Is zero percent a fair interest rate? A rare dissent against the Aleph Blog.

While reading the Aleph Blog recently, I was shocked to see an author whom I respect say that Bernanke’s policies “discriminate against the poor, and the lower middle class”, because the poor do not know how to invest, and are leaving their cash in the bank to be eroded by a negative real rate. I think that Bernanke’s policies actually do the opposite, discriminating against the rich and favoring the poor. The typical low/middle-income guy doesn’t care whether the $20k in his bank account is yielding -2% or 5% real interest. Either way, he is not going to able to survive on that income. Way more important to him is that he has a job. A zero Fed funds rate actually makes life harder for the moneyed class, who can no longer live off interest from a safe asset like Treasury bond, and are pushed to acquire real assets to protect themselves from the inflation. In so doing, they increase the demand for real assets in the economy, and more people are hired to produce the goods demanded, and the average poor guy gets a better shake in the employment market. So Bernanke, in my book, is doing the poor guy a favor.

But the more interesting question is : What is the correct “natural” rate of interest that can be expected from safe, liquid, cash-equivalent assets (bank accounts, Treasury bonds etc.)? Is it unfair that Bernanke is “artificially” depressing that rate down to zero?

To answer that question, we would have to lift the veil of money to reveal the fundamental nature of saving. Imagine a world without money, where people exchange goods through bartering. In this moneyless world, people would still want to save, that is, to consume less today so that they can consume more tomorrow. The only difference is that without money, they would have to save real goods. There are two fundamentally different ways to save. The first way is through storage. Simply stash that bushel of wheat in a warehouse, and one year from now, you can eat more wheat. Storage is a form of savings that is intrinsically yields a zero or negative rate. At best, you get back whatever you put in. At worst, your goods gets stolen or burns down. But there is a second way to save, which we’ll term investing. The farmer can, for example, experiment on new strains of wheat on a small portion of his land. During this period, his plot is producing less wheat than usual, because some resources are devoted to experimental strains, some of which can fail, so he is consuming less wheat today. But, assuming that the experiments are successful and he comes up with a wheat strain with greater yields, he reaps more wheat tomorrow. Investing carries the possibility of a positive interest rate; it is entirely possible that you can reap more than you put in. However, it is also a RISKY and ILLIQUID endeavor; it is also possible that you lose all that you put in, and you typically cannot terminate the endeavor without losing all you have already invested.

During normal economic times, with all resources already productively employed with little spare capacity, much of the saving in the economy is actually investing, which has an intrinsic positive yield (assuming risk is handled properly). Resources are simply too expensive to be stashed away in a warehouse somewhere. And that positive interest rate feeds through the entire financial ecosystem, such that even “riskless” financial assets like Treasury bonds and cash yield some small but positive real interest rate. But in a recession, where there is spare capacity and resources, some portion of saving in the economy becomes storing, which intrinsically carries a zero or negative interest rate. And in the financial ecosystem, only those that take risk deserve a positive real return. If you are very risk-averse in a recessionary environment, you should not be shocked to get a zero or negative real interest rate. Banks globally are having problems finding enough credit-worthy people and company to lend to in the midst of a recession, and therefore are stashing their money with central banks or in gold. Some banks are even turning away deposits. In this environment, there is no reason why riskless financial assets should yield anything at all. Bernanke can no more give the risk-averse a positive real rate than he can wave a magic wand and dispel the recession. (Well … actually he can, but not without harming other people.)

From the perspective of society as a whole, risk taking is the only important thing. Without risk taking, any kind of monetary policy is just a zero sum game, dividing the same fixed pie in different ways. Tighten policy to cause deflation, and those with liquid cash assets win. Loosen monetary policy to cause inflation, and those with cash lose while people with hard assets and the working poor win. But in the end, you’re just pushing the same amount of chips to different people. So, why not use a bit of financial coercion to get people to take risks again. Leave your assets in cash, and you lose 2% a year to inflation. But hey, if you take some risk and say buy stock, buy a house, start a company, or heck, even buy gold, you protect yourself against inflation and stimulate the economy at the same time. And I think we can all agree that growing the pie for everyone is a better economic objective than squabbling about who gets a bigger slice of the pie.

P.S. The above is simply a long-winded explanation of the economic concept of the “natural rate of interest”.