Confessions of a Supply-Side Liberal

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Pranav Krishnan: Fighting European Deflation with Negative Interest Rates


Pranav Krishnan is a student in my my "Monetary and Financial Theory" class. Pranav also has a blog that focuses on the finances of European football. Here is what Pranav has to say about eurozone monetary policy:


There were some positive signs around Europe, where it appeared that Spain’s unemployment rate had bottomed out in late 2013.

Perhaps talk of Europe’s recovery has come a little too early. While there were signs of positive growth in countries like Spain and Italy over the past few months, inflation was very low, and even more so inflation expectations.  David Roman of the Wall Street Journal wrote about a significant deflationary risk in Europe and how officials are expecting the European Central Bank to take the appropriate measures necessary to stem the tide. Josef Makuch, Slovenian Central Bank governor-rightly-feels that deflation could cause even more problems in the long term.

“Several [ECB] policy makers are ready to adopt nonstandard measures to prevent slipping into a deflationary environment,”

It appears that there might be more to this issue, than simply highlighting the risk of deflation.  The article was largely skimming the surface of what could become a wider problem later on.  Demosthenes Tambakis, a professor at the University of Cambridge, wrote for The Economist, outlining his opinion on why the Eurozone is at risk for deflation in further detail,  He points to very low inflation expectations across Europe and that alone increases a risk in deflation.  While he admitted that this risk shouldn’t rise so dramatically based on expectations alone, he does point out a few other institutional design elements that could contribute; Most notably, the European Central bank’s mandate, and the Zero Lower Bound.

The European Central Bank mandate is a bit pedantic in terms of legislature but it can play a role in the eyes of most economists.  The ECB, cites Tambakis, is committed to just below 2%, in contrast to say the Fed who wants to maintain a 2% average over time.  Tambakis believes that this causes an asymmetry which assures everyone that while they do not have to fear runaway inflation, they should worry when prices are too low because the ECB by design would be more reluctant to embark on expansionary monetary policy (increasing the money supply) than they are to contract.  While this point could make some sense in that the ECB might be unintentionally ‘guiding’ people to expecting less inflation in the medium-run and long-run, I would be surprised if this had a serious impact on inflation expectations.  Given the low levels of inflation in Europe, most economists and investors would likely expect lower levels to continue especially with the reduction in German growth rates.

The more likely argument seems to be the one about the Zero Lower Bound.  These risks are determined by the Shiller Index which predicts the long-run frequency of international stock market crashes.  Europe has faced two issues, in that they’ve suffered from the original financial crisis of 2008 and then the individual debt issues that each country faces. So, the natural reaction would be to cut interest rates to stimulate demand, but the Zero Lower Bound in Europe threatens to create a liquidity trap for the Eurozone.   In tandem with the dual mandate language set by the ECB, everyone already has very low expectations of inflation and the inability for countries to set monetary policy and stimulate demand individually threatens to worsen the situation for the Eurozone as a whole.

While there could be some legislation to create a more unified Europe fiscally and financially, the best thing the ECB can hope to do now is if they are going to be rigid about keeping inflation below 2% they should be more flexible about the Zero Lower Bound and allow the interest rate to hover in a broader range of negative interest rates.  The process will be rather painful because inflation expectations could plummet but in the long term, Europe could be better for it and escape the dangers of a long-term liquidity trap.

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Will the ECB Go Negative?


Photo of the European Central Bank from Wikimedia

On Wednesday (March 26, 2014), the Wall Street Journal had a remarkable news article by Brian Blackstone reporting on how the European Central Bank might be getting more serious about the idea of negative interest rates: "ECB Mulls Bolder Moves to Guard Against Low Inflation: Officials Indicate They Will Consider Negative Interest Rates, Asset Purchases." Here are the key passages: 

  1. "We haven’t exhausted our maneuvering room" on interest rates, Bank of Finland Governor Erkki Liikanen, told The Wall Street Journal in an interview in Helsinki. … Asked what tools the ECB has remaining, Mr. Liikanen cited a negative deposit rate as well as additional loans to banks and asset purchases.
  2. Bundesbank President Jens Weidmann, in an interview with news agency MNI, didn’t rule out large-scale asset purchases, known as quantitative easing, as a possibility. He also raised the option of negative deposit rates, though he said he wasn’t talking about any imminent decision.
  3. Mr. Draghi was less specific Tuesday on what the central bank might do. But in a speech in Paris, he sought to underscore the bank’s resolve in fighting excessively low inflation, which weakens consumer spending, business profits and investment. “We will do what is needed to maintain price stability,” …

    [Mr. Draghi’s] comment was reminiscent of his July 2012 pledge to do “whatever it takes” to keep the euro together. That remark triggered a lasting rally in government bond markets in southern Europe. The ECB didn’t even have to purchase any government bonds—Mr. Draghi’s words were enough.

