http://moslereconomics.com/wp-content/u ... s-Zero.pdfJOURNAL OF ECONOMIC ISSUES
Vol. XXXIX No. 2 June 2005
The Natural Rate of Interest Is ZeroMathew Forstater
and
Warren Mosler
This paper argues that the natural, nominal, risk free rate of interest is zero under rele-
vant contemporary institutional arrangements. However, as Spencer Pack reminded us,
“[n]atural and nature are complex words, fraught with ambiguity and contradiction”
(1995, 31). The sense in which we wish to employ the term natural here does not imply a
“law of nature,” which may be why “[Alfred] Marshall replaced the evocative label ‘natu-
ral’ with the more prosaic ‘normal’” (Eatwell 1987, 598). Marshall may have clarified it
the best when he wrote that “normal results are those which may be expected as the out-
come of those tendencies which the context suggests” ([1920] 1966), 28, emphasis added).
In this case, it is of the utmost importance to first clarify the context, to which we now
turn.
State-Issued Currency
The primary, defining institutional arrangement characterizing the relevant con-
text is that of a “tax-driven” state currency and flexible exchange rates. By state currency
we mean to indicate there is a government that taxes and has a monopoly of issue. A flexi-
ble exchange rate is commonly referred to as a “fiat” currency, in other words, a
state-issued currency convertible only into itself (Keynes 1930), as opposed to a fixed
exchange rate policy such as a gold standard or other convertibility to any other com-
modity or currency fixed by the state of issue (such as currency boards, pegged curren-
cies, or monetary unions). Examples of such monetary systems currently include the
United States, Japan, and most of the world’s industrial economies, including the
Eurozone, although the individual nations are no longer issuers of their currency.
There is a long tradition of analysis of state currency, or “state money,” referred to
by Charles Goodhart as the “cartalist” (or chartalist) school of monetary thought and
which he has contrasted with the “metallist” (Mengerian, monetarist) tradition (1998).
While authors such as Joseph Schumpeter (1954) passed down a view of chartalism with
a misplaced emphasis on “legal tender” laws, resulting in something of a “legal” or “con-
tractual” version of chartalism, Goodhart has made clear that the fundamental insight is
that the power of the state to impose a tax liability payable in its own currency is sufficient to cre-
ate a demand for the currency and give it value. Recent research into the history of economic
thought has revealed substantial evidence of past support for this thesis regarding
tax-driven money: we now know that, throughout history, many more economists
understood the workings of tax-driven money, and many if not most currencies in his-
tory were in fact tax-driven, contrary to what was previously thought to be the case (see,
e.g., Wray 1998, 2004; Bell and Nell 2003; Forstater forthcoming).
The idea of a tax-driven currency was once common knowledge. It can be found in
the writings of economists and others going back to Adam Smith and beyond. Smith
well understood that taxation is the key to understanding the value of state money (in
fact, he used the American colonies’ issue of paper money as an example—see Smith
[1776] 1937, 311–312). So did a diverse array of economists that came after him, includ-
ing John Stuart Mill, William Stanley Jevons, Phillip H. Wicksteed, and John Maynard
Keynes, among many others (see Forstater forthcoming).
A key distinction is that between the government as issuer of a currency and the
nongovernment agents and sectors as users of a currency. Households, firms, state and
local governments, and member nations of a monetary union are all currency users. A
State with its own national currency is a currency issuer. The issuer of a national currency
operates from a different perspective than a currency user. Operationally, government
spending consists of crediting a member’s bank account at the government’s central
bank or paying with actual cash. Therefore, unlike currency users, and counter to popu-
lar conception, the issuer of a currency is not revenue constrained when it spends. The
only constraints are self-imposed (these include no-overdraft provisions, debt ceiling
limitations, etc.). Note that if one pays taxes or buys government securities with actual
cash, the government shreds it, clearly indicating operationally government has no use
for revenue per se.
