A Negative Interest Rate?

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In the past few days, I have come across this question multiple times: “What would happen if there was a negative interest rate?”

First, let me define a positive, then a negative, interest rate.  Banks want us to give them our money so that they can lend it to others.  The bank pays us to give it our money then charges a premium to others to borrow that same money.  A negative interest rate would result in us paying the bank while we give it our money.  This is not entirely unfeasible; in fact, with the recent rise in bank fees, this may be the case for some smaller accounts. 

In a piece in Slate Online Magazine by Matthew Yglesias, which I commented on in my last post, Yglesias describes a negative interest rate as “in effect a tax on holding cash in the bank”.  He continues with the logic that if this were the case, we would all store money in shoeboxes.  That is, unless there was no physical money only “electronic” currency that we were forced to pay this “tax” on.  Then, he argues we could stimulate demand by “raising this tax” or equivalently making the interest rate more negative.

But even in the simple model economy I described in my last post (The Economic Overlapping Generations Model), a negative interest rate results in saving.  Specifically, by the need to store the value of current production.  The Value of Money is based on our need to store value not in the interest rate that we receive from the bank.

The Value of Money

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This past week Matthew Yglesias wrote two pieces for Slate that underestimate the value of money in our society.  His first piece was about eliminating paper money, where he argued that we could end recessions by eliminating paper currency.  In a blog post this Friday, he argued about the “Irrelevance of Money.”  None of Yglesias’ comments are directly untrue; in fact, the first paints a clear picture of how the cash we hold and the interest rate we receive drive spending decisions.  Yglesias does however, hide the other two main sources of value of money.

The origins of money are as a trading tool.  A currency, whether gold, silver, or printed paper, facilitated and continues to facilitate trade.  My cart full of corn for your week’s labor is a difficult trade if there is no means of payment beyond barter.  This is the most obvious use and value of money.

But money as a storage of value over time is money’s main source of value, and opposite to Yglesias’ claims, its obvious relevance.  Economists model the value of money using a model called “Overlapping Generations,” first formulated by Irving Fisher, then expanded upon by Paul Samuelson and Peter Diamond.

The non-mathematical description of the model and subsequent formula for the value of money goes like this:  When we are in our working age (the first generation), we generate income but in our later years we do not generate income.  Subsequently, we need to store our income from our younger years to our older year.  The way we do that is money.  Food rots and houses deteriorate, when we are not generating an income, we need to be able to provide by delaying consumption from our early to latter years.  In the model, the young “sell” services and goods to the old for “money,” and when the young turn old, they buy services from the new young generation, and so on.  In the “Overlapping Generations Model,” money increases utility and that increase has subsequent value.

Yes, money is the cause of many evils in the world, but money is not the sole cause of recessions as Yglesias claims.  Besides the everyday ease money creates in facilitating transactions, money is a necessity as a means of transferring wealth over time.