  4. Faced with a negative, or penalty, rate for parking funds at the ECB, commercial banks might instead lend their excess funds to other financial institutions, lowering short-term borrowing costs. It could also make euro-denominated assets less attractive to global investors, taking some of the froth off the value of the euro, and thereby boosting exports and inflation.

    One potential downside is that banks might pass along the added costs to customers by raising the interest rates they charge for loans. But Mr. Liikanen signaled he doesn’t think a negative deposit rate would generate unwanted side effects. “The question of negative deposit rates, in my mind, isn’t any longer a controversial issue,” he said.

  5. "The perception has been that [ECB officials] talk about it but won’t do it. I think they’re closer [to making the deposit rate negative] than has been perceived," said Ken Wattret, economist at BNP Paribas.

The next day (yesterday), Brian Blackstone had another article on the same topic: "ECB Faces Uncharted Waters With Negative Deposit Rate Move Could Encourage Lending and Weaken Euro, Bolstering Exports." One of the key worries discussed in the article is this: 

Critics say negative rates could weaken the already fragile European banking industry by sapping its profits.

"The banks that would suffer the most are those ones with lower profitability," said Alberto Gallo, head of European credit research at Royal Bank of Scotland. That includes small banks in Cyprus and Slovenia, Italian banks and some German Landesbanken, or public banks co-owned by the savings banks and regional governments, he added.

Banks also may pay less interest to savers and could raise the rates they charge on private loans to recoup their costs.

Here let me say something I say in all of my talks at central banks and their regional affiliates. Once the paper currency interest rate becomes something the central bank can choose, as in what I have proposed (see for example “How to Set the Exchange Rate Between Paper Currency and Electronic Money”) all 4 key interest rates under the central banks control can be moved up and down in tandem:

  1. The target rate (fed funds rate in the US)
  2. The lending rate (discount rate in the US)
  3. The interest rate on reserves or on excess reserves
  4. The paper currency interest rate. 

With all four rates moving up and down in tandem, the spreads between them that matter for bank profits can be kept at normal levels. In particular, reductions in the paper currency interest rate would make it possible for banks to reduce the deposit rates they pay enough that they can make profits even if the rates banks earn on loans are very low, even possibly negative. 

Note also that when people say that the demand by borrowers is low, that is at a zero or positive interest rate. At a low enough interest rate, I guarantee that the demand for loans would be high.  

By the way, I am headed to the European Central Bank this July to explain the details of implementing negative paper currency interest rates along with other negative rates. For modest negative paper currency interest rates, a time-varying deposit fee (on net paper currency deposits by banks bringing paper currency to or withdrawing paper currency from the central bank) should be sufficient to do the trick, even without the other measures I have talked about. I would be truly delighted to have Mario Draghi attend my seminar.   

Update, April 3, 2014: Brian Blackstone and Todd Buell reported on April 3 that the ECB’s discussion of negative interest rateshas the imprimatur of the ECB’s President Mario Draghi:

President Mario Draghi's revelation that the central bank had discussed negative interest rates and large-scale bond purchases—if needed to keep persistently low inflation from undermining growth—caught financial markets by surprise. …

Mr. Draghi said officials had discussed asset purchases, known as quantitative easing, as well as setting a negative rate on bank deposits parked at the ECB—moves that could help bolster the economic recovery and push up prices. The annual inflation rate in the euro zone is just 0.5%, far below the bank’s target of just under 2%. …

The ECB is “resolute” in its determination to keep its easy-money policies in place, he said, and “to act swiftly if required.”

Brian and Todd have this description of the negative interest rate being contemplated:

A negative deposit rate—it is currently zero—would force financial institutions to pay to park their excess funds at the ECB, which may encourage them to lend more to the private sector. Denmark has deployed negative rates since 2012, but it would be largely unchartered territory for a major central bank such as the ECB.

In the US, this would be called a negative interest rate on excess reserves. For negative interest rates to work best, it is important that other key interest rates also go negative, particularly the paper currency interest rate. 

