Henrik Jensen: Willem and the Negative Nominal Interest Rate

In the early years of the Third Millenium, before becoming Chief Economist of Citigroup, Willem Buiter laid out clearly the various options for eliminating the zero lower bound. Here are his two May 2009 blog posts summarizing his work on eliminating the zero lower bound:

Because of my trip to Copenhagen in September 2013, I discovered that Henrik Jensen of the University of Copenhagen had written a March 7, 2010 response to Willem’s posts in Danish. I begged Henrik to translate his post into English. He kindly agreed. Here it is. 

(Note: You can see what I have written on this topic here.)

Posted in Danish on http://altandetlige.dk/blog/henrikjensen/willem-og-den-negative-nominelle-rente.htm, 9 March, 2010. © 2010, Henrik Jensen. English translation, 17 September, 2013. © 2013, Henrik Jensen, 2013 blog post here.

he challenge: Can the nominal interest rate become negative?

The global economic crisis has made a special discontinuity in traditional economies very topical: The nominal lending rate is limited downwards by zero. This can be a binding constraint for monetary policy, if one wants to stimulate economic activity by lowering interest rates. Recently, Willem Buiter, a Dutch economist known for his forthright and provocative (in the best sense of the word) writings, has questioned whether this restriction should be taken at face value. He has instead advocated that the implementation of negative interest rates need not pose a particular problem in modern economies.  So, the answer to the headline question is “yes”.

In the “old” days (read: between the 1930s and mid-1990s), the zero lower bound on interest rates was a problem that had only academic interest, and which never created real challenges for monetary policy. Inflation was a phenomenon that was of significant importance, whereby the nominal interest rates in most economies were at a level far above zero. Statistically, it was therefore unthinkable that the “zero” could ever be a relevant scenario. The situation in which the nominal interest rate reached zero, was academically known as the “liquidity trap”, in the sense that bonds and money were perfect substitutes, such that an increase in the money supply could not cause the usual reduction in interest rates, with the consequent stimulatory effect on the economy,  as known from the IS/LM model.[1] Instead, cash would just be hoarded (the opportunity cost of holding money, the nominal interest rate, is zero).

This seemingly theoretical curiosity began to gain practical importance and academic attention due to, for example, the economic crisis in Japan during the 1990s when the Japanese short-term policy rate for long periods was around zero. Thereby, the traditional monetary policy response to economic downturns was no longer possible. Simultaneously, inflation became a phenomenon of minor importance in the industrialized world, implying that nominal interest rates adjusted correspondingly downwards. In consequence, economists began to take serious the possibility that the zero lower bound on interest rates could bind. In the new millennium, both the US and the ECB’s monetary policy-interest rates to reach record lows. A new literature arose where the zero interest rate floor was taken seriously, and where different strategies for conducting monetary policy under this restriction and strategies to get away from the restriction were discussed.

Reality then the made the issue very much pressing in the wake of the financial crisis that began in 2007 and struck violently through the end of 2008. Some would argue that monetary policy before the crisis had been too lenient in the United States and therefore directly was a contributing factor to the crisis. It is not my intention to take this interesting discussion here. My starting point will be that the crisis is there: the economy is contracting and inflation is low. Those who believe that monetary policy can and should play a counter-cyclical role in such a situation will without doubt argue that interest rate should be cut.[2] This will also be the recommendation if you let interest rates follow a Taylor-type rule. As is well known, a Taylor rule posits that the interest rate reacts to inflation deviations from its mean (or “target”) and output’s deviations from potential output. Whether it is an expression of optimal monetary policy is debatable, but data is often consistent with Taylor-rule behavior in many countries.

With data from the US, Rudebusch (2009) demonstrates this for the period 1988 to 2012, when data for 2009-2012 is the FOMC forecasts. A Taylor rule (with unemployment as the activity variable) is estimated using historical data, and Figure 1 shows that it explains the historical setting of Federal Funds rate reasonable well.[3] In addition, the figure shows that if the economy is going to experience an increase in unemployment over the next few years (and a slight decline in inflation), then the Federal Reserve should aim for a negative nominal interest rate; and a considerable magnitude. If it had the opportunity to continue the historical pattern of monetary policy, one should set an interest rate below -5 per cent. But since late 2008, zero is the lowest one could go.[4] So, the figure suggests that the zero lower bound is relevant to the US right now and in the near future. Instead of designing new types of monetary policy strategies when the restriction binds, a simple and natural question is therefore whether one can completely remove it, thereby eliminating the asymmetry in monetary policy it entails?

Figure 1: The Fed funds rate in the future if a historical Taylor rule is followed

Source: Rudebusch (2009)

Source: Rudebusch (2009)

Why is it seemingly impossible to have negative interest rates?

Before I discuss Willem Buiter’s solution(s) to how the zero lower bound can be eliminated, it is appropriate to recall briefly why the bound exists. Why does the Federal Reserve not just set the interest rate to -5 per cent, if that’s what is needed to mitigate the unemployment problem? The reason is simple. There is no sane person who will lend to -5 per cent. If they did have the means to invest they would rather leave them as cash under the mattress. There, they after all provide a return of zero per cent.[5]  So even though that there might be infinitely many that would borrow at -5 per cent (you get paid for borrowing, so the path to unbound riches is open), there will not be any lenders. I would think that even the bitterest opponent of assuming economic agents to possess minimal rationality will accept this.

So, the problem is the mere existence of cash. They provide zero percent interest, and thereby they define the lower limit on the nominal interest rate. Cash are anonymous bearer bonds that therefore cannot be taxed in any conventional manner. To eliminate the zero lower bound, Buiter’s proposal is not surprisingly founded in different ways to challenge cash’s zero return.[6] If cash for example decreased in value by 10 per cent, then it’s suddenly not so foolish to lend out to -5 per cent. It is better than choosing the mattress. Infinite wealth accumulation through borrowing is not possible anymore, despite the “subsidization” of borrowing, since borrowers cannot gain from accumulating cash as cash now have even lower negative return than the lending rate.

Willem Buiter and his solution(s)

Who is Willem Buiter?

As indicated in the Introduction, Buiter is known as a sometimes controversial economist who says things very directly. His production is an interesting mix of mainstream state-of-the-art macro theory and intriguing and harsh attacks on different aspects of the same theories. He has besides his academic career served as external member of the Bank of England’s Monetary Policy Committee (one of the few foreigners ever), for the first three years of UK’s then relatively new inflation targeting regime (1997-2000) . The fact that he is a man with own views, was proven clear. During his tenure he set a still unsurpassed record of dissenting in almost half of all committee votes on the interest rate (Gerlach-Kristin, 2003). Interestingly, it was not because he held a systematically more or less “conservative” view on interest-rate determination: he voted for higher and lower interest rates with the same frequency. From 1998, members should in the event of dissent indicate how much their preferred rate differed from the majority’s decision. In all cases, the deviations have been size +/- 0.25 percentage points. Except in one single case where Buiter in March 1999, against the majority, voted for a rate cut of 0.40 percentage points (Gerlach-Kristin, 2009). He is a man with attention to detail.

