Thursday, October 29, 2020

Why were interest rates ever positive?

We've been trained to believe that negative interest rates are weird. In On Negative Rates, J.W. Mason explains why positive interest rates for government bonds might be the stranger phenomenon. He makes the case for why we shouldn't think about finance as time travel, at least when thinking about interest rates for government bonds. A couple notes from the post..

One reason we expect bonds to have positive yields is the economic models we're taught:

"In a world with with a fixed or exogenous money stock, or where regulations and monetary policy create the simulacrum of one, there is a cost to the bank of holding government debt, namely the income from whatever other asset it might have held instead. Many people still have this kind of mental model in thinking about government debt. (It’s implicit in any analysis of interest rates in terms of saving.)"

But that model is not applicable to the modern economy:

"... in a world of endogenous credit money, holding more government debt doesn’t reduce a bank’s ability to acquire other assets. Banks’ ability to expand their balance sheets isn’t unlimited, but what limits it is concerns about risk or liquidity, or regulatory constraints. All of these may be relaxed by government debt holdings, so holding more government bonds may increase the amount of other assets banks can hold, not reduce it. In this case the opportunity cost would be negative."

So why haven't interest rates been negative before?

  • During the gold standard era, gold, not government debt, was the top of the money hierarchy
  • Central banks' use of interest rates for demand control have ensured a positive yield on public as well as private debt
  • Safety, liquidity, and regulatory benefits of government debt holdings weren't as large before the 2008 financial crisis.

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