Note: For more details on how to implement negative rates well, see the links collected in "How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide." 

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Q&A on Negative Interest Rates and Having an Exchange Rate Between Electronic Money and Paper Currency

I had an interesting email Q&A about electronic money with a questioner who liked the idea of publishing it here, but asked to remain anonymous. 

Questioner: I just read your article in Slate on electronic money and negative interest rates. One question I had is, if interest rates go negative, what’s to prevent someone from borrowing an infinite amount of money?

For example, if a bank is offering -1% interest on a loan, what’s to stop me from borrowing $1 million, immediately repaying $990,000, keeping $10,000 in profit, and then immediately taking out another $1 million loan and doing the same thing over and over again? Perhaps you could put limits on the amount of money a single person could borrow, but it seems the limits would need to be much higher for corporations, and anyone could start dozens of corporations. It seems ripe for abuse. What’s to prevent this from happening?

Miles: Just like savers have to wait to get the benefits of positive interest rates, borrowers have to wait to get the benefits of negative interest rates. I would have to wait until a year later to have the $1 million I borrowed shrink to $990,000. What is also important, no one will give me a negative interest rate long term. They will only give me a negative interest rate for a few quarters during a serious recession. So I can’t just wait and wait until the amount I owe shrinks to nothing. If I have to wait a year to get the -1% and I only get one year, then the maximum shrinkage I can get, total, is 1%.  

Questioner: Why are negative interest rates easier to implement with electronic money than paper money?

Miles: It is easy to make numbers shrink in an electronic account. Paper currency has a number written on the front of it in ink, so (unless a bill has so much electronics in it that it is effectively an electronic account), the meaning of that unchanging number on the front has to change over time. What I propose is a changing exchange rate between paper money and electronic money (=bank money). And it is advantageous to use the electronic money as way all the accounting is done (“unit of account”).

Questioner: The Fed can make paper money less valuable by printing money, quantitative easing, etc. Conversely, they can make money paper more valuable by reducing the money supply. Is your argument that these levers are less efficient than electronic money?

Miles: Yes. All of those depend on making all forms of money less valuable. My proposal makes paper money temporarily less valuable than other forms of money when we need it to be and as much as we need it to be, with high precision. (See “A Minimalist Implementation of Electronic Money and “How to Set the Exchange Rate Between Paper Currency and Electronic Money.”)

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Meet the Fed’s New Intellectual Powerhouse


Here is a link to my 47th column on Quartz: “Meet the Fed’s new intellectual powerhouse.”

I have two related columns not directly linked in this piece: “Monetary Policy and Financial Stability" and my discussion of Janet Yellen’s views: "Janet Yellen is Hardly a Dove: She Knows the US Economy Needs Some Unemployment.”

What I say in the column about how a low elasticity of intertemporal substitution affects how the Fed should respond to risk premia is informed by the discussion I gave of a paper of Mike Woodford and Vasco Curdia at a Bank of Japan conference (which I mentioned and linked to here.) Claudia Sahm, Matthew Shapiro and I are working on literature review of empirical work on the elasticity of intertemporal substitution for our paper on that topic. I will have more to say on that in the future. 

Update: I wrote this column (which is about much more than Jeremy Stein himself) just in time. On April 3, 2014, Jeremy Stein announced he was resigning from the Fed. But we might see him again in the future in high government office. 

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On the Great Recession


Graph from “US Jobs Losses & Some Bad Omens for Europe…” on the True Economics blog

I am honored to have David Andolfatto discuss my proposal for eliminating the zero lower bound in his post “Are negative interest rates really the solution?" David asks what model I have in mind when I write, for example, in "America’s Big Monetary Policy Mistake: How Negative Interest Rates Could Have Stopped the Great Recession in Its Tracks,” 

Even without the ZLB [the zero lower bound on nominal interest rates], there would have been some hit from the financial crisis that ensued with the bankruptcy of Lehman Brothers on Sept. 15, 2008, but negative interest rates in the neighborhood of 4% below zero would have brought robust recovery by the end of 2009. 

This post gives that model. 

Read more …

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Robert Eisler—Stable Money: The Remedy for the Economic World Crisis. A Programme of Financial Reconstruction for the International Conference 1933. Chapter XVII: Compensating the Effects of Inflation on the Cost of Living (pp. 232—247).