Because of his, to some, unorthodox writings, he was nicknamed “Maverick”. This moniker he brought with him when he later in his career, at the London School of Economics, started his blog “maverecon”, which ended up becoming published by the Financial Times. The blog unfortunately stopped as of 1/1 2010, when Buiter again left the academic world (hopefully only for a time). This time for a job as chief economist at Citi. Therefore he can not continue as an academic blogger. As he says: “In Maverecon I wrote under the cover of ‘academic immunity’. Academics have no duty other than to state the truth as they see it—to ‘speak truth to power’. This gives them the ability to be undiplomatic, blunt, tactless and outspoken in ways that are unacceptable in the wider world—the world of grown-ups.”

Buiter’s solution(s)

Before leaving academia, he luckily managed to write some interesting blog posts about negative interest rates, and the possibility of achieving them. Buiter (2009a) is the main post, and Buiter (2009b) is his very undiplomatic sequel, which responds to a series of wildly excited reader comments, which the first post raised. As he tactlessly, but very witty, notes: “Because the heat and emotion are based on heart-stopping ignorance and lack of elementary logic, I will have another go at explaining the basics.” But it must be stressed that he is not just firing blanks. As the serious economist he is, the writings are backed by academic articles that ensures that the posts do not amount to just politically or ideologically motivated aphorisms (two of these articles is Buiter, 2007 and 2009c). So even though his blog posts may not appeal to diplomatic, restrained, tactful and introvert adults, try giving the contents a chance for the sake of creative interest.

To the point! As shown in the previous section, the zero lower bound exists due to the existence of non-interest bearing cash. Therefore Buiter’s proposals range from removing them completely from circulation, to tax them in clever ways or to eliminate their economic importance as a unit of account.

Taxing cash is obviously the suggestion that interests Buiter the least. He wrote about it in the context of the Japanese crisis at the turn of the millennium, but the problem is simply that it seems rather impractical. As mentioned, cash is an anonymous bearer bond, so you would have to introduce a form of labeling cash, which can then be used to indicate a decline in value. The basic idea that cash should not be allowed to be accumulated at no cost goes back to Silvio Gesell , who proposed to introduce tokens (“scrips”), which should be stamped to maintain value. When stamping, the authorities can then charge a tax.[7] Alternative, one can also date notes and announce that the new notes are worth less than the old one, or simply introducing an expiry date.[8] If one before expiry does not get stamped the note (and paid taxes), or swapped it to a new (at a cost), it becomes valueless. Buiter argues that such proposals are not operational. Besides the huge administrative hassle, notes have the value that people assign it. So despite the fact that a banknote is officially expired, missing a stamp or similar, some might accept it as payment, if others will, and others will, etc. One can therefore imagine a situation where stamping do not have any real effect on how the public views the means of payment. Then nothing is accomplished, and the authorities would almost have to resort to frisking people in the streets asking: “Do you have an expired note on you? Well, your note is confiscated; here is a new one of less value”. So the risk of being detected must be large enough to make it unattractive to keep expired cash. It will therefore require a great deal of supervision to effectively “de-anonymize” (if there is such a word) an anonymous piece of paper as a banknote. As Buiter presents it, I am indeed convinced that this is not a viable option to break the zero interest rate limitation. Too much administration and costly interference by the public authorities.

The next proposal is much simpler but also (to some) quite drastic: Cash is simply eliminated from the surface of the earth. In modern economies, a larger and larger proportion of all trades are made by electronic means, and since most electronic payment instruments are not anonymous, a negative interest rate on their associated accounts poses no practical problem. The central bank can still manage short-term interest rates through manipulation of base money as base money besides cash also consists of bank reserves in the bank (see Woodford, 2003, whose basic model indeed consider such a “cashless limit”). An expansionary monetary policy in the form of expansion of the reserves will therefore push interest rates down, but in the absence of cash, the interest rate can now without problems be targeted at below zero in situations where this is considered desirable.[9]

A beneficial side effect of the elimination of banknotes and coins is that black economic activity and social services fraud become more difficult. Such activities are based on the existence of cash (cash in circulation is often used as an empirical proxy for “informal” economic activity; Smith, 1987). I have, e.g., never grasped why we need a 1000 kroner note in Denmark (around US $ 175). Or how about a 500 Euro note? I do not know many people who walk around with them in your pockets (my own bank could tell me that they do not take 500 Euro banknotes home as nobody wants them). Nevertheless, in Denmark about 30 billion kroner is in circulation as 1000 kroner notes . Simple arithmetic reveals that 30 million of these notes in circulation amounts to about 6 notes per Dane—from newborn to dying. It seems to me, to be diplomatic, quite suspicious.  Similar conditions apply for the Eurozone, which exhibits an absurd number of 500 Euro notes in circulation—even three times more than the number of 200 Euro notes![10]

Besides that criminals will have a considerably harder time without cash, the central bank will also lose seigniorage from the issue of cash. But since in most developed countries this represents a very small share of the financing of public expenditures, this loss will be correspondingly limited. Finally, there is a problem concerning monitoring again. Cash is useful for performing legal transactions that you would rather not see present on your bank statement. Elimination of cash can therefore be seen as a violation of personal freedom. But in a society that is already geared to electronic transactions, one could issue electronic payment cards that are charged with a give amount (as a phone card) from one’s bank account. When they are emptied after performing legal economic activities and must be “refilled”, then the interest rate—positive or negative—is applied.

Should the total elimination of cash as a way of making negative interest rates feasible appear too offensive, then Buiter has ready a final proposal. One implements a monetary reform, where you introduce cash that can be used as a means of payment (but you make sure that they do not have too high denomination to limit the scope for illegal transactions and fraud). At the same time one introduces a virtual currency, which acts as the economy’s unit of account (the numeraire), and which is used to carry out all electronic transactions. It will thus, and that is the idea, be the relevant unit of account for the majority of economic activity in society. The central issue is that the unit of account is being separated from the value of the cash in circulation. The basic idea originates from the Austrian multi-talent Robert Eisler, who developed it in the 1930s.[11] Buiter became aware of it when he worked on the taxation of cash as an opportunity to break the zero lower bound, and realized that this separation can pave the way for a more convenient way to facilitating the feasibility of negative nominal interest rates.

Let’s look at a situation where reform is implemented in Denmark. With the current monetary policy regime it is obviously not relevant as Denmark approximately copy the ECB’s interest-rate policy for the sake of the fixed exchange rate policy.  And since the Euro interest rates are subject to zero lower bound, the Danish interest rate does not need to be negative. But should, for instance, the Eurozone decide to somehow break the lower bound, and thus from time to time set a negative interest rate,  then Denmark has to be able to do the same if the fixed exchange rate policy must be preserved. In this sense, it is perhaps not entirely far-fetched to describe the reform from a Danish perspective.

All electronic transactions continue to take place in the in kroner, and kroner continue to be the unit of account for prices and wages. Kroner have, however, become virtual, and can no longer be used as a physical means of payment. That is, cash denominated in kroner cease to exist. Unlike the proposal with the total elimination of cash, cash are introduced that are not denominated in kroner, but in something we will call a “Bernstein” (and they are introduced—with all respect—only low denominations n order not to subsidize the black economy too much).[12] This Bernstein has all the usual characteristics of cash. It is a bearer bond that does not carry interest. One can easily imagine that there are bonds issued in Bernsteins, but the interest rate on these will have a zero lower bound, for the same reason as existence of cash denominated in kroner today makes a negative krone interest rate impossible.

