Making the case for negative interest rates

January 25, 2013, 7:15 PM UTC
Alan Blinder

FORTUNE — The nation’s biggest banks have been nursed by the Federal Reserve way too long, former Federal Reserve Vice Chairman Alan S. Blinder said Thursday as he kicked off the tour for his new book, After The Music Stopped: The Financial Crisis, The Response and the Work Ahead.

The Federal Reserve, says Blinder, should stop paying interest to banks for their overnight deposits and should move to charge them for parking money. He says if the Fed set negative interest rates for overnight deposits – in effect charging a fee – banks would have to figure out better ways to make money and one obvious alternative would be to lend more to customers.

The book, the 20th by the liberal Democrat economist who is the Gordon S. Rentschler Memorial Professor of Economics and Public Affairs at Princeton University, defends the U.S. government bailout prompted by the financial crash in the fall of 2008 as a job well done, while critiquing it as a misunderstood rescue that could have been done more cleanly. Blinder tries to adopt the perspective of middle class Americans who remain angry that the big banks stayed afloat with public money while doing little to help their retail customers during the bail-out.

Blinder, who joined the Clinton Administration’s Council of Economic Advisers in January 1993 before serving at the Federal Reserve from June 1994 through January 1997, says the central bank exercised its powers well to help the United States begin recovering from the September 2008 collapse of Lehman Brothers.

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Sparing no sitting ducks, Blinder blasts former President George W. Bush, former Treasury Secretary (and Goldman Sachs (GS) co-CEO) Henry “Hank” Paulson and their successors – President Barack Obama and Treasury Secretary Timothy Geithner – as communications failures whose collective silence about what was really going on amounted to public disservice.

While citizens fail to understand the positive role the Federal Reserve played, Blinder also says people have a right to be angry about the ongoing practice that encourages banks to keep their deposits out of general circulation.

“I have been advocating – and have not yet quite convinced (Federal Reserve Chairman) Ben Bernanke, although I am still working on it – that the Fed should lower, first to zero and then probably to negative, the interest rate it pays banks for holding reserves at the Fed,” Blinder said Thursday. “When I want to be polemical about it, I say things like: ‘My bank pays me one basis point on my checking account. Why are you paying my bank 25 basis points on their checking account?’”

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Implementing a negative interest rate is not hypothetical, Blinder explains. “The Danish National Bank paid banks negative 20 basis points. It’s a fee,” he says. “If you want to hold money on deposit there, you’re going to pay me. The Fed could do that. I believe if the Fed did that, the banks would not be eager to hold that money at the Fed and they would do something with it. It won’t just be sitting there, doing nothing. And costing the taxpayers 25 basis points.”

Interviewed by Fortune after the lunch, Blinder discussed some post-bailout hot topics, including former AIG CEO Maurice “Hank” Greenberg’s law suit claiming the government owes him money for causing the collapse of the international insurance giant.

Below is an edited transcript:

What is your take on the current AIG situation, the merit of Hank Greenberg’s lawsuit and the decision by the board not to participate?

The decision by the board was very smart. I mean, what a disastrous idea for the board to do that.

On the Greenberg suit, the courts will decide. As I look at it not from the lawyers’ perspective — you had a company that would have gone down the tubes were it not for the salvation by the Federal Reserve. To turn around and sue them because you did not get a good enough deal is fanciful.

Did AIG get into the position it was in because the Fed or other regulators were not paying attention?

First of all, you need to blame the protagonist. AIG’s people, with their board looking the other way or not paying attention, got themselves into that terrible position. Nobody forced them into it.

It is a legitimate question as to whether the regulatory apparatus should have ever let AIG get in such a big position on one side of a market. The answer to that, to me, is clearly no, but that doesn’t point a finger of blame at anybody because they basically were in one of these cracks in the regulatory system and they weren’t answering to anybody. They were technically AIG FP –AIG Financial Products- which was technically supervised by the Office of Thrift Supervision. Thrift Supervision? What do they know about CDS (credit default swaps), derivatives and stuff like that. So this is sort of the quintessential example of where the regulatory system went wrong in leaving vast swaths of the industry essentially unregulated.

