7 ms·

The Natural Rate of Interest Is Zero (2004) [pdf]

38 points by jganetsk 9y ago

stretchwithme 9y ago
Being able to use money has value. To get people to forgo the use of their own money, you have to pay them something. If there were risk free investments (I don't think there are), wouldn't people invest in those directly instead of letting you do it with their money? Of course, there is always arbitrage.
- jganetsk 9y ago
  This paper is talking about intraday or overnight lending between banks... cases where loans have a term of less than 1 day. Yes, "to get people to forgo the use of their own money, you have to pay them something". The length of time the lender forgoes the use of their own money is a factor in the rate the borrower pays. As loan term tends toward zero, interest rate should tend toward zero as well. That's what central banks control, but often choose a non-zero value.
  - mikeash 9y ago
    I can see why interest should tend towards zero, but why would the rate?
    - jganetsk 9y ago
      Intuition: if you were my friend, and I gave you a loan for 5 minutes (maybe because your wallet is in your car and we are paying a restaurant bill), how much interest would I expect you pay it back with? Zero (think about Venmo payments). And the only way to have a zero-interest loan for a non-zero amount of time is setting the rate at zero. This loan has an extremely short term (5 minutes) and is extremely low risk (it's a small amount of money and we are friends). So all real loans should have a non-zero interest rate, but the rate should asymptotically approach zero as we decrease the term and the risk. If not zero, then what would you choose? What should be the floor on interest rates? If we think about the interbank lending market, once the aggregate supply of reserves is beyond what is necessary to settle daily payments, the interest rate falls to the floor (the rate the Fed pays on reserves). In this case, why should the Fed choose a non-zero floor? There are many answers the Fed could provide, and they do. But they definitely need to provide that answer, which is what the paper is claiming. And the paper also suggests that zero works pretty well, for a variety of reasons.
      - tomrod 9y ago
        > And the only way to have a zero-interest loan for a non-zero amount of time is setting the rate at zero. This assumption is where things break. You could have an interest rate whose nominal contribution for five minutes that rounds down below 1 mil, the smallest unit of currency. A five-minute interest rate of 0.00098% would result in rounding the interest on $5 to zero. However, taken over the course of 5 minute increments through a year, and you arrive at $14.01 dollars: $5 * ((1 + 0.0000098)^(12 5-min increments/hour * 24 hours/day * 365 days/year)) = $14.01 Plenty of folks would love a 280% annual return.
      - mikeash 9y ago
        I don’t think framing it in terms of friends is useful. I’d make that loan to be kind. I wouldn’t do it as part of a business arrangement, so a stranger would probably be out of luck. If I were in the business of making five minute loans, I’d charge an astronomical interest rate to cover the fixed transaction costs.
        tomatocracy 9y ago
        I think you're getting side-tracked into credit risk which is not what the paper is about at all. But your example is useful to understand why credit risk is not as simple as that. For a start, considered in the context of formal loans, lending money to a friend in that situation is far from a risk-free bet - because my friend might have got it wrong and left his wallet at home, not in his car in which case in 5 minutes time he'll default on payment. Of course I'll almost certainly get my money back eventually (since otherwise I'd either have just said I'd give him the money or declined to either lend or gift it), but now your talking about the risk that I'm deprived of my money for longer than I had anticipated as well as having the the cost of using my time in chasing him for it, so I'd want some interest to compensate for that risk. In reality, what we do is (to some extent) to agree a social convention that "next time it will probably be the other way around" so that those potential losses even out between us and it makes sense that we reduce our administrative burden by not charging each other for them in the form of interest. What is true is that as the time a loan is outstanding reduces, ability to judge the repayment risk is likely to improve to some extent in most cases. However even this isn't universal - for example if I lend against you receiving payment on an invoice just issued and where yuou have given your customer 30-day payment terms, I'm likely to have better certainty lending on a 60-day repayment term than a 1-day repayment term.
- volgo 9y ago
  There is. It's U.S. Treasury bonds. It's guaranteed profit and risk free
  - daxorid 9y ago