The simple trick is that with virtual kroner as a unit of account and the existence of a physical “parallel currency”, Bernsteins, then it is ossible that the krone interest rate can be negative: Monetary policy defines a spot exchange rate, St, between kroner and Bernsteins, which indicates the number of kroner per Bernstein. Next, let Ft,t +1 indicate the forward rate. Absence of arbitrage opportunities between kroner and Bernsteins therefore requires that a Buiter-Eisler version of the covered interest rate parity condition is met:

1 + ikt = (1 + ibt ) ( Ft,t+1 / St )

where ikt is the krone interest rate and ibt is the Bernstein interest rate. It is seen that a negative interest rate on kroner can be achieved when the central bank lets the krone appreciate against the Bernstein (Ft,t+1 / St ) when its interest rate is zero. It this situation it is profitable to lend in kroner at a negative rate. The alternative investment in Bernstein cash in the mattress provides zero interest rate, but it will leave the investor with the same loss as the lending in kroner, since the relative purchasing power of the Bernstein has fallen. The real krone and real Bernstein interest rate will be the same. This can be seen by the fact that a product costs pkt kroner or St * pbt kroner, where pbt is the price of the product in Bernsteins. Use this “purchasing power parity” with the uncovered interest rate parity, where EtSt+1  replaces Ft,t +1, to get

(1 + ikt ) / ( Et pkt+1 / pkt ) = (1 + ibt ) / ( Et pbt+1 / pbt) ;

i.e., identical real interest rates (Et is an expectations operator). One cannot become infinitely rich by borrowing at a negative nominal interest rate either. Placing funds in Bernsteins makes no net gain; see the argument above. Investment in shares or durable goods will yield same negative returns as the lending rate as a result of arbitrage, which implies expected losses on these assets (from presumably higher price levels). But monetary policy has moved the intertemporal price of consumption and investment, so it becomes more attractive to consume and invest now than later. And that’s the whole idea of an expansionary monetary policy.

A negative rate of the krone is therefore feasible, and monetary policy stimulus through a reduction in the nominal interest rate, without worrying about a zero lower bound, becomes a reality.  It will be effective if, and this is an important “if,” most of the economy’s transactions are made in kroner. Buiter (2009c) discusses in detail how the actual choice of the unit of account of important economic transactions is not trivial to manage for authorities. History contains many examples of instances where official unit of account has not been used. For example, the Euro was the official unit of account in all EMU countries from 1999, but before Euro cash was introduced at the beginning of 2002, most transactions were made in the still existing national currencies. He argues that adequate legislation will help ensuring that relevant transactions carried out in the selected unit of account.

Compared with the proposal with total elimination of cash, this proposal is probably more attractive. One maintains cash in circulation, which may be downright practical in some circumstances while also ensuring anonymity in some (hopefully legal) transactions.[13] Also, the central bank will be able to extract some seigniorage. The only losers seem to be actors in the criminal realm of the economy, if one makes sure that the nominal value of Bernsteins is not too large; notes or coins above 50 kroner (around $10) should not be necessary.

So for countries or unions that conduct countercyclical monetary policy, it is hard to see why one should not eliminate the bizarre policy asymmetry that the zero lower bound imposes on central banks and which right now forces central banks around the world to engage in more or less experimental quantitatively oriented policies.

Too modern, old-fashioned or just crazy?

The colleagues I have discussed these ideas with, do not appear particularly enthusiastic. I have often heard the argument that it is would be incomprehensible to the population and “difficult” to implement. Or even that it involves the confiscation of citizens’ wealth (those that are creditors) and therefore may be illegal. I cannot see that it should be incomprehensible or cumbersome. It corresponds to a change in the unit of account and the introduction of a new type of paper currency; reforms of that scale have been implemented many times in history around the world. Yes, it may not be done from one day to the other (Buiter, 2009a, however, believes that it can be done in a weekend). On the other hand, it cannot be any more cumbersome than to phase in a new tax reform. Regarding the confiscation argument, I do not know the legal aspects, but I know that the government every month “confiscates" a significant percentage of my salary. Governments have done that without legal issues all over the world for a very long time (and thanks for that). The fact that monetary policy under the proposed system from time to time may imply a negative nominal interest rate completely pales in comparison.

Note also that it will often be in the business cycle downturns with low inflation, or perhaps deflation, where there may be a need for negative nominal interest rates. Therefore, the real interest rate can be positive, even though the nominal is negative. Even if the real interest rate goes negative as well, it will not be uncommon at all in a historical context. Several times, inflation has exceeded nominal interest rates in Denmark and other countries. If this happens in a situation of negative nominal interest rates, then it is perhaps even a more favorable situation than in the historical instances. I would clearly prefer a real interest rate of -2 per cent as a result of zero inflation and a nominal interest rate of -2 per cent, rather than as a result of an inflation rate of 15 per cent and a nominal interest rate of 13 per cent. (just to emphasize the fact that the zero lower bound is more topical in a low-inflation environment that we fortunately live in nowadays).

Many are probably likely to consider the proposal with considerable skepticism. Several of the responses to Buiter’s (2009a) blog post are in line with the most rude and perfidious comments you can find online, and many seem to suffer from the misconception that it’s all about systematically stealing from citizens. It lead me to wonder if the reluctance could be rooted in a kind of bounded rationality, which also typically causes people to flatly reject a decline in nominal wages even if it is accompanied with a corresponding fall in prices; see, e.g., Fehr and Goette (2005).

In any case, I find Buiter’s proposal interesting. It extends the scope for monetary policy action in the direction where it is most needed. Namely, when one wants to mitigate recessions. And why would anybody write off a greater scope for policymaking, which can be achieved without much cost? This would seem old-fashioned and completely crazy.

References

Bailey, M. J., 1956, The Welfare Costs of Inflationary Finance. Journal of Political Economy 64, 93-110.

Buiter, W. H., 2007, Is Numerairology the Future of Monetary Economics? Unbundling numeraire and medium of exchange through a Virtual Currency and a Shadow Exchange Rate. Open Economies Review 18, 127-156.

Buiter, W. H., 2009a, Negative interest rates: when are they coming to a central bank near you? ft.com/maverecon, 7 May, 2009.

Buiter, W. H., 2009b, The Wonderful World of Negative Nominal Interest Rates, Again. ft.com/maverecon, 19 May, 2009.

Buiter, W. H., 2009c, Negative Nominal Interest Rates: Three Ways to Overcome the Zero Lower Bound. NBER Working Paper No. 15118.

Champ, B., 2008, Stamp Scrip: Money People Paid to Use. Federal Reserve Bank of Cleveland, April 2008.

Fehr, E. and L. Goette, 2005, Robustness and Real Consequences of Nominal Wage Rigidity. Journal of Monetary Economics 52, 779-804.

Friedman, M., 1969, The Optimum Quantity of Money. In “The Optimum Quantity of Money and Other Essays ”. Chicago: Aldine.

Gerlach-Kristen, P., 2003, Insiders and Outsiders at the Bank of England. Central Banking XIV(1), 96-102.

