Miles Kimball: «Sovereign wealth funds could stabilize financial markets and would earn money by profiting from high risk premia.»
Professor Kimball, the Fed kept interest rates last week unchanged. What is your take on the current policy of central banks?
Central banks worry about the current environment. The tightening cycle seems to be coming to an end. It is about a balance of risks. From a political perspective, it might be easier now for the Fed and other central banks to keep rates unchanged or lowering them rather than increasing them. If a central bank raises rates in the current environment, people will blame it if the economy does badly. By contrast, it seems less risky to be lenient: if inflation heats up, inflation will just be moving in the direction of the inflation target. At this moment, politics and good policy are aligned. One positive factor is that long-term yields are much lower.
How is that positive?
During and after the financial crisis the expectations of interest rates were too high, the expectations turned out to be wrong as interest rates stayed low. Now the situation has changed: long-term yields and expectations for future interest rates are low. The reason is that markets know the playbook of central banks: how they would deal with an economic downturn with all the new policy tools. The last time the markets didn’t know that. This is positive for the economy, because long-term rates matter as well as short-term rates for the economy. And long-term rates depend on expectations of future central bank policy. However, given where it is now, the Eurozone could be in trouble if the ECB feels it can’t lower rates any further.
Do you mean you think the ECB should set negative rates further below zero?
Yes. Things are not going that well in the Eurozone. In comparison, Japan appears to have a much stronger recovery. The ECB should think of its next move, especially how to set lower rates. There is one easy thing they could implement that would open the way to set rates considerably lower.
What do you propose?
The immediate concern about negative rates is not yet that people would store paper currency, but a concern about bank profits and a concern that there would be bad headlines if savers faced negative interest rates on their accounts. Central banks should subsidize the provision of zero interest rates in checking and savings accounts, up to a limit. Then checking and savings accounts with balances under that limit would not be affected by negative policy rates. You could tell people: We are implementing negative rates in a way that shields regular people from negative rates in their checking and savings accounts.
But wouldn’t that dilute the effect of a negative interest rate policy?
It is totally misguided to think that negative rates on small checking and savings accounts are a crucial part of the transmission mechanism. A few thousand dollars per person could be exempted without any serious harm to the transmission mechanism. Those with large amounts in checking and savings accounts would still be subject to negative rates, and it is the interest rate on the last dollar or euro or franc in large accounts that matters for transmission.
How do you answer concerns that negative rates are a burden for bank profits?
Central banks do worry about the effect on bank profits when negative interest rates reduce net interest margins. But the main way in which negative rates reduce net interest margins is that banks are reluctant to reduce rates on checking and savings accounts below zero. If the central bank subsidizes zero rates for small checking and savings accounts, it deals with this in two ways: first, with the subsidy, bank profits do not suffer from providing zero rates to small accounts, and second, the limit on the quantity of checking and savings that can get the subsidy makes it easier for banks to explain why they need to have negative rates on large accounts beyond that level.
Are there other ways to help banks in a negative rate environment?
Even if a central bank doesn’t want to subsidize zero rates for small accounts, there are many ways in which central banks can effectively throw money at commercial banks to help their balance sheets. The question is more whether it is politically viable to throw money to commercial banks—and the answer is yes if it is done in the right way. In the Eurozone, the LTRO programs offers banks cheap liquidity to do more lending. And in Switzerland, you have tiered reserves, which excludes some bank reserves from negative rates. Nevertheless of concerns about net interest margins, which the subsidy for zero rates on small accounts takes care of, negative rates are helpful to bank balance sheets. First, banks profit from capital gains when interest rates decreases. Second, banks benefit from a more robust economy as fewer people and businesses default.
The Fed stopped its interest rate hikes not only due to macroeconomic news but also due to financial market turmoil. Should financial markets influence monetary policy?
I am not sympathetic to the idea that central banks should observe the stock market closely. There is too much noise trading. The conditions in the stock markets are not very important for the capital costs of companies; stock prices affect financing costs directly only when a firm does an IPO. What is more important is the risk premium observable in the market for commercial paper or junk bonds. There is research suggesting it would be better monetary policy if rates were routinely cut almost one-for-one if the spread between commercial paper rates and Treasury bill rates, or the spread between junk bond rates and Treasury bill rates increases beyond what can be justified by increased default risk. Though this policy can be justified without any reference to financial stability, it also helps improve financial stability.
What if a central bank is not ready to implement deep negative rates?
One solution would be to finance a sovereign wealth fund by issuing Treasury bills. This is much safer than borrowing to spend money with the idea of using fiscal policy to stimulate the economy. I think it is much better to add debt to buy assets than to add debt to increase government spending. Sovereign wealth funds could stabilize financial markets and would earn money by profiting from high risk premia. Organizationally, they should be independent of Central Banks as they require a different kind of expertise.
When advocating intervention in financial markets, you seem to mistrust markets.
I defer to the market microeconomically, but not macroeconomically. If the government wants to intervene in a microeconomic way, there should be a high burden of proof. However, markets by themselves do a bad job stabilizing the economy at a macroeconomic level. There are chronically high risk premia, fluctuations are too large, and sticky prices lead to regular business cycles. I also don’t agree with free bankers who say that a private market should be responsible for monetary policy. Governments have a large risk-bearing capacity, that political entrepreneurs will try to use in one way or another—typically by government guarantees that are off budget but often cost taxpayers dearly when something goes wrong and the government has to pay up on the guarantee. This applies also to the need for the government to do bailouts if the economy would otherwise fall apart. With a sovereign wealth fund, taxpayers would not only bear the risks but would also gain the profits from this risk-bearing capacity. And done right, a sovereign wealth fund would add to financial stability and so make it less likely that the government would need to do a bailout. However, higher capital requirements, beyond those currently mandated, are the real key to greater financial stability.
What do you think of Modern Monetary Theory, which advocates using debt-financed fiscal policy to have full employment?
I think in an extreme interpretation MMT is technically not correct. In a not so extreme interpretation, it is equivalent to standard economic theory—which means it would have none of the new implications MMT folks are claiming. But even if MMT is not correct, it might be politically helpful and I welcome a diverse field of opinions. Here is how it might be helpful: government spending is currently not responsive enough to the level of interest rates – if interest rates are low, spending—especially government spending on genuine investments that will raise government revenue later on—should be higher. However, I don’t think fiscal policy should do the job of monetary policy to stabilize the economy. Whenever I hear a central bank president saying they need more help from fiscal policy, I want to say: “Don’t wait for fiscal policy—do your job!” If their tools are not sufficient, they should innovate to add new tools to their toolkit.