    Sovereign debt is only risk-free relative to the issuing government's continued existence. The historical average duration of empires, republics, dynasties, and monarchies is 349 years. The assumptions we make about financial markets in the developed world seem to completely ignore political factors, as if issuing governments or unions that exist today will always exist - as if history has somehow ended. When you buy a 30y US Treasury bond at auction, you are getting paid 3.13% to assume that between years 231 and 261, representing 8.6% of the average lifespan of empires, no existentially threatening political upheaval will occur in the United States. Seeing the political division of the populace in the 2016 election, I wonder if this is a prudent assumption.
    - dmurray 9y ago
      You get paid 3.13% every year. So you are getting paid closer to 94% for making that assumption. Plus you get some of the 94% paid out early, so if you were wrong about there being no terrible upheaval, you still got something out of it (hopefully you didn't reinvest the interest in more Treasuries, or keep it in cash). So even when you put it like that - the odds don't seem too bad.
    - xvedejas 9y ago
      I also wonder if this is a prudent assumption. Existential threat is really hard to measure. If we want to know the average lifespan of a modern republic that has existed for about 250 years already, we don't have many data points to compare to. Here are ones that may count: - San Marino has been a republic for over 1000 years - The Netherlands was a republic from 1581 until 1806 - Switzerland has been a republic since 1648 - Paraguay, Chile, Argentina, and a dozen other Latin American countries have been republics continuously for over 150 years. Not without their share of upheaval, but even in the case of Venezuela I don't know that you can argue that the country stopped existing in sudden crisis. And that's all I can find, for "modern" republics >= 150 years old at present or at cessation. The next closest is France, which is also still a republic. We don't have too much data but I would listen to an argument that modern republics seem to be unusually long-lived compared to more traditional government types. With no better information available, you can choose either to trust the examples we have, or to adopt the doomsday prepper mentality. When trust is cheaper, it's not any surprise to me that people trust the government to continue existing.
- kazinator 9y ago
  > To get people to forgo the use of their own money, you have to pay them something. Temporarily forgo the use and accept a nonzero risk of never seeing it again. This is one reason why there is a range of interest rates.
mcnamaratw 9y ago
So are the authors lending or just talking?
- matte_black 9y ago
  I too would be interested in this as I'd like to take out a mortgage.
  - OscarCunningham 9y ago
    They're talking about the risk-free rate (no offence intended :-) ).
  - phlo 9y ago
    In Switzerland, the current target interest rate (set by the Swiss National Bank) is -1.25 to -0.25 percent, with current rates around -0.75%. This means banks need to pay the SNB on their funds deposited there. Many of them pass that on to their customers: Deposits don't earn any interest to speak of, and for large sums (starting from 1M or so), banks commonly charge interest. At some points, the yield on Swiss Gov't bonds was even negative. If you can offer a safe (and bank-accepted) way to store that money, you stand to make a killing. On the other hand, even in that environment, mortgages aren't free. Rates range from 0.5 to more than 2%. Part of that is the banks' margin, part of it comes from fixing the interest rate for some (2-10) years. [1] https://www.snb.ch/en/iabout/stat/statpub/zidea/id/current_interest_exchange_rates https://www.snb.ch/en/iabout/stat/statpub/zidea/id/current_i...
    - Dylan16807 9y ago
      I'm surprised the rate would get that negative. Especially when they have a 1000 Franc note (worth around 1000 dollars). At that level you can fit trillions of dollars in a single vault. A respected bank could build a new vault, staff it with multiple guards, charge 0.2% or 0.1% for storage, and make their investment back in under a year. Even with smaller notes. Obviously I'm missing something here, but what? Is it not safe enough?
politician 9y ago
(2004)
- sctb 9y ago
  Updated. Thanks!
jnordwick 9y ago
(2004) and talking about the risk free overnight rate. "Deficit spending will result in net central bank reserve credits in the aggregate banking system, which will drive the short-term overnight inter-bank lending rate to zero." Also, we now pay interest on reserve balances which goes against one of the paper's assumptions.
- jganetsk 9y ago
  The paper mentions that: "While government security sales may be used to drain the excess reserves to maintain some positive overnight rate, or the central bank may pay interest on reserve balances, absent such government intervention the base rate of interest is zero. In other words, the natural rate of interest is zero."
  - jnordwick 9y ago
    That's what I'm saying. The paper was written in a time before interest payments on reserve balances, and it explicitly says that is one of the requirements for the paper to hold. We now pay interest on reserves, but I'm not sure what that entire policy is or how it works.