Gerlach-Kristen, P., 2009, Outsiders at the Bank of England’s MPC. Journal of Money, Credit and Banking 41, 1099-1115.

Mankiw, N.G., 2009, Reloading the Weapons of Monetary Policy . gregmankiw.blogspot.com, 19 March, 2009.

Romer, D., 1996/2006, Advanced Macroeconomics (first edition / third edition), Boston: The McGraw- Hill Companies.

Rudebusch, G. E., 2009, The Fed’s Monetary Policy Response to the Current Crisis , Federal Reserve Bank of San Francisco Economic Letter, 2009-17, May.

Smith, J. D., 1987, Measuring the Informal Economy. The Annals of the American Academy of Political and Social Science 493, 83-99.

Woodford, M., 2003, Interest and Prices. Princeton University Press.

[1] At the risk of committing a blunder in terms of history of economic thought, I dare to say that the idea of liquidity trap comes from Keynes. This is at least what David Romer writes in the first edition of its Advanced Macroeconomics (1996), where the subject is relegated to a minor exercise in Chapter 5. This signals in itself that the situation was not considered relevant at that time. In the third edition (2006) of his book, however, Romer devotes a separate section to the zero interest rate bound. (So, ost definitely textbooks are revised in light of changes in society and relevant new insights—contrary to what many critiques of modern macro would assert! But appropriately, changes are implemented through decisions of scientifically qualified individuals, and not because of populist statements from politicians or people just seeking to bash economists.) Anyway, in an IS/LM universe, only fiscal policy can stimulate demand and output in a liquidity trap. This obviously explains the discussion of the need for fiscal easing in the current situation.

[2] From now on, “interest rate" means the central bank’s policy rate.

[3] The interested reader can download the entire data set—including estimation—as an MS Excel spreadsheet by opening the link to the article.

[4] Americans therefore live in a situation where the Friedman (1969) rule for optimal (steady-state) monetary policy applies. As Friedman argued (and before him, Bailey, 1956), it is best if the private opportunity cost of holding money—the nominal interest rate—is equal to the marginal social cost of producing money. Since the latter is approximate zero, the nominal interest rate must also be zero. In a multitude of theoretical models with flexible prices appears this result is unusually robust. Introducing realistic sluggish adjustments in nominal variables, the need for stable prices means that a positive nominal interest rates, ceteris paribus, desirable (if the steady-state real interest rate is positive—a reasonable assumption). Friedman’s insight nevertheless demonstrates that positive nominal interest rates have costs when there is money that does not gives interest. But many will probably, along with Rudebusch, not think that the elimination of the “Friedman cost” can compensate for the loss of output and employment in the current recession.

[5] The real value of cash is of course eroded by inflation, but inflation erodes the value of an investment in, e.g., a bond by the same percentage. So when comparing returns between bonds and money we do not need to consider inflation, and I ignore it for the most part. Moreover, I ignore non-financial costs of holding cash (for example, storage costs and the risk of theft). Introduction of these would reduce the return of cash to below zero, but probably not by much.

[6] It should be said immediately that Buiter stands on the shoulders of his predecessors. All proposals have historical roots, but Buiter’s accomplishment is to bring the ideas forward in a modern form in a situation where innovation is welcome.

[7] See Champ (2008) for a description of Gesell’s proposal (and actual implementations in the beginning of the last century), and for a review of how both Irving Fisher as Keynes found the idea interesting as this—cumbersome—stamping would make people spend money more quickly, which could be beneficial in a recession.

[8] Or consider a stochastic version where a lottery from time to time determines that all banknotes ending on digit n lose their value. This idea is attributed by a student of N. Gregory Mankiw (Mankiw, 2009). Buiter (2009b) mentions that Charles Goodhart has had the idea for years.

[9] Banks can of course still make profits on their interest rate spreads. Whether they offer zero per cent for customers’ deposits and lend to 2 per cent, or offer -5 per cent for deposits and lend to -3 per cent, give the same profits.

[10] Buiter has informally inquired at the ECB why they issue a 500 Euro note, which is after all quite a hefty size. One of the arguments was that house sales in Spain were often made in cash and therefore it would be too difficult to trade if you had to carry a lot of notes of small denomination. Similarly, I know from a reliable source that car trades in Germany often only takes place with cash. So people have to go to the bank, make withdrawals, and nervously carry several thousand Euros in cash on the way to the car dealer. To such arguments, based on such dubious trade patterns, I say just as Buiter (2009b): “Quatsch“.

[11] Eisler’s goal with the idea was monetary stability, since he interpreted the virtual currency (called "money banco”) as being defined in relation to a product bundle. That it can be dangerous to propose controversial economic reforms is well known, but Eisler nearly lost his life by it. Prior to World War II, he proposed that Austria should join the Pound Sterling zone, and was immediately arrested by the Nazis and sent to concentration camp. He survived 15 months of forced labor in Dachau and Buchenwald. He lived in England afterwards.

[12] Here, I follow Buiter (2009c) by naming a parallel currency after a central bank governor. He uses the term “Wim” in honor of the ECB’s first president, Wim Duisenberg.

[13] It would also be preferable for people who seem to weigh a currency as a national symbol very heavily. There could then be a referendum concerning the name of the new currency. Or one could simply keep the krone as the cash currency, and then call the virtual something else; Buiter (2007) has a fun suggestion: “Phlogiston”. If one is afraid that Danish identity is lost by that name, one could call it “The Danish people’s sovereign unit of account in honor of God and Fatherland”. I personally do not care.

Banks Now (2008) and Then (1929)

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The Hellhound of Wall Street: How Ferdinand Pecora’s Investigation of the Great Crash Forever Changed American Finance

James Grant’s October 2010 review of Michael Perino’s book The Hellhound of Wall Street is titled “Out for Blood: A Portrait of the prosecutor charged with investigating the 1929 crash.” Trying to distinguish between size of shock and ability to withstand a shock of a given size, James Grant contrasts the stability of banks back then compared to banks now:

For 10 days in March 1933, Pecora’s investigatory target was Charles E. Mitchell, chief executive of National City Bank, later to become Citigroup. “Sunshine Charley,” as Mitchell was mockingly known after his fall from grace, came pre-convicted, but his bank was a pillar of strength. Today, in the wake of the serial bailouts of 2008-09, Mitchell’s managerial achievement seems almost mythical. From the 1929 peak to the 1933 depths, nominal GDP fell by 45.6%—the American economy was virtually sawed in half. By contrast, during our late, Great Recession, nominal GDP dropped by only 3.1%. Yet this comparatively minor perturbation sent Citigroup into the arms of the federal government to the tune of $45 billion in TARP funds and wholesale FDIC guarantees of the bank’s tattered mortgage portfolio.

National City did accept a $50 million federal investment in 1934, after Mitchell resigned. However—and herein lies the difference—the bank’s solvency didn’t hinge on that cash infusion. Many banks did fail in the Depression, of course. But from today’s perspective the wonder is that so many didn’t.

