“If the rate of interest were so governed as to maintain continuous full employment, virtue would resume her sway;– the rate of capital accumulation would depend on the weakness of the propensity to consume. Thus, once again, the tribute that classical economists pay to her is due to their concealed assumption that the rate of interest always is so governed.” – John Maynard Keynes, The General Theory (1936, p. 76)

Many economists like to say that price limitations – including wage regulations – are bad for an economy. And they are right. Most of them are just omitting the biggest price limit of all: the zero-lower-bound of interest rates (ZLB). The ZLB is practically the minimum wage of capital. The same economists also argue that (most) subsidies distort the market. And they are right. And one of the biggest subsidies in our current economic system is the fact that the government guarantees bank deposits (as the entries on bank accounts are misleadingly called) practically for free. This encourages excessive hoarding of liquid credit, which destabilizes the macroeconomy and, especially, makes it very profitable for banks to overleverage themselves, i.e. to hold insufficient shareholder equity to carry their risks. This is because it allows them to impose their business risks (mainly the volatility and default risks of their assets) onto taxpayers without their credit costs rising. According to the Modigliani-Miller theorem, credit costs would otherwise rise with leverage, offsetting the higher expected returns for shareholders.

As risk-free credit is wholly unproductive, we could summarize the situation by saying that, currently, a large amount of capital is on a massive unemployment support! This results in a chronic oversupply of capital – which means a momentary oversupply of labor.

No wonder we have persistent unemployment and deflationary pressures – and would have even more so without wage regulations and sustained government deficits, which are compensating for excessive private saving. In a working economic system, the market interest rate should be determined by people’s willingness to save (the “supply of capital”, the inverse of people’s “time preference” or impatience to spend) and the availability of profitable real investment opportunities (the “demand for capital”). Essentially it is meant to keep the credit market in balance, i.e. keep the amount that people want to be owed by others (i.e. save monetary assets) equal to the amount that others want to be in debt. This is practically the same as keeping the aggregate supply and demand of labor in balance, as monetary saving occurs by an individual earning more than he spends and invests in real assets (buys labor). When people want to hold less monetary savings than others want to be in debt, there is more demand for labor than there is supply of it and the competition over the limited labor causes upwards pressure in wages, which results in inflation – a rise in the general price level.

The “conventional monetary policy” of central banks in modern credit money economies is practically keeping inflation stable by keeping aggregate demand and supply  in balance. (Supply is often affected less as people seldom have the option of working less.) This, and the fact that most money (liquid credit) in today’s system is matched by private debt, is why it has been so effective at maintaining price stability. Mainstream monetary policy has arrived at this “right conclusion” partly by accident, as many monetarist and New Keynesian models still assume the causality between the interest rates and inflation pressures to run through the money supply.

The effects of conventional monetary policy (interest rate adjustments) on the price level via aggregate demand and supply.

The effects of conventional monetary policy (interest rate adjustments) on the price level via aggregate demand and supply.

Our current monetary system is probably the biggest subject of misunderstandings in economics – today and throughout the past century. There are widely spread hoaxes (like the “perpetual debt hoax”, see e.g. this, this and this), whole political movements trying to make money work like our languages assume it works as well as massive amounts commodity money (gold standards, bitcoin etc.) and other anti-fiat propaganda dominating social media and the rest of the internet. Out of economic theories, Modern Monetary Theory comes closest to explaining the credit nature of our current monetary system and understanding the mathematical implications of the balance sheet operations involved in banking as well as fiscal and monetary policy. But unfortunately its main advocates, Post-Keynesian economists, have not quite grasped the essence of the Credit Theory of Money either and tend to draw quite illogical, populist policy conclusions from their frame. They omit systemic risks, want to maintain the minimum wage of capital and further entrench the “job creation paradigm”Fixing the Root Bug (section 1.2 as well as chapters 1.3.5, 2.2.5, 2.2.6 and 5.1.1) explains:

  • How we are tricked by our language in terms of money: We have the wrong conceptual metaphor, when we use expressions and words like “deposits”, “lending/borrowing money”, “creating/destroying money”, “having money in the bank”. (The whole history of economic thought is one big victory march for the Sapir-Whorf hypothesis.)
  • Different theories of both the nature, functions and origins of money
  • Why commodity currencies (and others of inelastic supply) are inherently unstable (constant speculative bubbles) and, together with private land ownership, are useful tools for usury and extortion.
  • Why automatic market interest rate mechanisms in any fixed-quantity currency don’t work to stabilize the economy (as they should in theory)
  • Why the value of our current euros and dollars is not “based on nothing” or “the blind trust of the public”, but the fact that someone else owes them
  • Why bitcoin will never stabilize (and is one of the most cunning crossbreeds between a Pyramid scheme and a Ponzi scheme in economic history)
  • How “a medium of exchange” can by no means be considered to be an exhaustive description of any money (that can be held beyond an individual trading day)
  • How the quantity of money, in our current system, is endogenous (the central bank has hardly any control over its quantity) and how the quantity theory of money (the presumed causal relationship between the amount of money in the economy and the general price level, which has always been a very rough approximation) has hardly any validity in our current credit money system
  • Why “money supply” and “the supply of money” are very misleading terms that can be interpreted in many ways.