    - jganetsk 9y ago
      The paper still holds. It is saying that the natural rate of interest, i.e. the "base case", is zero. It mentions interest on reserves and bond issuance to drain reserves both as ways to "move away from the base case". It claims that, regardless of mechanism, we should justify our actions to move away from the base case. It also claims that the base case is a good policy for a variety of reasons.
- bubbleRefuge 9y ago
  I know Mosler and he was a proponent of paying interest on reserves. Doing so avoids the complexity of having to execute Fed interest rate policy using treasuries.
jonny_eh 9y ago
I suspected that low interest rates would be around for a while, if not forever. So when I got my mortgage, I got the 7/1 ARM, instead of the standard US 30-year fixed.
- jganetsk 9y ago
  The paper is talking about the overnight, risk-free interest rate, not a long-term mortgage, which is just one point on the yield curve. If we think of the yield curve as a 3D graph, where one axis is interest rate, another axis is term, and a third axis is risk, then the paper is claiming that there is a point at (0, 0, 0). But central banks often change the interest rate to something non-zero at (0, 0).
bubbleRefuge 9y ago
Takeaways: -the federal government is self funding. (my opinion: we should take advantage of this by lowering taxes or spending more) - taxes create demand for money but don't fund government. - 'money' doesn't exist till the federal gov spends it into existence - interest rates are determined exogenously by the fed. - large deficits tend to drive down , not up, interest rates because of the excess reserves created.
- api 9y ago
  I wish people understood that public debt is not really debt as ordinarily understood. It's really just an accounting artifact and tends to reflect and mirror net private savings. That is unless your country does not issue it's own sovereign currency. Then it is debt.
  - tcmb 9y ago
    Does this last sentence apply to the countries that have the Euro?
    - bb88 9y ago
      That would be correct.
      - candiodari 9y ago
        Not entirely. It doesn't apply to the Euro as a whole and that means it doesn't apply to countries that, if they have a big banking crisis would provide a medium-or-higher risk to the Eurozone as a whole. So it does't apply to France, Germany, Italy, Spain, perhaps Poland.
  - barrkel 9y ago
    Public debt is a promise to fund future obligations and things like pensions would be significantly devalued if it isn't honoured, so in political practice it is debt. That debts and savings are two sides of the same coin is tautological and doesn't require a state or fiat currency. Your current account with the bank is a debt the bank owes you. All savings are debts.
mhuffman 9y ago
It is also the natural amount of profit in perfect competition!
- taneq 9y ago
  When you put it that way, I really don't want to live in a perfectly efficient market.
HIPisTheAnswer 9y ago
USD is a promise to pay a dollar to the bearer of the receipt. A dollar is an amount of gold, and so is a franc, a pound, a baht, and probably many others. Conversion of a thing into itself is not a conversion. There is no risk free rate, and the behavior of capital constrained by worldwide tax hunt cannot reasonably be called 'natural'. One more thing: banks can only have reserves after covering the totality of their demand deposits, which means that virtually all public banks are insolvent... You say they can sell some assets to cover? Fine! Let's see the selling, and see how many come out alive! I'm waiting!
- betenoire 9y ago
  Where do I trade in this piece of paper in my pocket for gold?
  - ballenf 9y ago
    Certainly not in Kansas, anymore, Toto.
  - _red 9y ago
    Technically a FRN (Federal Reserve Note) is backed by a US Dollar. These are distinctions which seem odd today, and describe the odd system that we now have. A "US Dollar" is defined constitutionally as being "gold or silver". However you can no longer redeem a FRN for a USD....only for more FRN's. It raises several interesting legal questions when pondered, for instance when you pay taxes you are being taxed on USD earnings, although technically you've never been paid this.
    - pmyteh 9y ago
      There's no constitutional definition of a dollar: gold, silver or otherwise. The restrictions in article I section 10 bind the states, not the federal government. Since the suspension of convertibility into gold in the 70s, dollars are essentially a pure fiat currency - whether in FRNs, dollar coins or otherwise.
      - 9y ago
kazinator 9y ago
Zero interest means zero economic motivation to lend anyone any money. This is only possible in some ideal world in which there is very little demand loaned money, and those few who borrow always give it back in a timely way, so there is zero risk in lending. And lending is just between friends; you know, can you give me a hundred bucks? I will pay you back in a few weeks (exactly a hundred bucks). And they always do.