There is a moral to this story. We have better monetary policy now than at the beginning of the Great Depression. And we know enough to know that to save the economy we need to bail banks out, if they would otherwise drag the economy with them. But what we have not yet learned is that to keep banks from needing to be bailed out, the key is to have much higher equity requirements than those contemplated today, even under the heading of financial reform.

Here is how I frame the issue in my column “How to Avoid Another Nasdaq Meltdown: Slow It Down (to Only 20 Times Per Second)”:

In academic finance, concerns about high-frequency trading go under the heading of “market microstructure” issues. There are other bigger problems in finance at the macroeconomic level that I have talked about morethanonce [3 different links]. The best reason to fix unfairness—or even perceived unfairness—in market microstructure is so people aren’t distracted from noticing how those in the financial industry use low levels of equity financing (often misleadingly called capital) to shift risks onto the backs of taxpayers and rewards into their own pockets. In quantum mechanics, electrons can “tunnel” from one side of a barrier to another. Using massive borrowing to ensure later government bailouts, the financial industry has perfected an even more amazing form of tunneling: the art of tunneling money from the government so that the profits appear on their balance sheets and in their pockets long before the money disappears from the US Treasury in bailouts. By comparison with this financial quantum tunneling of money from the US taxpayer that has been a mainstay of the financial industry, high-frequency trading profits of a few billion dollars a year are small change.

And here is the question I posed in my column “Three Big Questions for Larry Summers, Janet Yellen, or Anyone Else Who Wants to Head the Fed”:

What do you think of what Anat Admati and Martin Hellwig have to say about financial regulation in their book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It? Their argument comes down to this: 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. (For follow-up questions on financial regulation, Admati and Hellwig have an invaluable cheatsheet.)

That is a question I now pose to all of you. I give my answer here and here.

Ben Bernanke: The Fed Does Less Monetary Stimulus Than It Thinks Is Warranted Because It Is Afraid of the Side Effects of Unconventional Tools

On January 14, 2013, Ben Bernanke came to a Q&A session at the University of Michigan, sponsored by the Ford School of Public Policy. Here is the video and the full transcript can be found here. I thought Ben said some particularly important things about the use of unconventional tools of monetary policy and about financial stability. Let me excerpt four question and answer exchanges. I consider the last of the four the most important.

The Effectiveness of Quantitative Easing

Susan Collins (Dean of the Ford School): …the Fed, of course, has been keeping interest rates at close to zero since roughly 2008. And it’s dug pretty deep into its arsenal and very unconventional policies more recently in terms of, in particular, the very massive asset purchases recently launched its third round which are intended to bring long-term interest rates. Can you tell us how well you think that is working?

Ben Bernanke: So, to go back just one step, as you said, we’ve brought the short-term interest rate down almost to zero. And for many, many years, monetary policy just involved moving the short-term, basically, overnight interest rate up and down and hoping that the rest of the interest rates would move in sympathy. Then we hit a situation in 2008 where we had brought the short-term rate down about as far as it could go, almost entirely to zero. And so, the question is, what more could the Fed do? And there were many people–a decade ago, there were a lot of articles about how the Fed would be out of ammunition if they got the short-term rate down to zero. But a lot of work by academics and others, researchers at the central banks suggested there was more that could be done once you got the short-term rate down to zero. And in particular, what you could do is try to address the longer term interest rate, bring longer term rates down. And there are two basic ways to do that. One way is through talk, communication, sometimes called open mouth operations. [Laughter] The idea being that if you tell the public that you’re going to keep rates low in the long-term, that that will have the effect of pushing down longer term interest rates. But the quest–the one you’re asking about is what we call at the Fed large scale asset purchases or otherwise known as QE. The idea there is that by buying large quantities of longer term treasury securities or mortgage-backed security so that we can drive down interest rates on those key securities. And that, in turn, affects spending investment in the economy. The latest episode, you know, so far, we think we are getting some effect. It’s kind of early. But overall, it’s clear that through the three iterations that you refer to that we have succeeded in bringing longer-term rates down pretty significantly, and a clear evidence of that would be mortgage rates, as you know, a 30-year mortgage rate is something like 3.4 percent now, incredibly low. And that, in turn, makes housing very affordable. And that, in turn, is helping the housing sector recover, creating construction jobs, raising house prices, increasing activity in that sector, real estate activity, and so on. So, I think broadly speaking, that we have found this to be an effective tool. But we’re going to continue to assess how effective, because it’s possible that as you move through time and the situation changes that the impact of these tools could vary. But I think what we have decisively shown is that the short-term interest rate getting down to zero, but economists call it the zero lower bound problem, it does not mean the Fed is out of ammunition. There are still things we can do, things we have done. And I would add that other central banks around the world had done similar things and have also had some success in creating more monetary policy support for the economy….

Inflation and Financial Stability Risks of Fed Stimulus

Susan Collins: And I wonder what you might say to those who argue that … the massive asset purchases have created extremely high risks, perhaps, under appreciated risks for future inflation.

Ben Bernanke: …the Federal Reserve has a dual mandate from the Congress to achieve or at least to try to achieve price stability and maximum employment. Price stability means low inflation. We have basically taken that to be two percent inflation. Inflation has been very low. It’s been below two percent and appears to be on track to stay below two percent. So, our price stability record is very good. Unemployment, though, as we’ve already discussed, is still quite high. It’s been coming down but very slowly. And the cost of that is enormous in terms of lost, you know, lost resources, hardship, talents and skills being wasted. So, our effort to try to create more strength in the economy, to try and put more people back to work, I think that’s an extraordinarily important thing for us to be doing. And I think it motivates and justifies what has been, I agree, an aggressive monetary policy. So, that’s what we’re doing and that’s why we’re doing it. Now, are there downsides? Are there potential costs and risks? There are some. You mentioned inflation. We have, obviously, used very expansionary monetary policy. We’ve increased the monetary base which is demand reserves that banks hold with the Fed. There are some people who, I think, that’s going to be inflationary. Personally, I don’t see much evidence in that. Inflation, as I’ve mentioned has been quite flow. Inflation expectations remain quite well-anchored. Private sector forecasters do not see any inflation coming up. And in particular, we have, I believe, we have all the tools we need to undo our monetary policy stimulus and to just–to take that away before inflation becomes our problem. So, I don’t believe that significant inflation is going to be a result of any of this. That being said, price stability is one part of our tool mandate, and we will be paying very close attention to make sure that inflation stays well contained as it is today. A second issue, I think, probably worth mentioning is financial stability. This is a difficult issue. The concern is–has been raised at–by keeping interest rates very low, that we induce–the Federal Reserve induces people to take greater risks in their financial investments, and that, in turn, could lead to instability later on, again, a difficult question. In fact, I could take the rest of the hour talking about this, so I don’t think I’ll do that. But what I will say is that we are, first of all, very engaged in monitoring the economy, the financial system. The Fed has increased enormously the amount of resources we put into monitoring financial conditions and trying to understand what’s happening in different sectors of the financial markets. We’ve also, of course, been part of the very extended effort to strengthen our financial system by increasing capital in banks, by making derivatives and transactions more transparent, by stiffening supervision, and so on. So, we are taking measures to try both to prevent financial instability and to identify potential risks that we would then address through regulatory or supervisory methods. So, we’re very much attuned those–to these issues. But once again, I think this is something that we need to pay careful attention to. And as I–as we discussed in our statement and have for a while, as we evaluate these policies, we’re going to be looking at the benefits which, I believe, involve some help to economic growth to reduction in unemployment. But we’re also going to be looking at cost and risk. We have a cost benefit type of approach here. We want to make sure that the actions we’re taking are fully justified in a cost benefit type of framework. …interest rates will eventually rise. We hope they rise, because that means the economy will be strengthening. So, you know, we’re not going to playing games with that. We are going to follow our mandate, which means do what’s necessary to help the economy be strong. … Indeed, I think the worst thing we could do would be if we raise interest rates prematurely and caused recession, that would greatly increase budget deficits.

