Friday, April 17, 2015

John Cochrane is too grumpy about negative rates

John Cochrane has written two posts that question the ability to implement negative interest rates given the wide range of 0%-yielding escape hatches available to investors. These escapes include gift cards, stamps, tax & utility prepayments, and more. In a recent post entitled However low interest rates might go, the IRS will never act like a bank, Miles Kimball and his brother rebut one of Cochrane's supposed exits; the Internal Revenues Service. I've responded to Cochrane's other schemes here.

Think of Cochrane's exits as arbitrage opportunities. As nominal rates plunge into negative territory, the public gets to harvest these outsized gains at the expense of institutions that issue 0% nominal liabilities. The Kimballs' point (and mine here) is that because these institutions will lose money if they continue to issue these liabilities, they will implement policies to plug the holes. Cochrane's multiple exits aren't the smoking gun he takes them to be.

In a new post, Cochrane tries to salvage his argument by making an appeal to symmetry. He points out that in the symmetrical casea world with positive inflation and higher nominal rateswe don't actually observe people adopting the sort of behavior that Miles believes they would adopt in a negative rate world. So in practice, Cochrane doesn't believe that removing cash in order to implement negative interest rates will work.

This is a fair tactic to take. In general, people should demonstrate similar behavior whether nominal rates are positive or negative. However, is it true that in an environment with positive inflation and high nominal rates, institutions issuing liabilities (or those purchasing those liabilities) allow themselves to be systematically made the targets of arbitrage?

Take Cochrane's main example; gift cards. As I described here, once rates fall deep into negative territory, retailers will simply stop issuing gift cards since they won't care to earn a negative spread. Cochrane's appeal to symmetry implies that gift card issuers behave differently when rates are positive. Well let's imagine that rates are at 5%. An issuer of 0% gift cards is certainly not setting itself up to be arbitraged—in fact, given that it is funding itself at 0% in a 5% yield environment, it will be earning an excess return on each card issued. Nor will the liability-using public choose to subject itself to the money-losing obverse side of the trade. People can simply choose to avoid investing in 0% gift cards in favor of a 5% alternative. Likewise for the other liabilities that Cochrane mentions. Rather than prepaying taxes and earnings 0%, the public will pay at the last moment and harvest a 5% return until then. Instead of delaying the cashing of a check, they'll deposit it the day they receive it in order to earn interest.

So when interest rates are positive, people will try to avoid behaviour that allows them to be taken advantage of, whether they be an issuer or buyer or liability. Symmetrically, it follows that this same behaviour should prevail when rates are negative.

In his post, Cochrane seems to be changing the subject of the conversation from arbitrage to the indexing of contracts. His point is that during periods of positive inflation and high interest rates, nominal payments were not indexed to the nominal interest rate. His example is the IRS, which does not offer interest for early payment when market interest rates are high. Factually he is right. But this criticism is besides the point. The IRS doesn't offer interest to those who pay their taxes early because prepaid taxes aren't the government's main form of funding, treasury debt is. If the government's main form of financing *was* to offer savings accounts to tax payers, then you can be sure that those accounts would have to promise nominal payments that rise in line with the market's nominal interest rate—otherwise no one would open an account and the government would suffer a cash crunch. Nor would the government offer an excess nominal rate, since every American would exploit the situation and open an account—at the government's expense.

No one wants to be the dupe and end up on the wrong side of an arbitrage. If anyone is arguing for asymmetry, it is Cochrane. He needs to explain why liability issuers and users would exhibit such a degree of irrationality as to allow themselves to be exploited as rates fall into negative territory, but so rational as to avoid being exploited at positive rates.


  1. I think the negative interest rate discussion needs some re-framing.

    Consider a producer of a product, who is an employer.

    Assuming positive interest rates, our producer can go to a lender with the following offer: "Loan me some money and I will share the results of my business with you.".

    Assuming negative interest rates, our producer would have less incentive to go to a lender. Instead, he would go to his laborers and suppliers and say something to the effect of "I am paying a TAX to the bank every time I hold money. You have the same problem. Let's use as little money as possible. With your approval I will pay you only as much as you must have for unavoidable expenses."

    So, whoa on the whole idea of negative rates. The banks would want to lend early and lots, so someone else would take the capital loss. The borrower would be discouraged from borrowing early because he would take a capital loss on any idle funds. The receiver of money for labor or services would want to unload the money (a foolish thing to do) so, unless he needed the money, he would urge delay of payment. Negative rates begin a march away from unrestricted use of money for transactions.

    1. I'm not following you. Assuming negative interest rates, our producer has more incentive to go to a lender, not less, since they are being paid to take on the loan.

  2. Maybe I am confused.

    I expect to have interest paid on my bank deposits. This would be positive interest rates, and I would report the interest to the government as income.

    If there was negative interest rates on my deposits, I expect that I would pay the bank for holding my account. That would be an expense and I would report that expense to government to reduce my taxable income.

    So why would negative interest rates be positive to me as a producer?

    1. All things staying the same, a negative interest rate dissuades a producer from lending to a bank. The producer will want to keep less deposits, or reduce their net long position in deposits. That same negative interest rate encourages a producer to borrow from the bank. In other words, they will want to increase their net short position in deposits.

  3. Wouldn't the real escape just be any assets that will hold value and hasn't it already been happening for a while?

    1. A negative interest rate policy is designed to trigger people into taking those escapes. People will retreat into houses, gold, consumption goods, education, etc.

    2. Ok, thanks JP, so do you have any thoughts about how this thing will end? What will make the 36 years or so trend of falling interest rates stop and reverse?

    3. Dan, I wish I knew the answer. But there is no fundamental reason that a reversal needs to occur. As long as inflation stays low, and even turns to deflation, and bonds continue to become more like cash, then rates can keep falling for much longer.

  4. A very simple example of the symmetry at higher rate levels:

    Starting at a high level of rates, when the Fed or the Bank of Canada drops their administered funds rate, that will force down market rates in general, which in turn forces commercial banks to compete with their own lending rates. Banks will respond in addition to that by dropping their administered liability rates (savings accounts, term deposits, etc.). They do this to preserve core net interest margins.

    That's the same kind of directional liability management defensiveness that is required in zero bound territory.

    To the extent that we all tend to have a carved out net interest margin of sorts, we all behave like banks.

    For that reason, I was underwhelmed by the linked post on IRS behavior.