38 points by jganetsk 9y ago

Being able to use money has value. To get people to forgo the use of their own money, you have to pay them something. If there were risk free investments (I don't think there are), wouldn't people invest in those directly instead of letting you do it with their money? Of course, there is always arbitrage.

jganetsk 9y ago
This paper is talking about intraday or overnight lending between banks... cases where loans have a term of less than 1 day. Yes, "to get people to forgo the use of their own money, you have to pay them something". The length of time the lender forgoes the use of their own money is a factor in the rate the borrower pays. As loan term tends toward zero, interest rate should tend toward zero as well. That's what central banks control, but often choose a non-zero value.
- mikeash 9y ago
  I can see why interest should tend towards zero, but why would the rate?
  - jganetsk 9y ago
    Intuition: if you were my friend, and I gave you a loan for 5 minutes (maybe because your wallet is in your car and we are paying a restaurant bill), how much interest would I expect you pay it back with? Zero (think about Venmo payments). And the only way to have a zero-interest loan for a non-zero amount of time is setting the rate at zero. This loan has an extremely short term (5 minutes) and is extremely low risk (it's a small amount of money and we are friends). So all real loans should have a non-zero interest rate, but the rate should asymptotically approach zero as we decrease the term and the risk. If not zero, then what would you choose? What should be the floor on interest rates? If we think about the interbank lending market, once the aggregate supply of reserves is beyond what is necessary to settle daily payments, the interest rate falls to the floor (the rate the Fed pays on reserves). In this case, why should the Fed choose a non-zero floor? There are many answers the Fed could provide, and they do. But they definitely need to provide that answer, which is what the paper is claiming. And the paper also suggests that zero works pretty well, for a variety of reasons.
    - tomrod 9y ago
      > And the only way to have a zero-interest loan for a non-zero amount of time is setting the rate at zero. This assumption is where things break. You could have an interest rate whose nominal contribution for five minutes that rounds down below 1 mil, the smallest unit of currency. A five-minute interest rate of 0.00098% would result in rounding the interest on $5 to zero. However, taken over the course of 5 minute increments through a year, and you arrive at $14.01 dollars: $5 * ((1 + 0.0000098)^(12 5-min increments/hour * 24 hours/day * 365 days/year)) = $14.01 Plenty of folks would love a 280% annual return.
    - mikeash 9y ago
      I don’t think framing it in terms of friends is useful. I’d make that loan to be kind. I wouldn’t do it as part of a business arrangement, so a stranger would probably be out of luck. If I were in the business of making five minute loans, I’d charge an astronomical interest rate to cover the fixed transaction costs.
      - tomatocracy 9y ago
        I think you're getting side-tracked into credit risk which is not what the paper is about at all. But your example is useful to understand why credit risk is not as simple as that. For a start, considered in the context of formal loans, lending money to a friend in that situation is far from a risk-free bet - because my friend might have got it wrong and left his wallet at home, not in his car in which case in 5 minutes time he'll default on payment. Of course I'll almost certainly get my money back eventually (since otherwise I'd either have just said I'd give him the money or declined to either lend or gift it), but now your talking about the risk that I'm deprived of my money for longer than I had anticipated as well as having the the cost of using my time in chasing him for it, so I'd want some interest to compensate for that risk. In reality, what we do is (to some extent) to agree a social convention that "next time it will probably be the other way around" so that those potential losses even out between us and it makes sense that we reduce our administrative burden by not charging each other for them in the form of interest. What is true is that as the time a loan is outstanding reduces, ability to judge the repayment risk is likely to improve to some extent in most cases. However even this isn't universal - for example if I lend against you receiving payment on an invoice just issued and where yuou have given your customer 30-day payment terms, I'm likely to have better certainty lending on a 60-day repayment term than a 1-day repayment term.
volgo 9y ago
There is. It's U.S. Treasury bonds. It's guaranteed profit and risk free
- daxorid 9y ago
  Sovereign debt is only risk-free relative to the issuing government's continued existence. The historical average duration of empires, republics, dynasties, and monarchies is 349 years. The assumptions we make about financial markets in the developed world seem to completely ignore political factors, as if issuing governments or unions that exist today will always exist - as if history has somehow ended. When you buy a 30y US Treasury bond at auction, you are getting paid 3.13% to assume that between years 231 and 261, representing 8.6% of the average lifespan of empires, no existentially threatening political upheaval will occur in the United States. Seeing the political division of the populace in the 2016 election, I wonder if this is a prudent assumption.
  - dmurray 9y ago
    You get paid 3.13% every year. So you are getting paid closer to 94% for making that assumption. Plus you get some of the 94% paid out early, so if you were wrong about there being no terrible upheaval, you still got something out of it (hopefully you didn't reinvest the interest in more Treasuries, or keep it in cash). So even when you put it like that - the odds don't seem too bad.
  - xvedejas 9y ago
    I also wonder if this is a prudent assumption. Existential threat is really hard to measure. If we want to know the average lifespan of a modern republic that has existed for about 250 years already, we don't have many data points to compare to. Here are ones that may count: - San Marino has been a republic for over 1000 years - The Netherlands was a republic from 1581 until 1806 - Switzerland has been a republic since 1648 - Paraguay, Chile, Argentina, and a dozen other Latin American countries have been republics continuously for over 150 years. Not without their share of upheaval, but even in the case of Venezuela I don't know that you can argue that the country stopped existing in sudden crisis. And that's all I can find, for "modern" republics >= 150 years old at present or at cessation. The next closest is France, which is also still a republic. We don't have too much data but I would listen to an argument that modern republics seem to be unusually long-lived compared to more traditional government types. With no better information available, you can choose either to trust the examples we have, or to adopt the doomsday prepper mentality. When trust is cheaper, it's not any surprise to me that people trust the government to continue existing.
kazinator 9y ago
> To get people to forgo the use of their own money, you have to pay them something. Temporarily forgo the use and accept a nonzero risk of never seeing it again. This is one reason why there is a range of interest rates.

