A Modest Proposal Not Involving Irish Children*

By David L. Brown

I see from the news that on Tuesday the Federal Reserve is expected to lower interest rates to near zero. Here’s an excerpt from the Reuters story tonight:

WASHINGTON, Dec. 14, 2008 (Reuters) — The U.S. Federal Reserve is expected to drop interest rates close to zero on Tuesday, but anticipated remarks on unconventional methods to dispel a year-old recession are what will really matter.

Economists forecast a clear statement that the U.S. central bank will aggressively deploy so-called quantitative easing measures to shelter the economy from a steepening downturn, but do not expect details of what steps it will actually take.

Those words would accompany a decision by the Fed to lower its target for overnight rates by at least a half-percentage point, economists believe.

A half-point cut would take the bellwether federal funds rate to just 0.5 percent, the lowest on records dating to July 1954, as the central bank battles a recession many think will stretch well into next year.

Remember back in the 1990s when Japan took their interest rates down to zero? It took them more than a decade to even see daylight again after that. Well, I guess that proves that low interest rates aren’t necessarily sufficient to revitalize a sinking economy.

Or does it? I suggest that the problem with that conclusion is that central bankers never take the concept far enough—that is to say, to negative interest rates. When the Fed hits the rock bottom of zero, there’s nowhere else for them to go—or so they believe.

But think for a moment about what negative interest rates could achieve? Banks could borrow federal funds at, say minus five percent, and loan the money to customers at, say minus three percent while keeping a two point profit. The government would pay the banks $50,000 on every million they borrowed, and the banks would pay customers $30,000 on every million they loaned out. You could finance a million dollar house, for example, and the bank would pay you $30,000 a year. Sweet!

Now THAT would go a long way toward solving all our financial problems, wouldn’t you agree?

Actually, negative interest rates paid to banks would make sense only if the banks were required to lend out the money, and at appropriate negative rates, rather than just sitting on the cash. That way it would assure that the economy would be stimulated.

Of course even with negative interest rates there would still be the issue of the principal amounts on the loans. If you bought that million dollar house the negative interest would reduce your payment, but you’d still be required to pay back the principal. And (unless the tax code were to be changed) you’d owe taxes on the negative interest, instead of taking a deduction as you do when you pay positive interest. And finally, the amount of negative interest you would receive would decline as the principal is paid back.

Still, the benefit would be tremendous. It would be sure to stimulate the economy and unlike the concept of lowering interest rates only to zero and then stopping while the economy continues to fall, there would be no limit to how much rates could be reduced.

That would give the Fed the ability to keep applying stimulus until it had the desired effect, whether it took minus five percent, minus ten percent, or even lower rates. What a powerful tool that would be for stimulating the economy.

Of course this is nothing more than a pipe dream. The government would never actually just give taxpayer money to banks, would they? Would they? Oh, wait!

*Footnote: If you need to be reminded, in the 1700s Jonathan Swift wrote an essay titled “A Modest Proposal” in which he suggested as a solution to poverty and famine in Ireland that the Irish should eat their children. He was, of course, being satirical. I am not.

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