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Why Should the Risk Free Interest Rate be Zero When the Government Creates its Own Money?

ByShaun Snapp

Executive Summary

  • This article covers a logical risk-free interest rate under the scenario where the government creates its own money.

Introduction

The explanation for a zero percent interest is found in the following quotation.

“Under a state money system with flexible 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 collection, 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) 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 (overnight interbank lending rate, or Fed funds rate in the United States). 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 economy. 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 experience 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. Under a state currency system with floating exchange rates, the natural, nominal, risk free rate of interest is zero.”

Source: Mosler Economics

http://moslereconomics.com/wp-content/graphs/2009/07/natural-rate-is-zero.PDF

Under the government-created debt-free money model, the risk-free rate can be zero percent. Obviously, higher rates would happen for higher risk levels. A government that creates its own money has a question to answer whether it charges interest and how much and how much in taxes. The government does not need revenues from either of these sources, but there are still policy goals necessary to keep some charge on interest in cases of risk and create a demand for the national currency. And collecting taxes is a primary way to create demand and value for a national currency.