A revolution has come to Europe–the revolution of negative interest rates. 10-year Swiss government bonds now have a negative yield. Short-term funds kept at the Swiss National Bank now pay -.75%: that is, private banks have to pay .75% per year to the Swiss National Bank to tend their Swiss francs. Denmark now pays -.75% for short-term funds while Sweden is at -.25% and the Eurozone is at -.2%. How low can interest rates go?
Ben Bernanke has started a blog, now that (in his words) he is free from “being put under the microscope by Fed watchers.” In the first few posts, he got into a debate with Larry Summers about what it means that interest rates are so low. Paul Krugman joined in with his own post “Liquidity Traps, Local and Global.” These three—a former Fed Chairman, a brilliant former Treasury Secretary, and a prolific Nobel laureate New York Times columnist, and without question three of the most famous economists in the world—are unanimous in writing that interest rates cannot go much lower than where Europe is now. Ben Bernanke writes:
The Fed cannot reduce market (nominal) interest rates below zero, and consequently—assuming it maintains its current 2% target for inflation—cannot reduce real interest rates (the market interest rate less inflation) below -2%. (I’ll ignore here the possibility that monetary tools like quantitative easing or slightly negative official interest rates might allow the Fed to get the real rate a bit below -2%.)
Larry Summers similarly writes as if there were some law of nature preventing interest rates from falling very far below zero: “The most obvious answer is that short term interest rates can’t fall below zero (or some bound close to zero) and this inhibits full adjustment.” And Paul Krugman stipulates the same presumption in technical jargon, speaking of a “liquidity trap” and a “zero lower bound.”
Every one of them knows better.
Interest rates can go as low as needed
What prevents interest rates from falling much below zero is not an immutable law of nature but an artifact of the way we handle paper currency. If we change our paper currency policy, interest rates can go as low as needed to bring economic recovery after an adverse shock throws the economy into a serious recession. Under our current paper currency policy, paper currency earns an interest rate of zero. As long as that is the case, it is hard to get any lender to accept an interest rate much below zero. But having paper currency earn an interest rate of zero is a policy choice, not a law of nature. As long as the paper currency interest rate is lowered along with other interest rates, the only limit to how low interest rates can go is the economic expansion that low interest rates would stimulate—an expansion that would then raise interest rates by increasing the demand for loans.
The reason that Ben Bernanke, Larry Summers and Paul Krugman talk as if the paper currency policy is immutable is that economists have known for over a century how to make interest rates on paper currency and because no nation has yet implemented negative interest rates on paper currency. Thus, many economists have become discouraged, thinking that the policy will never be broken. Ben Bernanke, Larry Summer and Paul Krugman all have written at length about the damage that this zero lower bound on paper currency can cause—most recently in making recovery from the Great Recession such an agonizingly slow process. But they have given up too easily in accepting zero as a limit.
Other economists, now notably including Harvard economist Kenneth Rogoff (who has become famous in part for his now controversial work with Carmen Reinhart on the effects of national debt on growth) see an eventual victory over the zero lower bound when paper currency is entirely supplanted by credit cards, debit cards and other forms of electronic transactions.
What many don’t realize is that a plan due to Willem Buiter, Chief Economist of Citigroup (and foreshadowed by Robert Eisler in 1932) to generate negative interest rates on paper currency can be implemented in a matter of weeks rather than decades. Miles, on his blog and in presentations to central banks around the world, has explained the nuts and bolts of how to implement this plan. The key is to charge private banks a paper currency deposit fee when they bring paper currency to the cash window of the central bank (returning that fee at the current going rate when a bank takes paper currency back out). The fee needs to gradually increase during the time when interest rates are negative, but can gradually shrink back to zero when interest rates are positive again. During the period the fee is gradually increasing, this effectively gives a negative interest rate on paper currency to any bank or other financial firm that withdraws paper currency, stores it and then redeposits that cash.
Among the economists who take a paper currency deposit fee seriously as a way to break through the zero lower bound are many in central banks around the world. Of the many indications of this, one that we have permission to talk about publicly is that the Bank of England, which was the first to host Miles for a seminar on “Breaking Through the Zero Lower Bound” in May 2013, has invited him back to give a keynote speech on that topic to the Chief Economists’ Workshop on the future of money, on May 19.
Another important mark of how seriously economists are taking this possibility of a change in the current paper currency policy are the arguments by University of Chicago Finance Professor John Cochrane that a change in paper currency policy alone is not enough to allow deep negative interest rates, in his blog post “Cancel currency?” (followed up by “More Cash and Zero Bound.”)
Cochrane was inspired to blog on this topic by Rogoff’s discussion of the possibility of eliminating paper currency entirely. His discussion of the disadvantages of eliminating paper currency entirely is only directly relevant to that extreme proposal, but much of what he says about our current paper currency policy is also relevant to the policy of generating a negative interest rate on paper currency through a paper currency deposit fee that gradually changes over time.