mcnamaratw 9y ago

So are the authors lending or just talking?

matte_black 9y ago
I too would be interested in this as I'd like to take out a mortgage.
- OscarCunningham 9y ago
  They're talking about the risk-free rate (no offence intended :-) ).
- phlo 9y ago
  In Switzerland, the current target interest rate (set by the Swiss National Bank) is -1.25 to -0.25 percent, with current rates around -0.75%. This means banks need to pay the SNB on their funds deposited there. Many of them pass that on to their customers: Deposits don't earn any interest to speak of, and for large sums (starting from 1M or so), banks commonly charge interest. At some points, the yield on Swiss Gov't bonds was even negative. If you can offer a safe (and bank-accepted) way to store that money, you stand to make a killing. On the other hand, even in that environment, mortgages aren't free. Rates range from 0.5 to more than 2%. Part of that is the banks' margin, part of it comes from fixing the interest rate for some (2-10) years. [1] https://www.snb.ch/en/iabout/stat/statpub/zidea/id/current_interest_exchange_rates https://www.snb.ch/en/iabout/stat/statpub/zidea/id/current_i...
  - Dylan16807 9y ago
    I'm surprised the rate would get that negative. Especially when they have a 1000 Franc note (worth around 1000 dollars). At that level you can fit trillions of dollars in a single vault. A respected bank could build a new vault, staff it with multiple guards, charge 0.2% or 0.1% for storage, and make their investment back in under a year. Even with smaller notes. Obviously I'm missing something here, but what? Is it not safe enough?

politician 9y ago

(2004)

sctb 9y ago
Updated. Thanks!

jnordwick 9y ago

(2004) and talking about the risk free overnight rate. "Deficit spending will result in net central bank reserve credits in the aggregate banking system, which will drive the short-term overnight inter-bank lending rate to zero." Also, we now pay interest on reserve balances which goes against one of the paper's assumptions.

jganetsk 9y ago
The paper mentions that: "While government security sales may be used to drain the excess reserves to maintain some positive overnight rate, or the central bank may pay interest on reserve balances, absent such government intervention the base rate of interest is zero. In other words, the natural rate of interest is zero."
- jnordwick 9y ago
  That's what I'm saying. The paper was written in a time before interest payments on reserve balances, and it explicitly says that is one of the requirements for the paper to hold. We now pay interest on reserves, but I'm not sure what that entire policy is or how it works.
  - jganetsk 9y ago
    The paper still holds. It is saying that the natural rate of interest, i.e. the "base case", is zero. It mentions interest on reserves and bond issuance to drain reserves both as ways to "move away from the base case". It claims that, regardless of mechanism, we should justify our actions to move away from the base case. It also claims that the base case is a good policy for a variety of reasons.
bubbleRefuge 9y ago
I know Mosler and he was a proponent of paying interest on reserves. Doing so avoids the complexity of having to execute Fed interest rate policy using treasuries.

