According to popular thinking an easy interest rate stance and monetary pumping by the Fed encourages borrowings and spending. More spending leads to a stronger economic growth and more employment.
It is however held that this time around an easy interest rate stance and money pumping are not working. Not only bank’s are reluctant to lend but also individuals are clinging to their money thereby weakening the aggregate demand and weakening prospects for economic recovery.
So how could the Fed force people to spend more?
The former White House Chief Economist and currently a Harvard professor of economics Gregory Mankiw offers a solution to this dilemma. (It May Be Time For The Fed To Go Negative — The New York Times April 19,2009).
Mankiw suggests that the US central bank could do the trick by offering negative interest rate.
Why not lower the target interest rate to, say, negative 3 percent? At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.
But who is going to lend at negative interest rates?
Our Harvard professor offers the following solution to this dilemma. Mankiw suggests that the Fed could announce that a year from now all money with a serial number, between zero to nine, which is randomly selected, will no longer be legal tender.
Suddenly, the expected return to holding currency would become negative 10 percent. That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10. Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw — it’s a benefit.
The threat of confiscating people’s money (Mankiw calls it a tax on money) will force them to spend it — precisely what is needed to revive the economy, says Mankiw. He also of the view that a tax on money will also force banks to reduce their excess cash and boost lending.
In the week ending April 15 commercial bank loans stood at $5,996.7 billion — a fall of 1.6% from the end of January and a fall of 2.2% from November last year. (The data is adjusted for large commercial bank acquisitions of non-bank institutions in the week ending October 1 2008).
Banks surplus cash has continued to pile up. In the week ending April 22 banks excess reserves stood at $862.39 billion — an increase of $91.12 billion from the end of March. Note that between January 2000 to August 2007 the average level of excess reserves stood at $1.6 billion.
Another idea to boost spending, according to Mankiw, is that the Fed must commit itself to produce inflation ahead. In this case, borrowing at zero interest rate and repaying the debt with devalued dollars will provide an incentive to borrow and spend.
What however, drives the economy is not demand as such but the production of goods and services. The more goods an individual produces the more of other goods he can secure for himself.
This means that an individual’s effective demand is constrained by his production of goods. Demand, therefore cannot stand by itself and be independent — it is limited by production.
According to James Mill,
When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation’s power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation…. Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.
If a population of five individuals produces ten potatoes and five tomatoes — this is all that they can demand and consume. No government tricks can make it possible to increase effective demand. The only way to raise the ability to consume more is to raise the ability to produce more. (Neither printing money nor tax on holding money can strengthen the ability to produce more).
The dependence of demand on the production of goods cannot be removed by means of loose interest rate policy and monetary pumping, or government threat of confiscating people’s money.
On the contrary the loose Fed’s interest rate stance and money printing will only impoverish real wealth generators and weaken their ability to produce goods and services — weaken the effective demand.
 James Mill, ‘On the Overproduction and Underconsumption Fallacies’. Edited by George Reisman, a publication of the Jefferson School of philosophy, Economics and Psychology — 2000.