By Brendan Brown 

A conundrum has long been known to monetary economists, but only comes into the open during the once in a quarter-of-a-century type of recession apparently plaguing the global economy.

The quandary is how, in a conventional monetary economy, to bring interest rates down to the negative levels essential to speedy recovery during periods when there is a sharp decline in spending propensities.

If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes.

The interest rate under discussion is the risk-free nominal rate as quoted on short-maturity government bonds, most obviously US T-bills or short-dated German government bonds.

Over the course of decades, particularly during the Japanese “lost decade” of asset deflation, suggestions have emerged as to how to solve the conundrum.

These include the periodic stamping (for a small fee) of banknotes (without the stamp they would not be valid). The idea is that by imposing a running tax on banknote hoarding, nominal risk-free rates could fall to negative levels.

In the age of the information technology revolution, surely the authorities could devise a simple and practical method of effective taxation of banknote hoards?

There are two cues to a practical method of taxing notes. The first comes from what happened during US financial crises in the 19th century.

Banks under stress of cash drains (depositors withdrawing funds) suspended temporarily the 1:1 link between cash and deposits, so their notes sold at varying discounts. The second comes from the launch of the euro; a conversion of old banknotes into new.

These cues lead to the solution.

The relevant government would announce that existing banknotes were to be converted into new notes at a fixed date, say three years from now, at a discount (for example 100 old dollar banknotes would be converted into 90 new).

In the interim, 1:1 conversion of banknotes into deposits would be suspended. Instead, a crawling peg would be established. At the start, the exchange rate between deposits and banknotes would be virtually 1:1. At the end it would be 0.9 banknotes/deposit.

As the discount grew, retailers would quote different prices for cash or cheque/card settlement. And as to the note switch-over costs, the “experiment” of Europe’s economic and monetary union demonstrates the feasibility.

The looming conversion would provide an essential degree of freedom for monetary policy. In terms of our illustrative arithmetic, the risk-free interest rate could fall to a negative 3.33 per cent a year without triggering cash withdrawals from the banking system.

Is the exercise worth it?

The main reason for believing it is stems from an appreciation of how the bursting of a global credit bubble influences the equilibrium level of risk-free interest rates relative to risky rates of return and in absolute terms.

Most of us would agree that the bursting process ushers in a period during which soberly-measured risk premiums increase sharply.

This means that the risk-free rate must plunge to be consistent with an average overall cost of capital which reflects the new glut of savings.

So, in terms of our illustrative arithmetic, it is plausible that the neutral risk-free nominal rate of interest in the US and Europe, especially taking account of a likely near-term drop of the price level, is significantly negative.

The central bank and government, by devising a system in which such negativity can express itself, can give a big fillip to the recovery process.

The most direct channel for this fillip most likely passes through the equity market.

Pervasive negative risk-free rates across the advanced economies would underpin equity market levels.

Investors faced with certain substantial nominal loss on risk-free holdings would bid up the price of equity which could offer rich risk premiums even at a presently feebly level of prospective earnings.

And it is equity market developments which hold the key to the economic recovery.

As consumers across the globe retrench, the forces of equilibrium should (if not thwarted by zero rate traps) bring about a redistribution of economic output, away from the production of consumer goods and towards capital goods (including technological know-how).

A higher rate of business investment matched by lower consumption now will have a counterpart in higher-than-otherwise consumption in the far-off future.

A resilient equity market with its counterpart in a low cost of equity capital is the key motor behind that transformation.

Firms across much of the global economy would respond to the combination of squeezed profit margins, low equity capital costs and continuing technological progress by “capital deepening” (increasing the ratio of capital to labour).

That would mean a challenging increase in frictional unemployment and pressure for increased social insurance of the losers.

Losses and losers are an inevitable consequence of the big credit bubble which is bursting. In the equity markets these losses reflect swathes of now obsolescent capital stock in the wrong place at the wrong time.

The key to rapid progress towards re-building wealth is to nurture the golden egg of the equity market, in which the coming capital spending upturn will be financed and to minimize monetary disequilibrium in the meantime.

The scheme proposed here for sharply negative interest rates promises much on both objectives.

Brendan Brown is director of economic research, Mitsubishi UFJ Securities International and author of “Bubbles in Credit and Currency” (Palgrave, 2008)

November 20, 2008 12:35pm in Central banks, Credit squeeze, Recession | Comment