The story [of electronic money as a way to end recessions quickly and end inflation forever] really goes back to 1932, in the middle of the Great Depression. A guy named Robert Eisler realized that they could get out of the great depression if they distinguished between bank money and paper money.

That is how I began my remarks at the Cryptocurrency Conference I participated in this past Tuesday. I learned about Robert Eisler from posts by Willem Buiter, in which Willem Buiter gives the modern theory of eliminating the zero lower bound.

One of the audience mentioned Silvio Gesell, who is much better known because John Maynard Keynes talked about him in his book The General Theory of Employment, Interest and Money(You can see the passage in my post on Silvio Gesell here.) But I see my proposal for eliminating the zero lower bound as closer in spirit to Robert Eisler’s proposal, first because he emphasizes an exchange rate between bank money (=electronic money now) and paper currency, and second, because he envisioned the bank money as having a stable value in relation to the goods and services that people buy. By contrast, instead of being comfortable with an exchange rate between bank money and paper money, Silvio Gesell proposed a system that encouraged people to buy stamps to put on the depreciated paper money to bring it up to par, and Silvio put less stress on having at least one type of money that maintained a stable value in relation to goods and services.  

Needless to say, Robert Eisler’s proposal is far from identical to mine. The biggest difference is that Robert Eisler imagined international fixed exchange rates in bank money coexisting with flexible exchange rates between bank money and paper currency. Also, Robert Eisler is far from clear about the necessity to keep the level of economic stimulus just right if the bank money is to keep a stable value. He writes as if using paper money price indices to set the exchange rate would be enough to yield a stable value for the bank money. Finally, he does not emphasize as I would the great importance of encouraging everyone to use the bank money as the unit of account. Indeed, in what he writes, he does not himself always use the bank money as the numeraire, and so sets a bad example in relation to what I consider the crucial unit of account function of the stable-value bank money. Nevertheless, in the most important respects, Robert Eisler anticipated the kind of monetary system I advocate.  

In a tweet, I called Robert Eisler the “grandfather of emoney monetary policy.” The father of emoney monetary policy is Willem Buiter, who first explained the principles clearly. (Also see the children’s fairy tale about Willem Buiter’s role.) 

Robert Eisler’s book Stable Money is not available on Amazon, and even the University of Michigan library system had to ask for an interlibrary loan from the University of Nebraska library in order to put a copy in my hands. I consider what he has to say important enough that I scanned the key chapter, available at this link. For those who prefer a modern font, I also typed out the key passage, comprising most of that chapter, which lays out Robert Eisler’s proposal for a new paper currency policy. (I put footnotes in square brackets at the appropriate points.) 

Here is Robert Eisler, Stable Money, pp. 232—247:


The present writer himself would condemn any scheme of monetary reorganisation which began by raising the purchasing power of one group at the expense of another. [Cp. Sir William Beveridge, Unemployment, p. 416: ‘The absorption of the unemployed in a temporary boom could probably be achieved very rapidly by a government prepared for inflation, but the inevitable after-effects of such a policy rule it out.’]

Fortunately, the proper method of for avoiding this and for counteracting automatically and continually the above enumerated evils of inflation is quite well known ever since, in 1747, Massachusetts Bay Colony introduced a simple ‘tabular standard’ based on the prices of wheat, meat, leather and wool in order to compensate for the effects of the inflation of the ‘Colonial Notes’ circulation on the revenues of its creditors, officers and soldiers. [Cp. Willard C. Fisher, ‘Tabular Standard in Massachusetts History,’ Quarterly Journal of Economic, 1913, pp. 415-417.]

Nothing is necessary but the introduction of a new, very simple monetary law in all countries willing to participate in the proposed currency expansion scheme—a law extending the well-known principle of ‘index-wages’ to all existing contracts in terms of money.

Read more …

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Cryptocurrencies: Is the Dollar Doomed? Video of a Discussion Between Miles Kimball, Justin Wolfers and Matt Yglesias on Electronic Money

Justin Wolfers, Matt Yglesias and I had a panel discussion on Bitcoin and monetary policy at the New America Foundation’s Cryptocurrency Conference last Tuesday (February 11, 2014). You can see the video above. Here are my favorite tweets tweeted during our discussion. Also, Alex Kendrick tweeted a very kind recommendation of the video above. 

In addition to going to D.C. for this conference, I did a piece in Slate in connection with this conference: "Governments Can and Should Beat Bitcoin at Its Own Game."

You can see videos of the other events at the Cryptocurrency Conference here. 

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