When the U.S. government makes payment by check in exchange for goods and
services (including labor), or for any other purpose, the check is deposited in a bank
account. When the check “clears,” the Fed (i.e., government) credits the bank’s account
for the amount of the check. Operationally, “revenue” from taxing or borrowing is not
involved in this process, nor does the government “lose” any ability to make future pay-
ments per se by this process. Conversely, when the U.S. government receives a check in
payment for taxes, for example, it debits the taxpayer’s account to the amount of the
check. While this reduces the taxpayer’s ability to make additional payments, it does not
enhance the government’s ability to make payments, which is in any case operationally
infinite. In the case of direct deposit or payment by electronic funds transfer, the govern-
ment simply credits or debits the bank account directly and, again, without operational
constraint. The government of issue in such circumstances may be thought of as a
“scorekeeper.” As in most games, there is no reason for concern that the scorekeeper
will run out of points. On the other hand, nongovernment agents can only spend when
in possession of sufficient funds from current or past income, or from borrowing. They
are indeed revenue constrained—their checks will “bounce” if there are not sufficient
funds available.
Given that a government of issue is not revenue constrained, taxation and bond
sales obviously must have other purposes (see Bell 2000). As we have already seen, taxa-
tion (and the declaration of what suffices to settle the tax obligation) serves to create a
notional demand for the government’s (otherwise worthless) currency. The process can
be viewed in three stages:
1. The government imposes a tax liability payable in its currency of issue.
2. Faced with this need for units of the government’s currency, taxpayers offer
goods and services for sale, asking in exchange units of the currency.
3. The government “issues” its currency—spends—in exchange for the goods and
services it desires.
The nongovernment sector will be willing to sell sufficient goods and services to the gov-
ernment to obtain the funds needed to pay tax liabilities and satisfy any desire to net save
(financial assets) in that unit of account. Note that, from inception, and as a point of
logic, in order to actually collect taxes, the government, as the monopoly issuer of the cur-
rency, must, logically, spend (or lend) first. Note that it would be logically impossible for
the government to collect more than it spends (or run a budget surplus) unless it had
already previously spent more than it collected (past budget deficits). Thus the normal
budgetary stance to be expected under these institutional arrangements is a budget
deficit.
The government budget deficit is also “normal” in the sense that it is the mirror
image of the nongovernment surplus in the basic macroeconomic accounting identity:
Government deficit = Nongovernment surplus
where nongovernment surplus includes both the domestic (or resident) private sector
and the foreign (nonresident) sector, which includes foreign firms, households, and gov-
ernments. It is therefore equivalent to the well-known identity:
(G – T) = (S – I) + (M – X)
Government budget deficit = Domestic private sector surplus + foreign sector surplus
where the foreign sector surplus is another way of expressing the trade deficit. The gov-
ernment budget deficit permits both the domestic private sector and the foreign sector to
“net save” in the government’s unit of account. Only a domestic government budget defi-
cit permits the domestic private sector and foreign sector to actualize their combined
desired net saving.
We are now in a position to demonstrate our proposition: the natural rate of inter-
est is zero. First, to reiterate the argument thus far: Under a state money system with flex-
ible exchange rates, the monetary system is tax driven. The federal government, as issuer
of the currency, is not revenue constrained. Taxes do not finance spending, but taxation
serves to create a notional demand for state money. Spending logically precedes tax col-
lection, and total spending will normally exceed tax revenues. The government budget,
from inception, will therefore normally be in deficit, which also allows the
nongovernment sector to “net save” state money (this in fact has been observed in all
state currencies).
The Natural Rate of Interest Is Zero
If spending is not revenue constrained, why does the government (conceived here
as a consolidated Treasury and Central Bank) borrow (sell securities)? As spending logi-
cally precedes tax collection, the government must likewise spend sufficiently before it
can borrow. Thus, government spending must also, as a point of logic, precede security
sales. To cite a “real world” example, market participants recognize that when Treasury
securities are paid for, increasing Treasury balances at the Fed, the Fed does “repos” on
the same day; the Fed must “add” so the Treasury can get paid.
Since the currency issuer does not need to borrow its own money to spend, security
sales, like taxes, must have some other purpose. That purpose in a typical state money
system is to manage aggregate bank reserves and control short-term interest rates (over-
night interbank lending rate, or Fed funds rate in the United States).