Cochrane gives this list of ways to effectively earn an interest rate of zero even if paper currency, along with money in the bank is earning a negative interest rate. His examples are:
Prepay taxes. The IRS allows you to pay as much as you want now, against future taxes.
Gift cards. At a negative 10% rate, I can invest in about $10,000 of Peets’ coffee cards alone. There is now apparently a hot secondary market in gift cards, so large values and resale could take off.
Likewise, stored value cards, subway cards, stamps. Subway cards are anonymous so you could resell them.
Prepay bills. Send $10,000 to the gas company, electric company, phone company.
Prepay rent or mortgage payments.
Businesses: prepay suppliers and leases. Prepay wages, or at least pre-fund benefits that workers must stay employed to earn.
It’s not easy to get a guaranteed zero interest rate
Of this list, we take the first—prepaying taxes—very seriously; more on that below. But for all the rest, the counterargument to Cochrane is simple: although private firms are happy to offer a zero interest rate while interest rates in general are higher than zero, they would stop giving that kind of deal if interest rates in general were negative. They would have to carry the freight of the negative interest rate every time they let a customer put in a given dollar value of money now, to get back the same dollar value later. If they did give someone a zero interest rate when interest rates in general were negative, we predict it would typically be some sort of promotion to get people to do something else that added to the businesses’ bottom line. People who had already purchased gift cards, or had a contract that implicitly specified a zero interest rate before the business knew interest rates would turn negative would benefit from those favorable preexisting arrangements, but the businesses wouldn’t give them that deal again.
JP Koning is one of the best bloggers out there on the nature and workings of money. In his post “Does the Zero Lower Bound Exist Thanks to the Government’s Paper Currency Monopoly?” he argues along these lines, in effect, that the zero lower bound is a creation of government, because no other organization but government has both the deep pockets and the willingness to run a loss. JP also chimes in in the comment section of Cochrane’s post explaining why gold doesn’t provide a way to escape negative interest rates, and pointing out that business customs can adapt to new situations. He writes:
No, gold won’t allow a zero riskless nominal return. The moment negative rates are put into place the price of gold will spike to level at which it would be expected to decline at a rate equal to the negative interest rate. You’re still penalized.
I’m also underwhelmed by your claim that our legal and financial system deeply enshrines the right to pay early. It also enshrines the right for contracts to require people to pay penalties for early payment. Take for instance prepayment penalties on mortgages or auto loans. A ‘legal revolution’ as you refer to it isn’t required… the laws already exist.
What JP Koning says about gold is true for any asset that can change in price according to market pressures. The only reason that paper currency as it is handled now creates a zero lower bound floor under interest rates is because central banks currently guarantee that a paper dollar will stay at par relative to dollars in the bank. Take away or modify that guarantee through a paper currency deposit fee that changes over time, and interest rates can go as low as needed.
In general, the place to look for things that could put an effective floor under interest rates is the same place one would look for something that could put an effective floor under, say, milk prices: some kind of government guarantee. In Japan, for example, the post office acts as a bank, and a zero interest rate on funds in this government-run bank could act as a floor under interest rates.
The question that Cochrane raises is whether a tax authority like the IRS can be used if it were a government bank offering a zero interest rate on deposits.
The IRS is not a bank
In confronting the question of whether to IRS in particular can be used as if it were a government bank offering a zero interest rate, it helps to be a US tax lawyer used to dealing with complex tax questions, as Chris is. There are two key points:
- The tax code actually has several interest rates, including an overpayment rate, an underpayment rate, and zero. The non-zero rates are a function of Federal short-term borrowing rates and while it has never happened, there is no obvious reason that they could not be negative.
- The IRS is not a bank with in-and-out privileges. Paying taxes is easy. Getting money back is possible but complicated and uncertain as to time and interest rate.
Underpayment and overpayment rates are defined as the “Federal short-term rate” rounded plus an adjustment (3 percentage points in general, but more or less in specific circumstances, including 0.5 percentage point for large corporate overpayments and 5 percentage points for large corporate underpayments). The Federal short-term rate is determined month by month, and is defined by statute as:
[T]he rate determined by the Secretary based on the average market yield (during any 1-month period selected by the Secretary and ending in the calendar month in which the determination is made) on outstanding marketable obligations of the United States with remaining periods to maturity of 3 years or less.
Translated, this says that if the 3-month Treasury bill rate were negative, the Secretary of the Treasury could declare a negative Federal short-term rate. While an effective zero interest rate would apply to prepayments of taxes, overpayments of taxes could be returned after application of the overpayment rate—which could be negative. Alternatively, an overpayment might be characterized as a deposit. When a deposit is returned, it can be returned dollar for dollar, or with interest, depending on the circumstances. Although it is hard to predict what the IRS would do, in a negative interest rate environment it would be reasonable to expect the IRS to apply a negative interest rate to deposits related to disputed taxes, and to return other amounts quickly, effectively rejecting any deposit not related to a dispute.