The ZLB is practically caused by physical cash. Cash always yields a zero nominal interest and hence banks cannot charge a notably negative nominal interest rates on their accounts without causing many people to withdraw their savings as cash. For facilitating negative real interest rates there are hence two lucrative alternatives:

  • Eliminate cash: This starts becoming a feasible option in many developed countries where electronic money (e.g. card payments and account transfers through e-banking) are already more “liquid” (a more commonly accepted form of payment) and less costly than payments in physical cash.
  • Adopting a higher target inflation rate (in the range of 6-10%): What matters in the end is not the nominal interest rate (the percentage paid on loans or deposits), but the real interest rate: how much the purchasing power of credit savings and the debts (are expected to) change. Inflation stability, i.e. the predictability of prices, is important. Unexpected changes in prices are practically immediate wealth transfers between creditors and debtors. But there are few valid arguments for why the inflation rate needs to be as low as 1-2 %. As long as inflation is predictable, it can be compensated nominal interest rates. The only difference is that, with higher inflation, physical cash has higher holding costs and there is more “room-to-cut” real interest rates to keep inflation stable.

Section 4.2 in FtRB:

  • Discusses common concerns with (and false allegations against) higher, stable inflation
  • Mentions other effects of the possibility of negative real rates
  • Presents current cases and previous suggestions of higher inflation targets, their political opposition and other possible guidelines for monetary policy
  • Assesses risks of regulatory capture and corruption with central banks
  • Addresses the question of how “inflation” should be defined (what the CPI should be composed of)
  • Explains how there would be hardly any need for public fiscal stimuli without the ZLB
  • Explains how real estate bubbles are not caused by “too low interest rates”, but the monopoly nature of land, and how implementing LVT together with eliminating the ZLB can mitigate adverse housing market effects.

…and proposes setting a proper price (e.g. 3 or 5 %) on the government deposit guarantee, which it claims would:

  • Allow a simple, market-based bank regulation mechanism, based on the risk premiums of corporate bonds, allowing banks to do what they are meant to (manage risks, instead of focusing on hiding them)
  • Remove the subsidy of risk-free credit, encouraging deleverage (reducing debt-levels)
  • Reduce excess liquidity in the economy, reducing instability including hyperinflation risks
  • Lower interest rates on government debt, making the government earn additional “revenue” when rates are negative.

The free deposit guarantee issue and bank solvency shortly:

A broader Banking 101 session:

“The perfectly just proposition that the laborer should receive the entire value of his product may be understood to mean either that the laborer should now receive the entire present value of his product, or should receive the entire future value of his product in the future.” … “Time preference may not always be a preference for present over future goods; it may, under certain conditions, be the opposite. Impatience may be and sometimes is negative!” – Irving Fisher, Theory of Interest (1930, p. 25 & 29)

“[I]t is time for central banks to stop pretending that zero is the floor for nominal interest rates.  There is no theoretical or practical reason for not having the Federal Funds target rate and market rates at, say, minus five percent, if that is what your Taylor rule, or whatever heuristic guides your official policy rate, suggests.

Economics as a science and economic reality have never had problems with negative real (inflation-adjusted) interest rates.  So what is the problem with nominal rates?  In a word, it’s currency [i.e. physical cash].” – Willem Buiter

“The zero lower bound is a nominal problem. However low the real interest rate, an economy can keep nominal rates safely in positive territory by running a sufficiently high rate of inflation.” … “Now again, just why the real, natural rate of interest is currently -4% is an interesting question, but it’s irrelevant to the challenge of closing the output gap. All that matters there is that expected inflation is between 1% and 2% instead of near 4%. That’s the problem; that’s what’s keeping tens of millions of people out of work and hundreds of millions languishing in a perpetually weak economy: a couple of percentage points of inflation.” – Ryan Avent

“Suppose that the short-term real interest rate that was consistent with full employment had fallen to negative two or negative three percent sometime in the middle of the last decade. Then what would happen? Then even with artificial stimulus to demand – coming from all this financial imprudence – you wouldn’t see any excess demand.” … “Then conventional macroeconomic thinking leaves us in a very serious problem.” Larry Summers

”First, it is precisely the existence of paper currency that makes it difficult for central banks to take policy interest rates much below zero, a limitation that seems to have become increasingly relevant during this century.” – Kenneth Rogoff, Costs and Benefits to Phasing Out Paper Currency (2014, p. 1)

”[O]ne virtue of a cashless economy is that we could always cure recessions with ‘old fashioned’ monetary policy. The so-called zero lower bound is a pure artifact of the existence of physical cash.” – Matthew Yglesias

“[O]ne of the reasons that our technology is impeded and prevented from feeding the world properly is the failure of one of our networks. It’s an information network and it’s called money – about which we have the most unbelievable superstitions and psychological blocks…” … “But money and our psychological attitude to money is a major obstacle to a proper development of technology, enabling it to do what it is supposed to do – that is to save labor, and to produce goods, services and so on adequately.” – Alan Watts

“A banker is one who centralises the debts of mankind and cancels them against one another. Banks are the clearing houses of commerce.” … “There is no such thing as a medium of exchange. A sale and purchase is the exchange of a commodity for a credit. Credit and credit alone is money.” – Alfred Mitchell-Innes, The Credit Theory of Money (1914)

“The convenience of use is decidedly in favour of a currency which can be expected to retain an approximately stable value.” – Friedrich A. Hayek, Choice in Currency (1976, p. 14 &  p. 20)

“But it’s very hard to be a currency when you’re also a commodity, governed by rules of scarcity and subject to speculative attack.” – Felix Salmon

“A deposit insurance system is like a nuclear power plant. If you build it without safety precautions, you know it’s going to blow you off the face of the earth. And even if you do, you can’t be sure it won’t.“ – L. William Seidman, Chairman, FDIC