Going off the Paper Standard
- adding to the national debt,
- maintaining zero interest rates for years on end and making quasi-promises to keep them zero for years more to come,
- large-scale purchases of long-term assets by the central bank that squeeze financial market spreads in ways that could have unpredictable side effects, or
- having a positive inflation target in good times to give running room for monetary policy in bad times.
My most direct attempt to make the case for including negative interest rates in the monetary policy toolkit is my Quartz column “America’s Big Monetary Policy Mistake: How Negative Interest Rates Could Have Stopped the Great Recession in Its Tracks.” I wrote that column in recognition of the political challenge of persuading people of the benefits of brief periods of negative interest rates during serious recessions.
In addition to the political challenge of
persuading people of the benefits of brief periods of negative interest rates
as an alternative to long slumps, the additions fiscal stimulus makes to
national debt, QE, or unending inflation intentionally engineered by the
central bank, there are technical challenges in making negative interest rates
deeper than a few score basis points possible. I have been on a tour of central
banks and their affiliates around the world—the Bank of England, the Bank of
Japan, Denmark’s National Bank, and the Bank of France already, and head to the
Fed on November 1, 2013—to explain how to deal with this technical challenge.
In all of these interactions with central bank economists and policy-makers,
there has been no serious dispute about the technical feasibility of
eliminating what economists call the “zero lower bound on nominal interest
The two key measures for eliminating the zero lower bound and making sharply negative interest rates possible are:
- Relative to current policy, but in fact, to eliminate the zero lower bound, all that is needed is to level the Establishing electronic money—the e-dollar, e-euro, e-yen, e-pound, or the like—as the unit of account, and
- Levying a time-varying fee—expressed as a given percentage of the amount of paper currency deposited—when commercial banks or other financial institutions deposit paper currency with the central bank in exchange for electronic reserves.
Because the paper currency deposit fee that commercial banks face changes over time, it can make the effective rate of return on paper currency negative when expressed in terms of electronic money. And this negative rate of return on paper currency is achieved without any need to keep track of when the paper currency was withdrawn. A longer interval between withdrawal and deposit of the paper currency occasions a bigger change in the deposit fee over that interval, and that is enough.
As long as paper currency earns a rate of return lower than the central banks target interest rate, the only forces that will limit how low the central bank can push interest rates are forces that are part and parcel of the recovery of the economy from a recession. Interest rates will only be able to go a few hundred basis points at most into negative territory before businesses ramp up their building of factories, buying of machines, and development of new products, households ramp up their purchases of cars, other consumer durables and houses, and financial investors send money to seek higher returns abroad, generating capital outflows—which, by a central identity of international finance, will increase net exports. All of these effects of lower interest rates are entirely standard and well understood from hundreds of instances in which central banks have lowered interest rates in situations where they had high enough inflation that the zero lower bound did not bind.
It might seem that the time-varying fee on the deposit of paper currency with the central bank would disadvantage paper currency playing field between paper currency and electronic money. It is straightforward to implement negative interest rates on electronic accounts as a “carry charge.” It takes a little more engineering to yield the equivalent of a negative interest rate on paper currency. Engineering that effective negative interest rate with a paper currency deposit fee that gradually increases over the course of a few quarters does not necessarily make paper currency unattractive in an environment where all other interest rates are also negative. The negative interest rate on paper currency simply makes it so that there is no place to hide from negative interest rates except through activities that stimulate the economy by raising productive investment, raising consumption or raising net exports. (Of all such activities, increased mining of gold in those countries that have viable gold deposits may be one of the least attractive from a policy point of view, but increased mining of gold would also stimulate the economy.)
The Path to Electronic Money as a Monetary System
A month ago, in my blog post “The Path to Electronic Money as a Monetary System,” I laid out in some detail how a transition to an electronic money system with a time-varying paper-currency deposit fee could work in practice. Trying to make each step as clear as possible, I ended up with 18 steps, all of which I consider advisable, but not all of which are absolutely necessary in order to eliminate the zero lower bound. Here is the short version of those 18 steps:
- Announce that eliminating the zero lower bound is possible from a technical point of view.
- Strengthen macro-prudential regulation by raising equity requirements (a.k.a. “capital requirements”) as far as possible, in order to minimize any financial stability issues arising from negative interest rates. Given the recent history of financial stability, this is, of course, a valuable step in its own right, quite apart from its role in enabling safe use of negative interest rates.
