Rushing into Economic Theory

Yep, I know even at this time of year, angels fear to tread on conventional wisdom when it concerns principles of economics, but hey, whom does that stop? Not me. It's rushing in time!

The other day I heard a guy on the radio say that the Federal Reserve can raise interest rates as much they think necessary, but they can't the rates indefinitely because zero is an absolute lower limit.

Hmmmmmm! Let's think about that for a minute. Okay, times up. My turn.

What is interest, anyway? If mystery writer Joe is out of money and needs, say, $100 to buy supplies and mail off his new manuscript, and if Fred has more money than he needs for his immediate needs, Joe may ask Fred for a loan. If they're really excellent friends, the transaction may be elementary: Fred hands over $100 to Joe, and Joe does all that stuff he was going to do with it, and then, later, Joe, who must have made a sale for a change, comes into enough cash that he can pay Fred the $100. That was a no-interest loan, but every right thinking person will agree that it's also okay to call it a zero interest loan. If Joe and Fred aren't all that close, however, Fred may still loan Joe the hundred bucks, provided he thinks Joe will be good for it. However, he is likely to expect to be paid somewhat more than he handed over. Ignoring the various slang terms for the extra dollars, one name for them is “interest.”

Once the idea of interest is established, details may be added, such as specifying when the loan is to be repaid and how many extra dollars Fred is to receive. If it's to be paid back in one year and the number of extra dollars is, say twenty, then Fred is said to have loaned the money at 20% per annum simple interest. Why 20%? You divide the extra amount, $20, by the loaned amount, $100, and use eighth grade arithmetic in which we learned how to convert the result to percent and it comes out 20%. Why “per annum”? Because “per annum” is Latin for “each year,” and because Joe has to manage his $120 payoff by the end of the year. Why “simple”? because they may also have a further agreement that if Joe can't manage it in a single year, and if Fred gives him an extension of the time, then for the next year he'll have to pay 20% not of $100, but of the amount he owes Fred at that time, namely $120. That's complicated, so the deal we were originally talking about is called “simple” by contrast.

That's it: if Joe must pay extra, then he's paying interest, in some form or other.

But what if Fred, anxious for Joe to succeed with his writing, says, “Joe, here's your $100, but to make things easier for you, it's okay, at the end of the year, to pay me back only $80, i.e. twenty bucks less.” Although negative numbers were invented in the first place by the business community, Joe may or may not realize that he's now promising to pay the original amount plus an “extra” consisting of a negative amount, i.e. $100 plus negative $20. We're just using terminology that has been available in finance since the late middle-ages. Now, let's see: if we divide -20 by 100, we get -0.20, and using our enlightened eighth grade training, that should be called -20% (pronounced “minus 20 percent.”). Note that -20% is less than zero percent. Note that compounding negative interest will not be dealt with here, because any fool can deal with it for him- or herself, so why should this fool do it for you? It's kind of ----please pardon the expression----interesting, though.

If Fred can do this, so could the Federal Reserve System.

Not that I think they should do it. How could I know what interest rates “The Fed” should charge. That's a terribly complicated matter. I only mean that zero percent is by no means really an absolute lower limit for interest rates. If “The Fed” really did charge negative interest, they would be giving banks more money than the banks were going to pay back, and that might or might not be a good thing, depending on whether a mechanism was in place to keep the banks' CEOs from simply awarding themselves the money they got but don't have to pay back. If, for example, the goal were to stimulate the economy and if the aforementioned mechanism (and others, no doubt) were in place, then negative interest might be wonderful, but if the goal is to avoid appearing to give federal funds to “the wrong people,” they might prefer to disguise the nature of the transactions by using more acceptable terminology. “Bailout,” supposedly, is not supposed to come to mind.

There are actually many ideas available for revising the conventional wisdom. For example, I was originally planning to point out that not all that many years ago a political party that shall remain nameless (in order to protect the Republicans) insisted that the budget of the USA should be managed just like that of a happy family. At the time they were talking against the other party's tendency to indulge in what many call “deficit financing.” The happy family, of course, wouldn't ever borrow more than they can quickly pay back (at positive interest, I'm sure). Today that same party contends that the US government's own money supply can only be augmented by failing to let it be augmented. Or at least, not overtly. You see, there's a certain word that starts with “t” and ends in “x” that has been despised for ages, and they don't want to be caught endorsing any use of it that doesn't occur alongside the verb “to cut.” The happy family analogy would be, if a family owes too many bills, the breadwinner should simply take a lower-paying job. To learn whether that works, one has only to talk to people in the happy family, who will be sure to reveal what they know. But since it's one thing to point out a small error made on the radio and quite another to mention a major error that dominates Washington , I won't travel that way today.