tend to avoid borrowing from a bank until we need so much money it's unrealistic to hope we can get it from family and friends, but we are quite happy to save even small quantities of money in a bank. We live in a world where there are a lot of potential alternatives to borrow from a bank, but little or no interest-bearing alternatives to save in a bank, unless you have considerable financial knowledge.

    In the negative interest world, there is a simple alternative to save at a zero interest rate: hoard cash, or cash substitutes such as gold. However, the bigger the amount, the bigger the risk to hoarding it yourself. In the negative interest rate world, people would quite commonly hoard some cash at home, but they would put it in a bank when the hoard gets too big. And people would be happy to borrow even small amounts. (Of course, that doesn't necessarily mean that the bank would be happy to lend them.)

    Funding shouldn't be a problem for banks: they'd get plenty of funding from savers desperate to put their cash somewhere safe. Of course, this means that people are desperate to put their cash somewhere safe, which is implied by the fact that there are negative interest rates. Make no mistake: a negative interest world is, by definition, a very risky place. It implies that hoarding cash is risky and interest-bearing investments are usually very risky. It implies that you expect your average enterprise to lose some money in the long run, that's why borrowers are paid. It implies a steadily contracting economy rather than a steadily growing one. The negative interest world is possible in principle, but very ugly.

    1. I agree mostly - and certainly with your final paragraph. That last line sums it up neatly.

      My only issue really is that I think the problems for banks are more serious than you realise. Banks have for some time now been losing out to non-bank savings in the competition for deposits, especially the various types of mutual fund. At the moment that shortfall can be covered by recycling the savings deposited in funds back into the commercial banking system via the interbank market. But if banks became dependent on deposits for their income, they would have to compete far more successfully with funds than they do at present. This is a considerable problem, because banks are intrinsically no safer than funds and have bigger overheads. An insured deposit is only safe because governments insure it: but if a pension fund invests savings in government debt, that investment is every bit as safe as an insured deposit, and if a wealth fund lends out money against government debt as collateral, that investment is also (in theory at any rate) safe. Banks can theoretically offer better access to savings than funds, but this exposes them to risk of bank runs. It would be a very difficult marketplace.

      The other problem would be that banks wouldn't want to lend. They would buy government debt and hoard cash instead. Savers would be wonderfully protected - arguably there would be no need for deposit insurance - but we would see the biggest credit crunch ever unless government started paying banks to lend (we are beginning to see that already with the UK's Funding for Lending scheme).

      So banks could only operate with full state support for both deposit-taking and lending. In which case they would be public entities, really. They might still be called "banks" and masquerade as private sector organisations, but in reality they would be agents of the state. And we are already a very long way down the road towards that. That was the point I was making.

    2. You're right that the nature of money has fundamentally changed in recent decades (since '71).

      "It is because nearly all money now is held in bank accounts and other forms of investment".

      Once upon a time, it used to be the case that there was "money", and there was "investments" (including risking your money in a bank, in return for a piece of the bank's profit from it's lending). You gave your money to the bank, you got a slice of the action, and (hopefully!) you could later get your money back from the bank. If the bank took too much risk and got into trouble, not everyone would get their money back and the bank would be history. And for your risk of potential loss, you received a commensurate yield to keep you interested.

      Today, however, there is (at least outside of the Eurozone) effectively no risk the bank will be unable to return ones money. Because all losses will be socialised, ensuring no depositors ever lose [nominally]. Hence the yields available.

      A credit balance in a bank account (a loan to a bank - an investment) is not the same as notes in a shoebox (your own personal share of the monetary base - money). Notes in a shoebox have zero yield because they have zero [nominal] risk. Balances in credit to the banks have a non-zero yield not because there is any risk your units may not be returned to you some day, but because there is a distinct risk that the monetary base will have to be expanded (debased) in order to achieve it - bank depositors (creditors) are receiving a reward from society for deferring monetary base expansion (debasement) via investing in a bank credit investment rather than demanding their slice of the base money supply already. Their deposited base money units circulate among society, and they retain fungible claim credits in the system, which also circulate at parity to the base money units.