In the contemporary economy, government “money” includes currency and central
bank accounts known as member bank reserves. Government spending and lending
adds reserves to the banking system. Government taxing and security sales drain (sub-
tract) reserves from the banking system. When the government realizes a budget deficit,
there is a net reserve add to the banking system. That is, government deficit spending
results in net credits to member bank reserve accounts. If these net credits lead to excess
reserve positions, overnight interest rates will be bid down by the member banks with
excess reserves to the interest rate paid on reserves by the central bank (zero percent in
the case of the USA and Japan, for example). If the central bank has a positive target for
the overnight lending rate, either the central bank must pay interest on reserves or oth-
erwise provide an interest-bearing alternative to non-interest-bearing reserve accounts.
This is typically done by offering securities for sale in the open market to drain the
excess reserves. Central Bank officials and traders recognize this as “offsetting operating
factors,” since the sales are intended to offset the impact of the likes of fiscal policy,
float, and so forth on reserves that would cause the Fed funds rate to move away from
the Fed’s target rate.
Our main point is, in nations that include the USA, Japan, and others where inter-
est is not paid on central bank reserves, the “penalty” for deficit spending and not issu-
ing securities is not (apart from various self-imposed constraints) “bounced”
government checks but a zero percent interbank rate, as in Japan today.
The overnight lending rate is the most important benchmark interest rate for many
other important rates, including banks’ prime rates, mortgage rates, and consumer loan
rates, and therefore the Fed funds rate serves as the “base rate” of interest in the econ-
omy. In a state money system with flexible exchange rates running a budget deficit—in
other words, under the “normal” conditions or operations of the specified institutional
context—without government intervention either to pay interest on reserves or to offer
securities to drain excess reserves to actively support a nonzero, positive interest rate, the
natural or normal rate of interest of such a system is zero.
This analysis is supported by both recent research and experience. Japan’s experi-
ence in the 1990s shows clearly that large government budget deficits as a proportion of
GDP (in the neighborhood of 7 percent) and a debt/GDP ratio of 140 percent do not
drive up interest rates, as conventional wisdom would have it. In fact, the overnight rate
has stayed at near zero for nearly a decade. In addition, Scott Fullwiler (2004) has dem-
onstrated that concerns about technological change in financial markets and other
recent developments such as financial deregulation disrupting the interest rate channel
of monetary policy are misplaced. On the contrary, since the 1990s, market rates have
become even more closely linked to the Fed funds rate:
The fact that banks are obligated to use reserve balances to settle their custom-
ers’ tax liabilities ensures that a non-trivial demand for reserve balances will
exist, which itself ensures that the federal funds rate target will remain “cou-
pled” to other interest rates. (Fullwiler 2004)
That the natural rate of interest is zero is also supported by recent experimental evidence.
L. Randall Wray (2001) has reported on a community service program run in the Eco-
nomics Department at the University of Missouri—Kansas City. Students are “taxed” in
the department’s own currency and must perform community service to obtain units of
that currency. The department’s “treasury” could offer interest-earning “bonds,” pur-
chased by students with excess (non-interest-bearing) units of the school’s currency, but
the rate of interest offered is entirely up to the discretion of the departmental treasury. If
the treasury did not offer interest-earning bonds, the base rate on the currency would be
zero:
[T]he “natural base interest rate” is zero on . . . hoards created through deficit
spending. . . . [U]nless the Treasury chooses to intervene to maintain a positive
base rate (for example, by offering interest on bonds), deficits necessarily imply
a zero base rate. (Wray 2001, 50)
Note that deficits with the department’s currency are “natural” in the sense that they
result from the student demand to net save units of that currency.
The central bank clearly controls short-term interest rates in a state currency with
flexible exchange rates, and there are a number of good reasons for setting the overnight
rate at its natural or normal rate of zero and allowing markets to factor in risk to deter-
mine subsequent credit spreads (see Mosler 2004). The Japanese experience has already
demonstrated that this does not cause inflation or currency depreciation. If anything,
lower rates support investment, productivity, and growth. While changing rates can
have important distributional or micro effects (and that can spur employment and out-
put growth, such as shifting income from “savers” to working people), the net income or
macro effect is zero since for every dollar borrowed from the banking system there is a
dollar saved, as the Fed clearly recognizes in its literature. Additionally, it can be argued
that asset pricing under a zero interest rate policy is the “base case” and that any move
away from a zero rate policy constitutes a (politically implemented) shift from this “base
case.”