- Ask banks and other financial firms to prepare contingency plans for negative interest rates.
- Develop accounting standards for negative interest rates that take electronic money as the unit of account, and give to paper money the value it is worth in the market relative to electronic money.
- Ask government agencies to prepare contingency plans for negative interest rates and non-par valuation of paper money.
- Make it clear that no one has the right to pay off large debts to the government in paper currency in contexts where transactions are now routinely conducted with bank money.
- Establish by law that debtors do not have the right to pay off large debts with paper currency at par when the market value of paper currency is below par.
- Formally make money in government insured bank accounts legal tender.
- Announce the intent to introduce an electronic money system.
- Lower the central bank’s interest rate on reserves to zero or slightly below zero.
- Lower the central bank’s target interest rate, interest rate on reserves, and the central bank’s lending rate substantially below zero.
- If there is any sign of large increases in paper currency withdrawal, institute a time-varying deposit charge when banks deposit paper currency with the central bank in exchange for reserves. Since the deposit charge starts at zero, and only needs to increase by a few percent per year at most, there will be plenty of time for people to get used to the deposit charge as it grows. The deposit charge only grows when negative interest rates are needed. When interest rates are positive, the deposit charge will be allowed to gradually shrink until it reaches zero again.
- Discount vault cash applied to reserve requirements according to the market value of paper currency.
- Implement the accounting standards appropriate for negative interest rates and paper currency at non-par valuations.
- Require payment of taxes and other substantial debts to the government in electronic form.
- Implement the contingency plans for government agencies.
- Ask all firms to post prices in terms of electronic money. (This could be in addition to prices posted in paper currency terms if firms want to post prices in both.)
- Make it clear that firms are allowed to specify in contracts (including loan contracts) and in retail sale the terms under which they will accept paper currency.
A response to FT Alphaville
In what represents an important step forward for this proposal, Izabella Kaminska gave detailed, largely favorable, reactions in her Alphaville post “Gold, paper, scissors, lizard, e-money.”
I will let you see for yourself the many positive reactions Izabella expresses, and her excellent descriptions of what I am proposing. Let me limit myself here to responding to the points at which Izabella questions the approach I am recommending. I have her words in bold, my answers in regular type:
- We’re not sure why he hasn’t considered the simpler option of abolishing paper currency altogether.... While it’s incorrect to assume that everyone in the economy has access to a digital platform that has the capability to store official e-money (whether a mobile phone or simply a digital account), we do have the means to issue digital wallets cheaply and efficiently to the entire population.... Technological solutions on this front abound. Because there is a strong demand by some for privacy in transactions, I do not consider it feasible to altogether abolish paper currency. At some point people would begin using foreign paper money, or some form of commodity money (such as the cigarettes that prisoners often use as currency). In my view, if people are going to use some form of paper currency or commodity money, for the sake of monetary policy it is better not to drive paper currency usage (with foreign currency) underground. In this context, note that negative interest rates alone would not necessarily drive people to use foreign paper currency, since foreign bank accounts would provide at least as high a rate of return as foreign paper currency (unless a foreign government was crashing head-on into the zero lower bound, with a lower target rate than their paper currency interest rate). It may be possible to develop digital currencies that allow full privacy of transactions, but on crime-control grounds, the government is likely to prefer paper currency to allowing fully private digital transactions.
- Or, alternatively, the substitution of current banknotes with some form of depreciating note technology. The trouble here is that any note technically sophisticated enough to have a value that changes over time would make it technically easy to compromise privacy, and so might as well be considered just one more type of electronic account. Also note that—other than its different privacy properties—the ordinary low-tech paper currency in my proposal, combined with a simple smartphone app that applies the appropriate exchange rate on a given day, is the functional equivalent a depreciating note technology.
- This strikes us as a tricky recommendation: a negative-rates-on-reserves policy would create a liquidity absorption effect and thus be equal to a tightening path. Unless, of course, the idea is to stimulate the economy through increased velocity of money alone…. The key problem with a negative rate regime, after all, is that while it encourages the circulation and velocity of money, it also contracts the money supply. In order to work, the velocity improvement must be substantial enough to diminish the risk associated with new loans — in that way compensating for the money supply contraction. There is no need to rely on increased velocity of money and the multiplication of money by banks alone. There is no limit on the central bank’s ability to create high-powered money. And the overall money supply is bounded below by the amount of high-powered money. In the absence of a zero lower bound, it is easy for the central bank to increase the money supply as necessary to achieve a given target interest rate.