Monetary vs. Regulatory Approaches to Financial Stability

Audience Question: Do you believe that the Fed should actively prevent future asset bubbles and if so what tools do you have to do that?

Ben Bernanke: Well, asset bubbles have been–they’re very, very difficult to anticipate, obviously. But we can do some things. First of all, we can try to strengthen our financial system, say, by increase–as I mentioned earlier, by increasing the amount of capital liquidity the banks hold, by improving the supervision of those banks, by making sure that every important financial institution is supervised by somebody. There were some very important ones during the crisis that essentially had no effective supervision. So you make the system stronger that if a bubble or some other financial problem emerges, the system will be better able to be more resilient, will be better able to survive the problem. Now, you can try to identify bubbles and I think there has been a lot of research on that, a lot of thinking about that. We have created a council called the Financial Stability Oversight Council, the FSOC, which is made up of 10 regulators and chaired by the Secretary of the Treasury. One of whose responsibilities is to monitor the financial system as the Fed also does and try to identify problems that emerge. So, you’re not going to identify every possible problem for sure but you can do your best and you can try to make sure that the system is strong. And when you identify problems, you can use–I think the first line of defense needs to be regulatory and supervisory authorities that not only the Fed but other organizations like the OCC and the FDIC and so on have as well. So you can address these problems using regulatory and supervisory authorities. Now having said all that, as I was saying earlier, there’s a lot of disagreement about what role monetary policy plays in creating asset bubbles. It is not a settled issue. There are some people who think that it’s an important source of asset bubbles, others would think, it’s not. Our attitude is, that we need to be open-minded about it and to pay close attention to what’s happening and to the extent that we can identify problems. You know, we need to address that. The Federal Reserve was created in about 100 years ago now, 1930 was the law, not to do monetary policy but rather to address financial panics. And that’s what we did, of course, in 2008 and 2009. And it’s a difficult task but I think going forward, the Fed needs to think about financial stability and monetary economics stability as being, in some sense, the two key pillars of what the Central Bank tries to do. And so we will, obviously, be working very hard in financial stability. We’ll be using our regulatory and supervisory powers. We’ll try to strengthen the financial system. And if necessary, we will adjust monetary policy as well but I don’t think that’s the first line of defense.

Costs and Benefits of Unconventional Tools of Monetary Policy

Question Tweeted In: This question comes from Twitter. Since the Fed declared it was targeting a two percent inflation rate in January of 2012, the FOMC has released its projections five times. And each one of these projections, the inflation rate has come in below this target. Why then has the policy been set to concessively undershoot the target?

Ben Bernanke: Was that 140 characters? [ Laughter ] I suspect many in our audience had related questions. [Laughter] Yeah. That’s a very good–it’s a very good question and let me try to address. As I said earlier when Dean Collins was asking me about the risks of some of our policies, I was pointing out that inflation is very low. Indeed, it’s below the two percent target and unemployment is above where it should be and therefore, there seems to be a pretty strong presumption that we should be aggressive in monetary policy. So, you know, I think that that does make the case for being aggressive which we are trying to do. Now, the additional point that I made, though, was that, you know, the short-term interest rate is close to zero and therefore we are now in the world of non-standard monetary policy [inaudible] asset purchases and communications and so on. And as we were discussing earlier, we have to pay very close attention to the costs and the risks and the efficacy of these non-standard policies as well as the potential economic benefits. And to the extent that there are costs or risks associated with non-standard policies which do not appear or at least not to the same degree for standard policies then you would, you know, economics tells you when something is more costly, you do a little bit less of it. We are being quite accommodative. We are working very hard to try to strengthen the economy. Inflation is very close to the target. It’s not radically far from the target. But in trying to think about what the right policy is, we have to think not only about the macroeconomic outlook which is obviously very critical, but also the costs and risks associated with the individual policies that we might apply.

The Costs and Benefits of Repealing the Zero Lower Bound...and Then Lowering the Long-Run Inflation Target

blog.supplysideliberal.com tumblr_inline_mvdxdbCZir1r57lmx.png

Here is a link to my second Pieria exclusive: “The Costs and Benefits of Repealing the Zero Lower Bound …and Then Lowering the Long-Run Inflation Target.”

The tag line at the bottom of Pieria’s cover page is from the post itself:

Repealing the zero lower bound has some costs, but those costs should be weighted against the benefits: not only ending recessions, but also ending inflation. 

Those words refer to my first column on electronic money: “How Subordinating Paper Currency to Electronic Money Can End Recessions and End Inflation.”

John Stuart Mill Prefers Preferences for Almost Anything But Indolence

John Stuart Mill makes an eloquent argument for freedom of desire in On Liberty, chapter III, “Of Individuality, as One of the Elements of Well-Being,” paragraph 5:

To a certain extent it is admitted, that our understanding should be our own: but there is not the same willingness to admit that our desires and impulses should be our own likewise; or that to possess impulses of our own, and of any strength, is anything but a peril and a snare. Yet desires and impulses are as much a part of a perfect human being, as beliefs and restraints: and strong impulses are only perilous when not properly balanced; when one set of aims and inclinations is developed into strength, while others, which ought to co-exist with them, remain weak and inactive. It is not because men’s desires are strong that they act ill; it is because their consciences are weak. There is no natural connexion between strong impulses and a weak conscience. The natural connexion is the other way. To say that one person’s desires and feelings are stronger and more various than those of another, is merely to say that he has more of the raw material of human nature, and is therefore capable, perhaps of more evil, but certainly of more good. Strong impulses are but another name for energy. Energy may be turned to bad uses; but more good may always be made of an energetic nature, than of an indolent and impassive one. Those who have most natural feeling, are always those whose cultivated feelings may be made the strongest. The same strong susceptibilities which make the personal impulses vivid and powerful, are also the source from whence are generated the most passionate love of virtue, and the sternest self-control. It is through the cultivation of these, that society both does its duty and protects its interests: not by rejecting the stuff of which heroes are made, because it knows not how to make them. A person whose desires and impulses are his own—are the expression of his own nature, as it has been developed and modified by his own culture—is said to have a character. One whose desires and impulses are not his own, has no character, no more than a steam-engine has a character. If, in addition to being his own, his impulses are strong, and are under the government of a strong will, he has an energetic character. Whoever thinks that individuality of desires and impulses should not be encouraged to unfold itself, must maintain that society has no need of strong natures—is not the better for containing many persons who have much character—and that a high general average of energy is not desirable.

