Confessions of a Supply-Side Liberal

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Marvin Goodfriend on Electronic Money

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Marvin Goodfriend

In this post, I wanted to line up a little more of the academic literature and history of thought on electronic money. In particular, Marvin Goodfriend ably lays out the principles behind electronic money in his November 2000 Journal of Money, Credit and Banking article

Here is what he says in his introduction:

… No one will lend money at negative nominal interest if cash is costless to carry over time. Therefore, the power of open market operations to lower short-term interest rates to fight deflation and recession is strictly limited when nominal rates are already low on average. (p. 1007)

Later, Marvin explains the difficulties caused by the zero lower bound in this way: 

The zero bound is a potential problem for two reasons. First, negative real interest rates may have helped the economy to recover from recessions in the past, particularly in periods of financial market stress. Second, deflation expectations in economic downturns can actually raise expected real interest rates when nominal rates are at the zero bound, with perverse effects on demand and employment. The possibility of a deflation spiral worries economists and central bankers alike. Nominal interest rates might only need to be negative occasionally and temporarily. If they are not free to do so, however, recessions could be much deeper and longer than otherwise. (p. 1010)

Indeed, it is no exaggeration to say that a large share of the economic problems the world has faced in the last few years are a result of the zero lower bound created by the fact that currency now earns an interest rate of zero.
Moreover, Marvin points out that the difficulties created by the zero lower bound have motivated prominent economists to recommend a higher rate of inflation than they otherwise would:
Keynes (1936) was very much concerned with the consequences for macroeconomics and monetary policy of the zero bound on nominal interest rates. That concern was revived by Summers (1991,1996) and Fischer (1996). Summers and Fischer argue that central banks should target inflation in a range as high as 3 percent per year so that the inflation premium would make room for nominal interest rates to fall an additional 3 percentage points before hitting the zero bound. (p. 1008)

The Larry Summers and Stan Fischer references are:

  • Fischer, Stanley. “Why Are Central Banks Pursuing Long-Run Price Stability?” In Achieving Price Stability, pp. 7-34. Kansas City: Federal Reserve Bank of Kansas City, 1996. 
  • Summers, Laurence. “Commentary: Why Are Central Banks Pursuing Long-Run Price Stability?” In Achieving Price Stability, pp. 35-43. Kansas City: Federal Reserve Bank of Kansas City, 1996.
  • Summers, Laurence. “How Should Long-Term Monetary Policy be Determined.” Journal of Money, Credit, and Banking, 23 (August 1991, Part 2). 625-31. 

Where Willem Buiter Goes Beyond Marvin Goodfriend. The only important thing Marvin misses is the possibility of a crawling peg exchange rate between electronic money (reserves) and currency that Willem Buiter discusses here and attributes to Robert Eisler in 1932:

Eisler, Robert (1932), Stable Money: the remedy for the economic world crisis: a programme of financial reconstruction for the international conference 1933; with a preface by Vincent C. Vickers. London: The Search Publishing Co.

Willem formalizes Eisler’s proposal of a crawling peg exchange rate between electronic money in two academic articles, which appeared after Marvin’s 2000 article:  

Buiter, Willem H. (2004) ,”Overcoming the Zero Bound: Gesell vs. Eisler; Discussion of Mitsuhiro Fukao’s “The Effects of ‘Gesell’ (Currency) Taxes in Promoting Japan’s Economic Recovery” . Discussion presented at the Conference on Macro/Financial Issues and International Economic Relations: Policy Options for Japan and the United States, October 22-23, 2004, Ann Arbor, MI, USA. International Economics and Economic Policy, Volume 2, Numbers 2-3, November 2005, pp. 189-200. Publisher: Springer-Verlag GmbH; ISSN: 1612-4804 (Paper) 1612-4812 (Online).

Buiter, Willem H. (2007), “Is Numérairology the Future of Monetary Economics? Unbundling numéraire and medium of exchange through a virtual currency with a shadow exchange rate”Open Economies Review, Publisher Springer Netherlands; ISSN 0923-7992 (Print); 1573-708X (Online). Electronic publication date: Thursday, May 03, 2007. See “Springer Website”.

