Shopping plaza near Japan’s Ministry of Finance where dinner conversation began to clarify the viability of both hard-money transitions and soft-money transitions as ways of dealing with the legal-tender issue.
I have continued thinking about the path to eliminating the zero lower bound by using electronic money as the unit of account in the months since I wrote “A Minimalist Implementation of Electronic Money.” In particular, as I discuss below, I think that switching legal tender status from paper currency to electronic money is less of and issue than I thought when I wrote “A Minimalist Implementation of Electronic Money.” That post was sparked by my visit to the Bank of England in May. This post is sparked by my upcoming visit to the Danmarks Nationalbank this Friday (September 6, 2013). If you have not yet read “A Minimalist Implementation of Electronic Money,” you should read that first in order to understand this post. You will also find my Powerpoint file "Breaking Through the Zero Lower Bound" helpful.
Implementing an electronic money system can look daunting politically when thinking of implementing the whole package at once, but it should be easier, and at least as effect to implement different elements in sequence. (Where I write “If possible,” it is possible to delay that step, or in some cases, do without it entirely, if necessary.) Let me lay out what I consider a reasonable order of implementation—starting with important elements of preparation that would be a good idea even apart from preparing for an electronic money system. Here is the path I currently recommend to get to electronic money as a monetary system:
- Have one or more members of the monetary policy committee give speeches explaining that substantially negative nominal interest rates are technically feasible, so that the central bank has as much ammunition as necessary to achieve monetary policy goals. The analogy I would make is to Ben Bernanke’s 2002 speech “Deflation: Making Sure “It” Doesn’t Happen Here,” which he gave shortly after being appointed one of the Governors of the Federal Reserve Board, arguing that the Fed had many tools at its disposal, that it could turn to if needed. This step can and should be taken long before a central bank actually makes the decision to pursue an electronic money system for monetary policy. At central banks that have a tradition of some independence for individual monetary policy committee members, this step could be taken by an individual member of the monetary policy committee, before there is a consensus for electronic money in the committee as a whole.
- Strengthen macroprudential regulation—in particular, dramatically raise equity (“capital”) requirements for banks and other financial firms. Here are some of my key posts on the importance of raising bank equity requirements: “What to Do About a House Price Boom,” ”Anat Admati, Martin Hellwig and John Cochrane on Bank Capital Requirements," "High Bank Capital Requirements Defended,” ”Canadians as the Voice of Reason on Financial Regulation,” “When Honest House Appraisers Tried to Save the World,” “Cetier the First: Convertible Capital Hurdles,” “How to Avoid Another NASDAQ Meltdown: Slow Down Trading,”
”Anat Admati’s Words of Encouragement for People Trying to Save the World from Another Devastating Financial Crisis,” and Three Big Questions for Larry Summers, Janet Yellen, and Anyone Else Who Wants to Head the Fed. Here is the key passage from Three Big Questions for Larry Summers, Janet Yellen, and Anyone Else Who Wants to Head the Fed: “… despite all of the efforts of bankers and the rest of the financial industry to obscure the issues, it all comes down to making sure banks are taking risks with their own money—that is, funds provided by stockholders—rather than with taxpayers’ or depositors’ money. For that purpose, there is no good substitute to requiring that a large share of the funds banks and other financial firms work with come from stockholders.”)
- Have the central bank and other financial regulators ask banks and other financial firms to prepare documents explaining how they would adjust their business model (and computer systems if necessary) to accommodate negative interest rates. These contingency plans should address how customers can be acclimated to negative interest rates in ways that do not cause banks’ and financial firms’ profits to suffer unduly from negative rates. In particular, banks and other financial firms should be asked to create plans that do not try to shield depositors (or money-market mutual fund holders) from negative rates in a way that could ultimately be unsustainable.
- Develop accounting standards for possible future situations in which some interest rates are negative and there is an exchange rate between paper currency and electronic money.
- Recommend that government agencies prepare contingency plans for how they would deal with negative interest rates and cash accounting when there is an effective exchange rate between electronic money and paper currency.
- If possible, use the government agency contingency planning exercise as an opportunity to prod government regulatory clarification or legislation that those who owe the government money (including taxpayers) are not allowed to pay large debts to the government in paper currency. It is advantageous to make this clear during a period of time before anyone has any reason to want to pay off large debts to the government in paper currency.
- If possible, put a limit on the size of private debts that can be paid off in paper currency. If this can be done, it will help a lot later on. I discuss below what to do if this cannot be done at this early stage. Again, it is advantageous to make it clear that large debts cannot be paid in cash before there is a reason why most people would want to do so.