Unfortunately, John Stuart Mill undercuts his argument for freedom of desire by implicitly attacking the desire for indolence and passivity. In modern American culture as well, two of the desires we are the most ready to denigrate is the desire to watch TV (which in recent years has been the medium for some of our greatest works of art) and for sleep–which can be one of the most beautiful forms of indolence and passivity. (I found it entertaining to see the varied google search results for the phrase “I’ll sleep when I’m dead.”) 

I often fail in my resolutions. But I value happiness enough that ever since my psychologist colleague Norbert Schwarz impressed upon me the high marginal product sleep has in producing happiness, I have made an effort to get more sleep. I have not regretted those efforts. And my wife Gail and I just finished a “Prison Break” marathon. 

Pieria #1—>Going Off the Paper Standard

Here is the full text of my 1st Pieria exclusive “Going Off the Paper Standard,“ now brought home to supplysideliberal.com. It was first published on October 9, 2013.

If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Pieria exclusive and the following copyright notice:

© October 9, 2013: Miles Kimball, as first published on Pieria. Used by permission according to a temporary nonexclusive license expiring June 30, 2015. All rights reserved.

This post is in part a response to Izabella Kaminska’s Alphaville post "Gold, paper, scissors, lizard, e-money.” I was delighted to see her reaction to this post in a tweet saying

Going off the paper standard - by @mileskimball http://www.pieria.co.uk/articles/going_off_the_paper_standard … Well argued response to queries I posed.

For almost a year now I have been advocating the use of negative interest rates for brief periods of time to cut recessions short without:

  • 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 rates.” 

The two key measures for eliminating the zero lower bound and making sharply negative interest rates possible are:

  1. establishing electronic money—the e-dollar, e-euro, e-yen, e-pound, or the like—as the unit of account, and
  2. 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:

  1. Announce that eliminating the zero lower bound is possible from a technical point of view.
  2. 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.
  3. Ask banks and other financial firms to prepare contingency plans for negative interest rates.
  4. 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.
  5. Ask government agencies to prepare contingency plans for negative interest rates and non-par   valuation of paper money. 
  6. 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. 
  7. 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. 
  8. Formally make money in government insured bank accounts legal tender.
  9. Announce the intent to introduce an electronic money system.
  10. Lower the central bank’s interest rate on reserves to zero or slightly below zero.
  11. Lower the central bank’s target interest rate, interest rate on reserves, and the central bank’s lending rate substantially below zero.
  12. 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.
  13. Discount vault cash applied to reserve requirements according to the market value of paper currency.
  14. Implement the accounting standards appropriate for negative interest rates and paper currency at non-par valuations.
  15. Require payment of taxes and other substantial debts to the government in electronic form. 
  16. Implement the contingency plans for government agencies.
  17. 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.)
  18. 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 sector. 

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 politically.  

Andrew Carnegie on Cost-Cutting

Link to a New York Times review of American Colossus by reviewer John Steele Gordon

In his book American Colossus: The Triumph of Capitalism 1865-1900, H. W. Brands writes this, quoting from his earlier book Masters of Enterprise: Giants of American Business from John Jacob Astor and J.P. Morgan to Bill Gates and Oprah Winfrey(p. 59) and from Joseph Frazier Wall's Andrew Carnegie(p. 337):

Carnegie obsessed over cost because it was the one part of his business he could control. “Carnegie never wanted to know the profits,” an associate said. “He always wanted to know the cost.” Carnegie himself explained: “Show me your cost sheets. It is more interesting to know how well and how cheaply you have done this thing than how much money you have made, because the one is a temporary result, due possibly to special conditions of trade, but the other means a permanency that will go on with the works as long as they last.” (p. 93)

Twitter Melee Over Negative Interest Rates →

This spirited Twitter discussion of negative interest rates serves as a useful compendium of issues that I need to address as I have time. 

Let me point out one big victory in this discussion that you might not otherwise notice: every one of the participants in this discussion takes for granted that the zero lower bound is a policy choice–not a law of nature, and discusses it seriously as a policy choice. 

The Red Banker on Supply-Side Liberalism

Icon for the Red Banker blog (which also appears in Wikipedia article on the “Commercial Revolution”)

Icon for the Red Banker blog (which also appears in Wikipedia article on the “Commercial Revolution”)

Frederic Mari blogs as the Red Banker. He gives a positive take on my first post “What is a Supply-Side Liberal?” in his post “Supply Side Liberalism: The Interesting Case of Dr. Kimball and Mr. Miles.” However, Frederic questions whether limited government is politically possible, saying

People oppose government spending but support all of its public good provision.

Here I wished he had discussed my central proposal for keeping the burden of taxation down while providing abundant public goods: a public contribution system that raises taxes rates, but lets people avoid 100% of the extra taxes by making charitable donations focused on doing things the government might otherwise have to do. These two posts lay out how a public contribution system would work: 

Also, my post 

is best understood in this context.

I discuss a few other ideas for how to reduce the burden of taxation based on the ways in which human psychology departs from over-simplified views of homo economicus in this popular post: 

The bottom line is this: In my book, it isn’t Supply-Side Liberalism without a serious effort to lower the burden of taxation for any given level of revenue, using everything we know about human nature.

Quartz #32—>Talk Ain't Cheap: You Should Expect Overreaction When the Fed Makes a Mess of Explaining Its Plans

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Link to the Column on Quartz

Here is the full text of my 31st Quartz column, “You should expect panic when the Fed makes a mess of explaining its plans," now brought home to supplysideliberal.com. It was first published on September 19, 2013. Links to all my other columns can be found here.

If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Quartz column and the following copyright notice:

© September 19, 2013: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2015. All rights reserved.

Back in June, Ben Bernanke told the press:

If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of [asset] purchases later this year.

That sentence was interpreted as signaling a tightening of the path of monetary policy, and rocked markets around the world. Bernanke and other members of the US Federal Reserve’s monetary policy committee made great efforts to fight that perception of tighter policy intentions, but it is only with yesterday’s announcement that

… the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its [asset] purchases

the markets have been convinced that the Fed intends to continue to use the “quantitative easing” provided by buying long-term government bonds and mortgage-backed assets to stimulate the economy until things look better.

I agree with Justin Wolfers, writing in Bloomberg, that the way Bernanke talked in June about “tapering” off asset purchases was a serious mistake, only partly rectified by the Fed’s announcement today. But the real fault lies with an approach to monetary policy that relies so heavily on communicating the Fed’s future intentions.

Monetary policy’s dependence on what the Fed calls “communications” is problematic because members of the Fed’s monetary policy committee don’t even agree on what war they are fighting. Some view the battle as one of fighting back from a close call with the possibility of another Great Depression. Janet Yellen, the clear frontrunner to succeed Ben Bernanke now that Larry Summers has bowed out, is in this camp. Some just want to make sure monetary policy doesn’t contribute to another financial crisis. Still others worry about avoiding the inflationary mistakes of the 1970s. It is hard for a many-headed beast to signal a clear direction.

