We are nowhere near the zero bound

Guest contributor – Eric Lonergan (Fund manager on M&G’s macro hedge-funds and multi-asset team, and author of “Money”)

We need more cash, not less.

Many economists just assume that central banks have hit “the zero bound” on interest rates and that conventional policy is thereby exhausted. Take Ken Rogoff’s bizarre proposal as an example:

“The idea of finding creative ways to get around the zero bound on interest rates has been championed for more than a decade by Willem Buiter, a former UK Monetary Policy Committee member. Phasing out paper currency is by far the simplest.”

Let’s forget about the idea of phasing out paper currency. What’s really odd is the assumption that we have hit a “zero bound” on interest rates. This has troubled me for some time. In economic theory and discussion we often just assume there is a single interest rate. The classic Solow growth models collapse all interest rates of all maturities and risk characteristics into a single r, the cost of capital and the return on savings.

Now economists often seem to slip into assuming that in the real world we have “zero interest rates” because the official overnight interest rate is close to zero. Bob Lucas alludes to this. One thing I like about Lucas is he sometimes states obvious things that everyone seems to be ignoring which are highly relevant. I was listening to this brilliantly clear lecture by Lucas where (at 9:20) he points out that no one in the real economy is borrowing at zero. In fact, in many cases, as the fed funds rate has fallen further, spreads have widened.

Eyeballing Lucas’s data, it looks out-of-date to me. Spreads on many forms of credit have compressed further, although his basic observation is correct: no one is borrowing at zero. He also omits one of the most important “interest” rates, the equity cost of capital. This is a repeatedly omitted factor in economic discussion for no good reason – perhaps because it is not directly observable. When firms weigh up investment decisions the cost of equity is central. Forget about a zero bound on the cost of capital, the real earnings yield on global equities is closer to 6%, or a nominal 8%.

How can we further reduce interest rates? Let’s start by defining the “true zero bound” (TZB). Sticking to the United States, the easiest official interest rate to understand is the discount rate. This is the rate of interest at which deposit-taking institutions (banks) can borrow from the Federal Reserve. Typically these are overnight loans, and the borrowing bank has to provide collateral. Currently the US discount rate is 75bps.

Ok, so currently banks can borrow, against collateral, overnight, at 75bps. That looks nothing like a zero bound to me. I have italicized each of the areas where policy can be eased. If we want to reduce interest rates there are four obvious areas to do it. Lend to non-banks, extend the maturity, relax collateral requirements, and reduce the interest rate. Logically, the TZB is when the central bank lends to anyone at infinite maturity, at a zero nominal interest rate, in unlimited amounts, and requires no collateral. Any activity can be financed at zero interest rates, so all interest rates are zero.

It goes without saying that we aren’t even close … anywhere. It also goes without saying that it would work. If any central bank went to unlimited TZB there would be a surge in demand, then inflation, and if they didn’t stop, hyperinflation. (As an aside, this line of reasoning reveals that the liquidity trap is a myth). So if we want to reduce interest rates further there are two options. Move gradually, step-by-step, towards the TZB, or go straight to the TZB and limit its scale.

The ECB is already doing the former. That’s what TLTROs etc are: a gradual extension of maturities and a relaxation of collateral requirements. Arguably, the Fed’s “credit easing” and the ECB’s purchases of asset-backed securities are an attempt to lend beyond the banking system.

I think it would be better to go straight to TZB, but limit the amount. In fact, that is precisely what Mark Blyth and I argue in our Foreign Affairs article. Cash is analogous to an infinite maturity loan at a zero nominal interest rate.

So let’s actually try zero interest rates. The US economy doesn’t need anymore stimulus, but the Eurozone clearly does. The ECB should move to the zero bound: allocate maybe 3% of GDP to infinite maturity, zero interest rates loans, to everyone. If that doesn’t work, we can think about the unconventional.