jonny_eh 9y ago

I suspected that low interest rates would be around for a while, if not forever. So when I got my mortgage, I got the 7/1 ARM, instead of the standard US 30-year fixed.

jganetsk 9y ago
The paper is talking about the overnight, risk-free interest rate, not a long-term mortgage, which is just one point on the yield curve. If we think of the yield curve as a 3D graph, where one axis is interest rate, another axis is term, and a third axis is risk, then the paper is claiming that there is a point at (0, 0, 0). But central banks often change the interest rate to something non-zero at (0, 0).

bubbleRefuge 9y ago

Takeaways: -the federal government is self funding. (my opinion: we should take advantage of this by lowering taxes or spending more) - taxes create demand for money but don't fund government. - 'money' doesn't exist till the federal gov spends it into existence - interest rates are determined exogenously by the fed. - large deficits tend to drive down , not up, interest rates because of the excess reserves created.

api 9y ago
I wish people understood that public debt is not really debt as ordinarily understood. It's really just an accounting artifact and tends to reflect and mirror net private savings. That is unless your country does not issue it's own sovereign currency. Then it is debt.
- tcmb 9y ago
  Does this last sentence apply to the countries that have the Euro?
  - bb88 9y ago
    That would be correct.
    - candiodari 9y ago
      Not entirely. It doesn't apply to the Euro as a whole and that means it doesn't apply to countries that, if they have a big banking crisis would provide a medium-or-higher risk to the Eurozone as a whole. So it does't apply to France, Germany, Italy, Spain, perhaps Poland.
- barrkel 9y ago
  Public debt is a promise to fund future obligations and things like pensions would be significantly devalued if it isn't honoured, so in political practice it is debt. That debts and savings are two sides of the same coin is tautological and doesn't require a state or fiat currency. Your current account with the bank is a debt the bank owes you. All savings are debts.

mhuffman 9y ago

It is also the natural amount of profit in perfect competition!

taneq 9y ago
When you put it that way, I really don't want to live in a perfectly efficient market.

HIPisTheAnswer 9y ago

USD is a promise to pay a dollar to the bearer of the receipt. A dollar is an amount of gold, and so is a franc, a pound, a baht, and probably many others. Conversion of a thing into itself is not a conversion. There is no risk free rate, and the behavior of capital constrained by worldwide tax hunt cannot reasonably be called 'natural'. One more thing: banks can only have reserves after covering the totality of their demand deposits, which means that virtually all public banks are insolvent... You say they can sell some assets to cover? Fine! Let's see the selling, and see how many come out alive! I'm waiting!

betenoire 9y ago
Where do I trade in this piece of paper in my pocket for gold?
- ballenf 9y ago
  Certainly not in Kansas, anymore, Toto.
- _red 9y ago
  Technically a FRN (Federal Reserve Note) is backed by a US Dollar. These are distinctions which seem odd today, and describe the odd system that we now have. A "US Dollar" is defined constitutionally as being "gold or silver". However you can no longer redeem a FRN for a USD....only for more FRN's. It raises several interesting legal questions when pondered, for instance when you pay taxes you are being taxed on USD earnings, although technically you've never been paid this.
  - pmyteh 9y ago
    There's no constitutional definition of a dollar: gold, silver or otherwise. The restrictions in article I section 10 bind the states, not the federal government. Since the suspension of convertibility into gold in the 70s, dollars are essentially a pure fiat currency - whether in FRNs, dollar coins or otherwise.
    - 9y ago

kazinator 9y ago

Zero interest means zero economic motivation to lend anyone any money. This is only possible in some ideal world in which there is very little demand loaned money, and those few who borrow always give it back in a timely way, so there is zero risk in lending. And lending is just between friends; you know, can you give me a hundred bucks? I will pay you back in a few weeks (exactly a hundred bucks). And they always do.