- The bigger risk, we’d argue, is that the economy, rather than accepting negative rates, would flee to an alternative digital currency like Bitcoin. But, as Kimball himself notes, this shouldn’t be a problem providing that the payment of government debts and taxes is legally required to be in official e-money. The future of private currencies, such as Bitcoin is unclear. It is especially unclear whether they can survive active government hostility. As it is, the government takedown of Silk Road has seriously hurt Bitcoin. But more fundamentally, JP Koning points out that no private firm would have an unlimited willingness to provide a safe zero interest rate if all other safe interest rates were negative. Doing so would be a good way to lose a lot of money. Stylized economic theory would predict that any asset in limited supply, including private digital currencies, should increase in value when interest rates go negative, and then face an expected capital loss from that high price that would generate a negative interest rate. This is the more clear since the negative interest rates that would raise the price of assets in limited supply would be temporary.
- The implementation of digital e-money is in many ways the equivalent of a central bank announcing that it is taking money creation power away from banks. In that sense it not only sees the central bank increasingly compete with banks, becoming a universal banker in its own right, it begins to challenge their raison d’etre. This is a possible policy direction, but it is far from inevitable. Given control of the paper currency interest rate, as well as the target rate, interest on reserves, and central bank lending rate, the central bank can lower all short-term rates in tandem, so that the spreads that banks and other financial firms live on remain well within their historical norm. To discuss this, let me leaving aside for a moment the international capital flows that would occur if some countries have electronic money while others have kept their zero lower bound. If people are earning -3% per year on paper currency, customers would be willing to hold money in bank deposits earning -2%, and banks could make profits from ordinary risky lending at small positive interest rates. As far as the international capital flows go, by the time they jeopardized commercial bank deposits they would have long since caused a dramatic increase in net exports that would generate a strong economic stimulus. And when all major countries have abolished the zero lower bound, international monetary policy reaction functions are likely to be similar to what we have seen in the past when interest rates were too high for countries to be up against the zero lower bound.
- The happy medium might consequently be introducing official e-money at a zero rate, whilst having the central bank/government influence economic activity via a combination of negative interest rates and real money printing (rather than against asset purchases). I don’t understand this comment. If the government directly offers accounts that pay a zero interest rate for any size of account, that zero interest rate in accounts with the government creates a zero lower bound just as surely as paper currency does now. Indeed, zero-interest government accounts would create a tighter zero lower bound because there would be no storage costs for money in the government accounts. If there are significant fees for the government accounts that go up proportionately to account size, those fees are effectively negative interest rates. So I don’t understand how the government manages negative rates while official e-money has a zero rate.
In case I misunderstood one of Izabella’s concerns or missed something entirely, let me make the general point that there are a variety of different approaches that can eliminate the zero lower bound. The two big engineering issues for monetary policy are (a) eliminating the zero lower bound and (b) putting financial stability on such a solid foundation with high equity requirements that central banks need not worry about the effects of interest rate policy on financial stability. Anything that can achieve those two objectives is likely to be a big improvement over current policy.
Among approaches that achieve those objectives, the main way
that I would sort through them is to favor approaches that have a greater
chance of adoption. Given what little I know or suspect about the politics of
electronic money at this point, that makes me lean toward approaches that are
as close to the current monetary system as possible, in which as many as
possible of the changes that are necessary to make substantially negative
interest rates possible can be carried out in a way that would seem technical
and even boring to those of the general public who do not work in the financial
The exchange rate between electronic money and paper currency would be salient to the general public,
but I have argued that this would be politically tolerable because banks would begin offering
paper currency at a discount for a substantial period of time before the
deposit charge hit the level of 3% or so that would induce retail shops to have
a paper currency price higher than the electronic money price. The negative
interest rates themselves will always be salient, and the case for them must be
made forthrightly. But the technical measures needed to make negative interest
rates possible can, I believe, be sold as part of the transition to a modern,
electronic money system, if the negative interest rates themselves can be sold