With unemployment rising and the financial system in shambles,its hard not to feel negative about the economy right now. The answer to our problems,however,could well be more negativity. But Im not talking about attitude. Im talking about numbers. Lets start with the basics: What is the best way for an economy to escape a recession? Until recently,most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services and so,the thinking goes,our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services,which leads to greater employment for workers to meet that demand. The problem today,it seems,is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero,so it has turned to other tools,such as buying longer-term debt securities,to get the economy going again. But the efficacy of those tools is uncertain,and there are risks associated with them.
In many ways today,the Fed is in uncharted waters. So why shouldnt the Fed just keep cutting interest rates? Why not lower the target interest rate to,say,negative 3 per cent? At that interest rate,you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand. The problem with negative interest rates,however,is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return,it would be better to stick the cash in your mattress. Unless,that is,we figure out a way to make holding money less attractive.
The idea of making money earn a negative return is not entirely new. In the late 19th century,the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress,people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves,Gesells concern about cash hoarding suddenly seems very modern. If all of this seems too outlandish,there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that,looking ahead,the Fed commits itself to producing significant inflation. In this case,while nominal interest rates could remain at zero,real interest rates interest rates measured in purchasing power could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars,they would have significant incentive to borrow and spend. Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And we have them today. A little more inflation might be preferable to rising unemployment or fiscal measures that pile on debt bequeathed to future generations.
Ben S. Bernanke,the Fed chairman,is the perfect person to make this commitment to higher inflation. Bernanke has long been an advocate of inflation targeting. But in the current environment,the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative. The idea of negative interest rates may strike some people as absurd. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today,these numbers are commonplace. Even children can be taught that some problems (such as 2x + 6 = 0) have no solution unless you are ready to invoke negative numbers. Maybe some economic problems require the same trick.
(The writer is professor at Harvard. He was an adviser to President George W. Bush)
