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Japan joins the negative rates club

Nothing wrong about negative benchmark rates

Haruhiko Kuroda, the boss of Bank of Japan, has shocked the markets and lowered the benchmark interest rate to minus 0.1 percent, with the commitment to do anything (including further moves below zero) to tear the deflationary expectations away from people's minds. Kuroda has joined Mario Draghi of ECB who has already dragged some rates beneath zero.

Most of us – including your humble correspondent – have the intrinsic feeling that negative interest rates (and even zero or low positive rates) are "sick". But if we are a little bit more careful and rational about "what is sick" about the negative values, I think that we must conclude that certain rates may be healthy when they're below zero.

These benchmark rates are pretty much analogous to the Federal Funds Rate in the U.S. What are they? Well, banks (and credit unions etc.) have some lower limit on their mandatory reserves. This arrangement exists to discourage "too intense" lending by the banks which could increase their profit but also increase the probability that they go bust at some point. I don't like regulation in most of the forms but I have reconciled myself with the idea that some regulation of the financial institutions' reserves is crucial for the financial system to work. Perhaps, some "mandatory transparency" (or verification that banks don't cheat when they are "voluntarily transparent" – which is improving the attractiveness of a financial institution) could play the same role: the ordinary people, instead of the central bankers, could be the watchdogs.

The attractiveness of high profits is too high – and the problems resulting from bankruptcy may sometimes be too low. So someone should check that those things are not happening much, that banks are only lending what they can afford to lend, what they really safely possess.

Fine. So each bank has to have some minimum reserves according to the law, calculated out of its other financial parameters. These reserves of all these banks are held somewhere in the central bank. The financial institutions may lend these reserves to other banks. Well, you may only lend some of the reserves if your reserves are above the required lower limit. Typically, a bank that has too much money in reserves and doesn't know how to lend them to commercial subjects is lending to a bank that knows how to lend the money to someone else.

And the interest rate at which these two banks are lending the money (physically located in the central bank) to each other is the benchmark rate. Is it wrong when it's negative?

What's wrong about a negative-rate savings account? It's wrong because for the individual depositor, it's better to keep the cash under the mattress. (At least in a system where "unverified" physical banknotes are allowed.) The important detail you should notice is that the saver has a choice whether he puts the money to a bank or to a mattress. And the mattress seems to guarantee 0% yields. Because of this choice, negative-rate saving accounts are basically uncompetitive.

Now, the situation is different in the case of the banks' reserves. The banks don't have the alternative option to put the money under the mattress. Well, at least the minimum reserves have to be located in the central bank because that's what the law says. In practice, the banks will always have much more money over there. So at least for the required money plus the money that accompany them, you won't face any "paradoxical situation" if you impose a negative rate on these loans (especially if the absolute value of the negative number is lower than one percent). This negative rate is an incentive for the banks to lend the money to commercial subjects – which helps to accelerate the economy and/or increase the inflation rate.

I think that the reduction of the minimum required reserves (perhaps in combination with a commitment to save the bank under certain circumstances) would have a similar effect but the constant minimum reserves combined with the negative benchmark rate is a more "egalitarian" way to approach all the banks.

There's obviously the risk that everyone sees that the central bank will be led to drag the rates even lower to the negative territory – so that even the saving accounts may want to have negative rates at some point, and that would lead to the paradoxical situations. But to charge a negative interest rate on some money that is "obliged" to be there, anyway, isn't directly creating paradoxical situations, I think. This part of the lending of the reserves is fully "regulated", anyway, so it's part of a country's monetary policy, you would say, which is why the free market isn't terribly useful in such transactions.

If the deflationary conditions seem to continue, it would look rather natural to me if the banks in non-inflating countries dragged the benchmark rates to the negative territory where positive saving account rates are still possible.

Bank of Japan has also vowed to continue its version of quantitative easing without changes.

I still think that it would be natural for central banks to start buying stocks and not just bonds – those could be much more effective methods to get the money to the economy and to reduce the random fear factor. Falling stock markets are among the most reliable signs of economic trouble ahead – and arguably major causes of coming economic troubles, too. The stock purchasing system may be viewed as a government's support mainly for those who are able to invest wisely and create jobs. Yes, it would help to increase the "wealth inequality" in the world as well – which is a very good thing. Also, the situation in which central banks hold substantial amounts of stocks could be understood as "backing of the currency by stocks". If you imagine that stocks are the only positive holdings in the balance sheet of a central bank, it would be, in some sense, literally true that the currency is backed by stocks.

Now, governments may hold much more stocks, too. You don't want them to control the majority of companies because that's socialism. (I think that the voting rights coming with these government-held stocks in this system should be surrendered, anyway.) But I think it would be "cleaner" if companies with stocks weren't paying any corporate income taxes at all. Instead, the governments would be getting these revenues – previously obtained from corporate taxes – in the form of dividends and/or capital gains connected with this stock.

Quite literally, governments could make a deal with all stock companies to switch to a new system in which the companies don't pay any corporate taxes (and perhaps its employees don't, either). But the company would issue a new package of stocks that would be owned by the government. Their amount would be such that the decrease of the stock price of the remaining stocks held by regular investors (due to the increase of the number of stocks) would exactly compensate the increase of the stock price from the knowledge that the company no longer has to pay taxes, and will therefore have higher profits.

At some level, you could view this change as a purely administrative change. The companies could be paying the money to the government and call it dividends, not taxes. But this setup would "feel" much better. The government wouldn't be a Mafia gangster who is blackmailing companies and stealing a fraction of their income (taxes are a form of racketeering). Instead, it would be another fair stockholder who gets his (or their) income just like everyone else.

This setup could easily and obviously replace the tax revenue from the same companies. But so far, it seems that it couldn't be enough to replace all taxes. I was thinking what the alternative sources for the government to replace all taxes – including those from much smaller companies and individuals – could be but I don't have a clear answer yet. But many more similar changes should be made to attach a more human face to the governments – even if the total amount of redistribution doesn't drop. With some sales or value-added taxes on top of the dividends, I am confident that income taxes (and some other types of taxes) could be entirely eliminated.

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