I discuss the idea of a crawling peg exchange rate between currency and electronic money in my posts 
Marvin Goodfriend’s Proposal. Marvin’s proposal follows Silvio Gesell’s line of thought instead of Robert Eisler’s. Marvin writes: 

Under my proposal, the floor on short-term nominal interest rates would be determined by the carry tax imposed by a central bank on electronic reserve balances. When interest rates are pressed against that floor, a monetary policy committee could vary the carry tax in order to adjust its interest rate target. The carry tax would anchor the short end of the yield curve much as, say, the intended federal funds rate does today in the United States. To assure that the carry tax on electronic reserve balances sets the economy’s nominal interest rate floor, a carry tax could also be imposed on currency and vault cash. I discuss how this might be done, too. (p. 1008)

Marvin elaborates later on as follows:

Modern payments system technology makes it possible to impose and vary a carry tax on electronic bank reserves at the central bank. With a system to do so in place, the zero bound would cease to be a technological constraint on interest rate policy. Whenever the intended target for the interbank interest rate reached zero, the policy committee could activate a daily tax on electronic reserve balances that would make the interbank rate negative. By calibrating the daily tax as a percent per annum, the policy committee could adjust the cost of carry so as to move the interbank rate in 25 basis point steps and continue to make interest rate policy exactly as it does today. 24

To supplement the carry tax on electronic reserves, a carry tax could be imposed on currency by imbedding a magnetic strip in each bill. The magnetic strip could visibly record when a bill was last withdrawn from the banking system. A carry tax could be deducted from each bill upon deposit according to how long the bill was in circulation since last withdrawn and how much carry tax was “past due.” Likewise, a carry tax could be assessed on currency held as vault cash in banks. (p. 1016)

There is a lot in Marvin’s paper, including a prescient discussion of balance sheet monetary policy, but let me focus two things I feel are particularly important: Marvin’s discussion of using an exchange rate target to stimulate an economy when up against the zero lower bound and his discussion of allowing a free floating exchange rate between currency and reserves.  
 
Marvin Goodfriend’s Critique of Foreign Exchange Rate Targeting as a Way to Deal with the Zero Lower Bound.  Marvin writes: 
McCallum (2000) suggests that a central bank confronting the zero bound should adopt the foreign exchange rate as its policy instrument. Specifically, he proposes following a monetary policy rule that varies an exchange rate policy instrument to stabilize inflation and output. This is not the place to discuss the operating characteristics of McCallum’s exchange rate rule. To get an idea of how an exchange rate instrument might work, however, suppose that a country pegged its currency at a much depreciated foreign exchange rate. The exchange rate depreciation, then, would create an increase in net exports, the nominal short interest rate would immediately match the foreign currency interest rate, and prices would move up over time in proportion to the exchange rate depreciation. The expected inflation would imply a low or even negative real interest rate for a while.

The problem with an exchange rate oriented monetary policy is that it could be perceived as working at the expense of its trading partners, and it might not work very well at all for a very large country such as the United States. If the United States adopted such a policy to lift itself out of a deflationary, zero bound trap, it might export deflation and recession without helping itself much. (p. 1012)

Suspension of Payment of Currency as a Way to Allow a Free Floating Exchange Rate Between Currency and Electronic Money. I find Marvin’s footnote 23 the most indispensable part of his paper, since to my knowledge, no one before or after has said it better. He writes:

23. In principle, as an alternative to imposing a carry tax on currency, banks could agree to suspend the payment of currency for deposits whenever a carry tax was imposed on electronic reserves at the central bank. Currency and deposits each have a comparative advantage in making payments. Currency is more efficient for small transactions made in person, and checkable deposits are useful for making larger payments at a distance. The respective demands for the two monies would be well-defined. The imposition of a negative nominal interest rate coupled with a suspension would cause the deposit price of currency to jump to the point that the expected negative deposit return to holding currency matched the negative nominal rate on deposits.

This mechanism is reminiscent of the temporary suspensions that occurred in the US prior to the establishment of the Federal Reserve. For instance, currency went to a few percent premium over deposits for a few months during the suspension that occurred in the aftermath of the banking panic of 1907.

Suspending the payment of currency for deposits would avoid the cost of imposing a carry tax on currency. After the initial capital gain, however, currency would bear the same expected negative return as deposits. Moreover, the proposal would involve the inconvenience of dealing with a fluctuating deposit price of currency. Furthermore, the possibility of making a capital gain on currency relative to deposits when a suspension occurs would create destabilizing speculative runs on the banking system. Such attacks would be annoying and costly for banks. Effort invested in attacking banks would be a waste of resources from society’s point of view. 

To put this in my own words, not letting people get cash when they go to the bank will work as a way to free up the exchange rate between currency and electronic money (reserves), but it is very messy—perhaps dangerously so—compared to a managed, crawling peg exchange rate between currency and electronic money. Nevertheless, historical incidents in which payment of currency was suspended may provide important parallels for electronic money, providing a lower bound on how well electronic money would work. I would be very interested in learning more about the history of suspensions of payment of currency.  

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  1. supplysideliberal posted this