In a negative interest rate environment, a taxpayer might want a zero interest rate through a dollar-for-dollar refund or return. The problem is that a taxpayer cannot confidently control how a prepayment or deposit is characterized, and cannot confidently control the timing of a refund or return. To the extent of an actual tax liability, or an actively disputed tax liability, and arguably even a near-term predictable tax liability, money sent to the IRS that is ultimately returned will probably be returned subject to the (possibly negative) overpayment rate. On the other hand, amounts in excess of tax liability (current, disputed, near-term predictable) don’t have an obvious category.
In a positive interest rate environment, taxpayers and the IRS may treat such amounts as zero-rated deposits (and so taxpayers generally are disinclined to make them). In a negative interest rate environment the IRS may simply reject such amounts as not having anything to do with taxes (and so taxpayers generally should be disinclined to make them).
The IRS also largely controls the timing of when a taxpayer gets the money from an overpayment or a deposit. The IRS could decide to return funds immediately upon request, or to return funds significantly later, and could make that decision differently depending on the applicable interest rate. In all this uncertainty, if the IRS takes a position that the taxpayer doesn’t like, e.g., that a negative rate applies, or that the remittance is rejected, or that a deposit will be returned immediately or will be delayed, there may be arguments in some particular cases that the IRS is wrong. However, that probably gets sorted out in court, in a case that could take years to resolve. If the negative interest rate situation only lasts a year or two, even a taxpayer victorious in court (something far from guaranteed) might not get the money back at a zero interest rate until interest rates had been positive again for long enough that a zero interest rate still wouldn’t be as good as what the taxpayer could have earned in the bank.
In short, the IRS is not bank. There are circumstances where money comes back from the IRS, but the effective interest rate might be positive or negative or zero, the taxpayer cannot strictly control or predict the interest rate, and the taxpayer cannot strictly control the timing of refund or repayment. The IRS would be a formidable adversary to someone trying to force it to be a bank when it didn’t want to be. This amount of uncertainty makes it very difficult to arbitrage interest rates against the government through the IRS.
The one concession that is clearly available in the tax law is that prepayment of taxes does have the effect of a zero interest rate. Formally, this may be as much as a one-year opportunity, but after taking account of payroll withholding and estimated tax payment requirements, the most a typical taxpayer could shift the timing of tax payments is only a quarter or two. Because that option is limited in quantity, and not available for unlimited arbitrage, it cannot put a floor under market interest rates. What it does do is provide a welcome shield against negative interest rates up to a reasonable amount of savings for people who are willing to save by paying their taxes early in the year.
We view this as a positive thing for the politics of negative interest rates; the option of prepaying taxes can help protect the diligent small-time savers who would be distressed by negative interest rates. Earlier payment of taxes in a recession combatted by negative interest rates would also partially smooth out the usual effect recessions have of temporarily worsening the government budget deficit.
As for long-term savers, they can always guard against the possibility of negative interest rates by buying long-term bonds that lock-in interest rates at current market levels, which at worst are currently only a little negative. And the monetary stimulus of negative interest rates is likely to soon bring even short-term interest rates back up once an economy is fully back on its feet.
Where do we go from here?
Right now, Europe is leading the charge toward lower interest rates. With the knowledge of how to prevent paper currency from putting a floor under interest rates in hand, there is no limit to how low their interest rates can go other than the self-limiting effect of low interest rates in spurring economic growth.
What about the US? Currently, the talk is all about when the Fed will raise interest rates above zero, not when it will go negative. But one thing could change that: the effect of Europe’s negative interest rates on value of the US dollar. The dollar has been appreciating in the last few months, as low interest rates in Europe encourage investors to send their funds to the US. The higher dollar is seen as one of the key things that slowed down the US economy in the first three months of this year by making it more expensive for people in other countries to buy US goods. If Europe pushes its interest rates further down, the Fed may need to do more than just delay when it raises interest rates—it may need to cut rates below zero to keep the US economy on an even keel.
Even if interest rates at the bank become negative, regular taxpayers may be able to keep a portion of their money from shrinking by prepaying fixed obligations, including taxes. But that won’t keep negative interest rates from prevailing in the economy generally, so long as the Fed changes its paper currency policy so that an effective negative interest rate on paper currency opens the way for the Fed to lower other rates (especially its target rate and the interest rate it pays banks).
The fact that the tax system does not allow unlimited interest-rate arbitrage to block negative interest rates across the board is a good thing: low and even negative interest rates and the stimulus they provide are one of the best defenses the US has against falling back into recession when we have so recently escaped the after-effects of the last recession.