- If possible, formally make insured bank accounts legal tender.
- Announce the intent to introduce an electronic money system, and the remaining steps for doing so. Note that everything before this point is a good idea even if the decision to introduce electronic money has not yet been made. This step is the one to take at the moment that decision has been made.
- Make sure the interest rate on reserves or on excess reserves is brought down to zero or slightly below zero. Note that if interest on reserves is negative, that negative rate should probably be applied to all reserves, not just excess reserves. If for urgent financial stability reasons the central bank must contribute to bank equity (“capital”) through positive interest on reserves, or by applying negative rates only to excess reserves, limit these effective contributions to bank equity from the central bank to banks that are not dissipating their bank equity by paying dividends or doing stock buybacks. That is, it makes no sense to pay positive interest on reserves to help bank equity (“capital”) when banks are just sending the funds on immediately to their shareholders.
- Lower the target interest rate, interest rate on reserves and the rate at which the central bank lends (the “discount rate” in the US) to substantially negative levels. (If very slightly negative levels would suffice, an electronic money system would not be necessary, since there is some storage cost to paper currency. However, even with slightly negative interest rates an electronic money system might work more smoothly by maintaining normal spreads between the paper currency interest rate and other interest rates. Slight negative interest rates for electronic money combined with a zero paper currency interest rate has the potential to create unwanted side effects.)
- Having announced this intention in advance, if there is any sign that large amounts of paper currency are being withdrawn, institute a tim-varying deposit charge for paper currency deposited with the central bank, as discussed in "A Minimalist Implementation of Electronic Money" and "How to Set the Exchange Rate Between Paper Currency and Electronic Money." Note that waiting until there are substantial excess paper currency withdrawals will make it clear that this step is well-justified. If possible, make the deposit charge apply to net deposits so that, in effect, there is a time-varying withdrawal discount for withdrawals of paper currency from the central bank that balances out and is equivalent to the time-varying deposit charge.
- At the same time the time-varying deposit charge is instituted, discount vault cash in accordance with the effective time-varying exchange rate between paper currency and electronic money.
- At the same time the time-varying deposit charge is instituted, put in place the accounting standards developed for situations with negative interest rates and an exchange rate between electronic money and paper currency.
- Make it clear that taxes and other large debts to the government must be paid in electronic money, if this has not been done already. In addition to avoiding a reduction in effective government revenue, this is important for establishing electronic money as the unit of account.
- Implement the government agency contingency plans for dealing with negative interest rates and an exchange rate between electronic money and paper currency.
- Ask all firms that post prices to post electronic money prices. It is fine if they want to post both electronic money prices and paper currency prices, but they should be discouraged from posting only paper currency prices. Firms will probably do this on their own, but if not, a regulation to that effect may be needed to help establish electronic money as the unit of account.
- Make sure that firms are allowed to specify in contract and in retail sale the terms on which they will or won’t accept paper currency.
Hard-Money Transitions vs. Soft-Money Transitions
In relation to both private debts and debts to the government, there are two options for dealing with preexisting debts:
A Hard-Money Transition to Electronic Money. Old debts (beyond a certain size) are only payable in electronic money. Insured bank accounts are formally given legal tender status so that there is some way to legally compel a lender to accept repayment.
A Soft-Money Transition to Electronic Money. Old debts are payable in paper currency (assuming the contract does not specify otherwise), but new contracts can specify that repayment must be made in electronic money.
To me, the soft-money transition seems unfair to lenders, but either option would preserve full freedom for the monetary authority to use substantially negative interest rates.
The key point is that the soft-money transition does the job, even though it doesn’t do it as fairly or as elegantly as the hard-money transition. As far as eliminating the zero lower bound is concerned, it is enough to allow lenders and retail establishments to distinguish between electronic money and paper currency going forward. It is only a guarantee of zero interest rates on paper currency going forward that creates a zero lower bound. So old debts can be handled either way without creating a zero lower bound.
Saying that contracts going forward can specify separately the acceptability of, or terms for, repayment in paper currency is much simpler than the possibility I raise in "A Minimalist Implementation of Electronic Money" of introducing a new, non-legal-tender paper currency. Instead of an old currency and a new currency, there would be old debts and new debts. Paper currency would be legal tender for the old debts in the ordinary way, while new debts would have new contracts, which most likely would not allow repayment in paper currency at par.