Interest Rates under a Fixed Exchange Rate Regime
While this paper focuses on a floating exchange rate regime, a brief summary of
interest rate determination in a fixed exchange rate regime offers context as well as con-
trast to the prior discussion.
Inherent in a fixed exchange rate is the risk of a government’s not honoring its
legally binding conversion features. Historical examples of this type of default in fixed
exchange rate regimes abound, and recent examples include Argentina’s and Russia’s
failing to honor conversion of their currencies into U.S. dollars at their central banks.
History is also filled with examples of default under various gold standards, with the
USA itself technically defaulting in 1934 when it both devalued the U.S. dollar versus
gold and permanently suspended domestic convertibility. Bondholders were subject to
this default as well since the U.S. dollars they received at maturity were subject to the
new terms and conditions.
Market forces translate this default risk into a term structure of interest rates.
Default risk is a function of maturity and creditworthiness, with the “risk free” rate
being the return on holding the object of conversion itself. So in contrast to a floating
exchange rate regime, where the term structure of interest rates is necessarily a political
decision generally reserved for the central bank, with a fixed exchange rate regime the
term structure of rates is a function of market forces.
In the case of a gold standard, the risk free rate is negative, as it is the storage charge
of holding physical gold. In fact, for all practical purposes, there is no such thing as “risk
free,” as physical gold can be stolen or otherwise lost even with the most sophisticated
security techniques. In the case of conversion into another government’s currency, such
as the U.S. dollar, the “risk free” rate is the risk free rate of U.S. dollar deposits, which is
the rate on U.S. Treasury securities or deposits at U.S. government–insured institu-
tions. This is the case today in Hong Kong, for example, where the risk free rate is that of
the risk free rate of the U.S. dollar.
With a fixed exchange rate, governments that spend by issuing currency and not
borrowing risk having those outstanding units of currency converted to the reserve cur-
rency (or gold, as the case may be) at the central bank. Therefore government borrowing
functions to protect central bank reserves and keep the government from defaulting on
its legal conversion requirements. Since holders of the currency have the option of con-
version to the reserve currency at the central bank, government securities can be
thought of as “competing” with the conversion option, with market forces determining
the indifference levels. This explains the very high interest rates paid by governments
with perceived default risk in fixed exchange rate regimes, in contrast to the ease a
nation such as Japan has in keeping rates at zero in a floating exchange rate regime,
despite deficits that would undermine a fixed exchange rate regime.
In recent history, today’s central bank systems with floating exchange rate policies
have followed fixed exchange rate (mostly gold standard) regimes. We suggest that policy
makers used interest rate data collected under these fixed exchange rate regimes as well
as their experience of using interest rates for reserve management and macroeconomic
policy under fixed exchange rate regimes to guide them after shifting to floating
exchange rates. The various correlations between interest rates and economic variables
were assumed to continue under the new floating exchange rate regime, including the
current notion of “real rates” versus “inflation,” and so on.
Mainstream analysis of the U.S. “twin deficits” is but one example of being “out of
paradigm” with respect to exchange rate policy. One reads daily of the USA facing a day
of reckoning due to “borrowing from abroad” to fund its imports. While this may have
had much validity under fixed exchange rate arrangements, with floating exchange rates
a current account deficit is instead the result of nonresidents realizing savings desires of
U.S. dollar financial assets. There is no “funding risk” for the USA nor are U.S. interest
rates per se a function of the trade balance.
Conclusion
Under a state currency system with floating exchange rates, the natural, nominal,
risk free rate of interest is zero. As many other key rates of interest in the economy con-
tinue to follow the Fed funds rate very closely, this will serve as the base rate in the econ-
omy, with markets determining the credit spreads through risk assessment.
Furthermore, there are a number of reasons why allowing the rate of interest to settle at
its natural rate of zero makes good economic sense. The conventional wisdom of a fixed
exchange rate system does not apply to floating rates, and this may be the source of
much of the confusion today.
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