      The value of the units of currency comprising ones bank credit balance are 1:1 fungible with units of the monetary base, to the extent that society has confidence your banker is able to meet all his obligations (on behalf of his customers) to: other bankers, the Treasury, and those demanding notes to put in their shoeboxes. As previously noted, there is today zero risk that he will be unable to meet these obligations (perhaps given a little time), because the Central Bank will absolutely ensure there is sufficient base money available to him, by hook or by crook, since none of the bankers' counterparties (i.e.: society at large) are willing to accept his default. As the monetary base is expanded, to ensure all of the bankers can meet their obligations, and therefore by extension all creditors of the bank to meet theirs, the real exchange value of each unit of the monetary base is diluted (and along with it, the fungible units of bank credit that use the monetary base as a reference for their own exchange value, which as previously noted circulate at parity with the base money units so long as there is full confidence in the issuing bank's ability to perform at midnight when all imbalances are cleared among the banks).

      [Since you mentioned gold as an alternative to cash...] Which is why many people buy gold bullion for their shoeboxes, rather than keep wads of notes in there. The stock of gold bullion is expanding at a much slower pace than the monetary base, so (not to say this makes them correct, because it doesn't - politics and financial speculators have much more to do with the gold story than retail bullion investors) they assume this means gold must naturally go up in value relative to currency (and are constantly surprised when it doesn't - none moreso than the long-only speculators who are riding the short-bus to the wrong destination).


    3. However, the main thrust of your post, negative rates across the spectrum, is indeed far more exciting to ponder. Some of us have been watching US T-bill yields with great interest (pun intended! ;) ) for some time, because this is the foundation off which all other credit markets take their cues and this market seems to want to turn negative even nominally and even in the face of Operation Twist (until the Fed recently all but ran out of short term T-bills and had to terminate the program - Section 8, Assets table, Row 7).

      It would appear there is still much to be said for nominal safety in the very short term, if not so much for the longer terms.

      Negative nominal short term rates would not suggest a great deal of faith in the future.

      A widespread acceptance of negative nominal returns would appear to imply deflation.

      We definitely live in interesting times!

    4. "The business of banks is matching savers and borrowers."

      Business of banks is NOT in matching savers and borrowers. Business of banks is in lending. The matching "function" is a by-product of double accounting.

  6. The UK does not "pay back" debt. Debt falling due is refinanced, not repaid.

    Debt service (interest) for the last year for which we have real figures (2011) was actually slightly less than defence spending - £44.6bn versus defence £45.7bn. Both are dwarfed by the three big spending items, namely health, welfare and pensions.

  7. Rehypothication has made the City extremely vulnerable, and nobody wants this. It is actually very much against the desire of the US for London to go under. You could learn so much.

    Don't waste your time reading one unless you plan to read the other

  8. Do not make the mistake of believing your own statistics. Use Shadowstats

  9. Hi Frances, love your blog
    Can I just point out that Kalecki wrote in 1943 this

    The rate of interest or income tax [might be] reduced in a slump but not
    increased in the subsequent boom. In this case the boom will last
    longer, but it must end in a new slump: one reduction in the rate of
    interest or income tax does not, of course, eliminate the forces which
    cause cyclical fluctuations in a capitalist economy. In the new slump it
    will be necessary to reduce the rate of interest or income tax again
    and so on. Thus in the not too remote future, the rate of interest would
    have to be negative and income tax would have to be replaced by an
    income subsidy. The same would arise if it were attempted to maintain
    full employment by stimulating private investment: the rate of interest
    and income tax would have to be reduced continuously."

    1. Andy - thanks. Excellent quote. Very perceptive of Kalecki.

  10. Frances, I don't understand this post. But I'll comment anyway in the hope of learning something.

    First, I don't see why the equivalence of government-guaranteed bank accounts and government bonds is a problem. The government is not finding it difficult to borrow money, as the yield curve shows. And if it does become difficult, the government is free to restrict its guarantees.