Do you think that can happen again in light of Dodd-Frank?

It will be harder. It will have to happen in a strange sort of way because you now have the responsibility and the authority of the FSOX (Sarbanes-Oxley Act) to be on the lookout for anything building up in the financial system that is systemic. They are not going to stop bad things from happening in the financial system. That has always happened and always will happen, but as long as they are small enough, they are not going to drag a lot of other entities and individuals down with them. It is the systemic risk that we are really concerned about and unless they are totally incompetent, another AIG should not be able to happen. There was no systemic risk regulator, going into the crisis. Now there is, in fact, there are two because the Fed also has that responsibility.

Is there any way the Fed is going to be able to fix the economy?

“Fix” is much too strong a word. I think you want to think about the Fed as being – at this point- as being a minor force for good, a Band-Aid on a big wound that is healing. If you look at what the Fed has done since the crisis blew up in 2008, it is enormous and it has had an enormous effect, salutary effect, on the course of the financial system and the economy. Unless we go into another serious crisis, the Fed is getting near the end of what it can do. I guess it is a two-part answer. If we have some sort of unforeseen financial calamity, the Fed has got lots of things it can do again, but short of that, it is not going to. The Fed is not going raise its lending to banks to $1.5 trillion again.

What about the LIBOR rigging scandal? Tell me what that means to you and what we should all be thinking about it?

The main thing it means to me is that we should never had put a rate –determined by the way LIBOR (London Interbank Offered Rate) was, and largely still is, although it looks like it may be changing – into such a key position in the financial markets. LIBOR was the base, as you know, of pricing for a lot of things and it was obtained by a bunch of phone calls that were hypothetical, rather than market transactions. And in the bad times, at the height of the crisis, which is what the scandal is now focusing on, there were basically were no transactions. It’s one thing if you just did a transaction an hour ago and you are not sure if you can transact at exactly that price now, but you tell that to the survey taker. It is a whole other thing if the market is dead and you on the phone at Barclays or Deutsche Bank or UBS or wherever you are, is just guessing. We should not be basing trillions of dollars of financial transactions on things like that. It should be market prices.

How would you fix it?

You could benchmark to many things; you could benchmark to Treasuries, for example.

How do we take the damage out of derivatives?

I would with minor, minor exceptions – the problem is the way the law is now, it looks like major, major exceptions – I would require them to be standardized and traded on organized exchanges, like we do with stock options. Right now, if I want to buy an option on Exxon Mobil at $92.19 that expires 111 days from now, I can’t do it. I have to go in increments of five and the dates that the market allows. Are we losing a lot from that? I don’t think so. We could do the same with derivatives. Some of them are easy, like the CDS (Credit Default Swap). It is really easy to do that with a CDS. I think if you dig deeply, the number in terms of dollar volume of derivatives that really need to be customized and OTC (over the counter) is quite small and we ought to try to push that limit. Push it as far as we can. And the industry is fighting this like mad.

Where will the next big disaster come from? Europe?

That was the best guess until last summer when Draghi did what he did. I don’t think it will happen, but I think the next big danger of a crackup is over the national debt ceiling whenever it comes to a head. Maybe that will be never. They already kicked down from the second half of February until the second half of May and maybe they will kick it again. And maybe, Lord knows, they will settle this. I would not bet on that. I am afraid this is going to be hanging over our heads a while and then it gets to be a little bit like we used to worry in the old days about somebody hitting the nuclear button by accident or in anger or something like nobody ever wants this to happen, but it happens. Something analogous to this could happen with the national debt ceiling. We should get rid of it.

How scared should ordinary investors be about the Republican demand that there be a debt ceiling in place, now that it has slid until May?

That depends. It has been there for years without being used as a serious weapon to hold the economy hostage. If we go back to that, the debt ceiling creates political theater, but is harmless. But if it is going to be used again and again as a serious threat, investors should be very scared.