Normally, when a sovereign country gets into financial trouble (generally because of too much debt), it will devalue its currency so that the prices of products it imports go up and labor costs and the prices of products it sells abroad go down. But since Greece could not devalue its currency (the euro), it was essentially forced to allow its labor costs to fall drastically. Since it is basically impossible to go to everyone in Greece and say, “You need to take a 25% cut in your pay, even though the prices of everything you’ll be buying will still be in euros,” the real world simply produced massive Greek unemployment – precisely what you would expect in a deflationary depression. Greece will likely continue to suffer for a very long time, whereas if the Greeks had left the euro, defaulted on their debts, and devalued their currency, they would likely be enjoying a quite robust recovery.

Greece’s present is a possible near future for other countries in Europe (Portugal is likely to be next, and Italy will surprise everyone with its severe banking problems), which is why the European Central Bank is so desperately fighting the deflationary impulse embedded in the very structure of the European Union.

Now, the United States is clearly not Greece. However, we are subject to the same laws of economics.

By definition, recessions are deflationary. Whenever we enter the next recession, we are going to do so with interest rates close to the zero bound. Most of the academic research both inside and outside the Fed suggests that quantitative easing, at least in the way the Fed did it the last time, is not all that effective. If you are sitting on the Federal Reserve Board, you do not want to allow deflation to happen on your watch. So what to do? You try to stimulate the economy. And the one tool you have at hand is the interest-rate lever. Since rates are already effectively at zero, the only thing left is to dip into negative-rate territory. Because, for you, allowing a deflationary malaise to set in is a far worse thing than all of the potential negative consequences of negative rates put together. It’s a Hobson’s choice; you see no other option.

Let’s do a little sidebar here. There’s lots of discussion in the media of the possible moves the Federal Reserve could make. Some people talk about the Fed’s buying the government’s infrastructure bonds, or buying equities or corporate bonds, or even doing the infamous “helicopter drop” of money into outstretched consumer hands. Those are not legal options for the Fed. The Fed is actually fairly restricted in what it can purchase. All of these outside-the-box transactions would require congressional approval and amendment of the Federal Reserve Act.

I can tell you that there is almost no stomach in the leadership of Congress or at the Fed to bring up the Federal Reserve Act for congressional action. Everyone is worried about potential mischief and political sideshows. Quite frankly, if the Federal Reserve decides that it wants to do more quantitative easing, I would much prefer that Congress authorize the Fed to purchase a few trillion dollars of 1% self-liquidating infrastructure bonds – or, as a last resort, to do an actual helicopter drop. The infrastructure bonds would create jobs and give our children something for their future, a much healthier outcome than the ephemeral boosting of stock and bond prices yielded by the last rounds of quantitative easing. In those instances, the benefits of QE went primarily to the well-off. But I digress.

The reigning academic orthodoxy for central bank believers is Keynesianism. Saint Keynes postulated that consumption is the fundamental driver of the economy. If the country is mired in recession or depression, then government and monetary policy should be geared toward increasing consumption in order to spur a recovery. Keynes argued that the government should be the consumer of last resort, running deficits as deep as necessary during recessions. (He also advocated paying down the debt during the good times, prudent advice roundly ignored.)

The current belief in vogue is that another way to increase consumption is to get businesses and consumers to borrow money and spend it. Hopefully, businesses will invest it and create new jobs, which will in turn enable more consumption. One way to stimulate more borrowing is to lower the cost of borrowing, which the Federal Reserve does by lowering interest rates. The opposite is also true: if inflation is a problem, the Fed raises rates, taking some of the inflationary steam out of the economy.

How would negative rates work? The Federal Reserve would charge a negative interest rate on the excess reserves that banks deposit at the Fed. Note this is not a negative interest rate on all deposits, just on “excess reserves” on deposit at the Fed. An excess reserve is a regulatory and political concept that is a necessary feature of the fractional reserve banking systems of the modern world. Banks are required to maintain a reserve of their assets against possible future losses from their loan portfolios. The riskier the assets the banks hold, the less those assets count towards the required level of reserves. Reserves are required to keep a bank solvent. Banks are closed and sold off when their reserves and capital are depleted below the allowed levels.

Any reserves in excess of the regulatory requirements are counted as “excess.” The theory is that if the central bank charges banks interest on their excess reserves, the banks will be more likely to lend that money out, even if at a lower rate, in order to at least make something on those reserves. Right now, banks are paid by the central bank for their excess reserves on deposit. Given the level of excess reserves at the Fed, these interest payments amount to multiple billions of dollars that are fed into the banking system each quarter; and that is one of the reasons why US banks have been able to get healthier in the wake of the Great Recession.

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