    Second, banks are not going to lend at negative interest rates. They will continue to charge substantial credit and administrative spreads to corporate and retail borrowers. I can't see why being able to attract deposits at very low rates should be a problem for them.

    Third, I believe the difficulties of the financial system are extrinsic. It can't work properly in the face of large and persistent trade deficits.

    btw, when you wrote that a negative yield curve would invert, I had to read on to find out what you meant. Is it natural (i.e. not inverted) for the 10-year rate to be, say, twice the 2-year rate, of for it to be, say, two points higher than the 2-year rate? I think the former.

    btw2, I think consols were created in the mid-18th century (consolidating existing government debt), decades before the Napoleonic Wars.

    1. Hi Paul.

      1) The problem is more political than anything. For financial markets government debt is simply another form of money, because the interest-bearing nature of cash means that there is no practical difference between one form of government-backed investment and another. I don't personally think that's a problem, though it does fundamentally change the nature and purpose of government debt. But governments (and, depressingly, a good many economists) don't understand that change, and so are intent on reducing their deficits and (longer-term) their debt, despite the fact that economies are stalling for lack of investment and financial markets are crying out for safe assets. I don't regard government debt levels as the major issue affecting the world economy and I really, really want governments to deal with the real problems and stop worrying about debt. High debt levels are a risk for future inflation, but then so is any form of excess liquidity.

      2) Ummm. Yes, I agree that banks are not going to lend to new borrowers at negative interest rates. So actually there would be a zero lower bound constraint on nominal lending rates if the policy rate turned negative. However, this piece is about extremes - it's a "thought piece" rather than a discussion of reality, though negative nominal deposit rates do seem to be on the horizon. And one thing that became very clear in the discussion above is that negative rates are a political phenomenon - they could not possibly exist by themselves for any length of time. Hence my conclusion that negative rates imply state control of banking.

      If political pressure were put on banks to follow the direction of policy rates into negative territory, banks would stop new lending. As I said in another comment further up this thread, we would have the mother of all credit crunches. Indeed the very low policy rates of the last few years may be a cause of the failure of bank lending - and certainly widening spreads. Banks have been raising lending margins to keep real rates positive. Ten years ago a typical UK mortgage was base + 1-2% - but now that is a negative real rate, so the margin would probably be more like 3-4%. That has huge future cost implications for people taking out new mortgages. At some point government will wake up to this and place pressure on banks to reduce margins.

      Having said all that....we have a large number of existing loans tied to policy rates. If the policy rate turned significantly negative, banks would be forced to maintain loans to those borrowers at negative nominal rates.

      3) I'm not convinced by the trade deficit argument. Trade deficits are at least partly caused by the workings of the financial system - especially the global use of the US dollar for trade finance, which forces the US to run substantial trade deficits because the worldwide demand for dollars far exceeds the production capacity of the US. This is the Triffin dilemma, and it also applies to those countries whose debt is globally accepted as a safe asset, because debt must be bought in the currency of its denomination.

      4) Yield curve inversion: your first example is a normal (if steep) curve, your second is a flat curve. Inversion is where longer maturities have lower interest rates than shorter ones, so the curve slopes downwards.

      5) You may well be right. The point is they are not redeemable, so they really shouldn't be regarded as debt in any normal sense of the word. They are equity - as is cash. Perpetual debt issuance is a form of monetary financing.

  11. I don't regard government debt levels as the major issue affecting the world economy and I really, really want governments to deal with the real problems and stop worrying about debt.

    What makes you think governments can deal with real problems? Overwhelmingly, people's needs are met not by government but by private companies.

  12. [...] Unfortunately my earlier post was remiss in recognizing contributions by Ashwin Parameswaran and Frances Coppola even prior to the outburst. [...]

  13. Is there any further reading you would recommend on this?

    bank deposit boxes


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