Secondly, the Fed’s approach of talk therapy is problematic because it is hard to communicate a monetary policy that is strongly stimulative now but will be less stimulative in the future. As I discussed in a previous column and in the presentation I have been giving to central banks around the world, adjusting short-term interest rates has an almost unique ability to get the timing of monetary policy right. Unfortunately, the US government’s unlimited guarantee that people can earn at least a zero interest rate by holding massive quantities of paper currency stands in the way of simply lowering short-term interest rates. Without being able to cut short-term rates, the two choices left are (a) stimulative both now and later or (b) not-so-stimulative either now or later. Since the appropriate level of monetary stimulus now and a year or two from now are likely to be different, it is easy to see how the Fed’s thinking—and the market’s interpretation of the Fed’s thinking—could oscillate between focusing on getting the right level of monetary stimulus now, and getting the right level of monetary stimulus later.

My own recommendations for the Fed are no secret:

  1. Eliminate the zero-lower bound on nominal interest rates—or at least begin making the case to Congress for that authority.
  2. Develop a more rule-based approach to monetary policy focused on the level of nominal GDP in which (aside from urgent crises like that in late 2008) the role of “judgment calls” would be limited primarily to judgments about the highest level of output consistent with avoiding a permanent increase in inflation. Such an approach would allow the Fed to speak with a more unified voice despite disagreements among members of the monetary policy committee.
  3. Deal with financial stability by raising equity requirements for banks and other financial firms rather than thinking that tight monetary policy is the key to financial stability.

The Unavoidability of Faith

Sometimes we think of faith as something optional, and something directed toward the supernatural. Not so. Faith is unavoidable, and faith directed toward the supernatural is a small part of all faith.

As for many discussions of faith, the starting point for my discussion of faith are the words of the (unknown) author of the Epistle to the Hebrews. Using William Tyndale’s translation with modern spelling, Hebrews 11:1 reads

Faith is a sure confidence of things which are hoped for and a certainty of things which are not seen. 

In my book, the more evidence we have to go on and the less faith we have to depend on, the better. That is, I disagree with the words the resurrected Jesus is reported to have said to a doubting Thomas (John 20:29, Tyndale):

Thomas, because thou hast seen me therefore thou believest: Happy are they that have not seen and yet believe.

Rather, happy are they who have much evidence to base their choices on. But choices–to act, or not to act–often have to be made when evidence is scarce. That is where faith comes in.

One might be tempted to think of faith as a Bayesian prior. But it isn’t that simple. In Bayesian decision-making, “prior beliefs” are left unexplained. But in the real world they come from different ways of responding to and reasoning about past experience. New data sometimes simply updates prior beliefs within the same paradigm, as Bayesian theory suggests. But other times, new data upends the thin tissue of reasoning and reaction that was crucial for the formation of those prior beliefs, resulting in a much bigger change in views than straightforward Bayesian updating would imply. And sometimes additional reasoning–in the absence of any additional data whatsoever–can dramatically change one’s views.

A simpler point is that what is prior to one set of events is posterior to earlier events. Putting both points together, faith is what one believes at a given moment in time, however one has managed to cobble together those beliefs.

In situations where one is willing to think of one choice as inaction, with costly actions having debatable benefits, one can distinguish between a “belief in nothing” that leads one to continue in inaction, and a “belief in something” that leads one to act. When proponents of action say “Have faith!” they are advocating a belief in a high enough marginal product of action to make it worth the costs. That is very much the perspective of the Lectures on Faith, which were once part of the Mormon canon, but now enjoy only semi-canonical status. (The full text of the Lectures on Faith can be found here.)  Let me quote a passage from the Lectures on Faith that has stuck with me, again modernizing the spelling:    

If men were duly to consider themselves, and turn their thoughts and reflections to the operations of their own minds, they would readily discover that it is faith, and faith only, which is the moving cause of all action, in them; that without it, both mind and body would be in a state of inactivity, and all their exertions would cease, both physical and mental.

Were this class to go back and reflect upon the history of their lives, from the period of their first recollection, and ask themselves, what principle excited them to action, or what gave them energy and activity, in all their lawful avocations, callings and pursuits, what would be the answer? Would it not be that it was the assurance which we had of the existence of things which we had not seen, as yet? Was it not the hope which you had, in consequence of your belief in the existence of unseen things, which stimulated you to action and exertion, in order to obtain them? Are you not dependent on your faith, or belief, for the acquisition of all knowledge, wisdom and intelligence? Would you exert yourselves to obtain wisdom and intelligence, unless you did believe that you could obtain them? Would you have ever sown if you had not believed that you would reap? Would you have ever planted if you had not believed that you would gather? Would you have ever asked unless you had believed that you would receive? Would you have ever sought unless you had believed that you would have found? Or would you have ever knocked unless you had believed that it would have been opened unto you? In a word, is there any thing that you would have done, either physical or mental, if you had not previously believed? Are not all your exertions, of every kind, dependent on your faith? Or may we not ask, what have you, or what do you possess, which you have not obtained by reason of your faith? Your food, your raiment, your lodgings, are they not all by reason of your faith? Reflect, and ask yourselves, if these things are not so. Turn your thoughts on your own minds, and see if faith is not the moving cause of all action in yourselves; and if the moving cause in you, it it not in all other intelligent beings?

Application 1: The Cognitive Economics of Human Capital

Let me apply this idea to Jill’s decision of whether to go to college and learn economics or not. Some consequences of college might be relatively easy to discern, such as the costs,  and if she is relatively well informed, the likely effect on her future wage. But what about the benefits learning economic analysis might have for her future decision-making? A tempting approach to analyzing Jill’s problem would be to think of her computing what her life would be like (or a probability distribution thereof) if she does go to college, as well as what her life would be like if she doesn’t go to college, compare the two to see which one she prefers, and make that choice. But in this case, Jill can't compute what her life will be like if she goes to college and learns economics because she doesn’t know now the analytical tools that could influence her life in critical ways if she does go to college and learn economics. In other words, she can’t make a fully rational choice (according to the demanding standards of most economic models) of whether or not to go to college without knowing the very things that she would be learning in college. But if she knew those things already, she wouldn’t need to go to college!  

The Handbook of Contemporary Behavioral Economics: Foundations and Developments, page 343 points to the more general conundrum of which Jill’s problem is an example:

The inability to formulate an optimization problem that folds in the cost of its own solution has become known as the “infinite regress problem,” with Savage (1954) appearing to be the first to use the regress label.  

Application 2: The Cognitive Economics of R&D

Another good example of the infinite regress problem is the decision of which lines of research to pursue. The issue is stark in a decision of whether or not to undertake a research project in mathematical economic theory. There is no way to make a fully rational decision according to the demanding standards of most economic models because the most economic models assume that information processing (as distinct from information acquisition) comes free, but the issue is precisely whether one’s own finite thinking ability will allow one to find a publishable theoretical result within a reasonable amount of time. Therefore, one must make the decision according to a hunch of some sort–or in other words, by faith. The analogy that makes one believe that a proof might exist is not itself the proof, and may fall apart. But that analogy makes one willing to take the risk. Except in cases where undecidability of the sort that shows up in Goedel’s theorem comes into play, the only fully rational probability that one could find a proof would be either 0 or 1, because one would already know the answer. But that just isn’t the way it is when you make the decision. You have some notion of the probability you will be able to find a proof–a probability that by its nature cannot have a firm foundation, yet still guides one’s choice: faith.

Application 3: The Cognitive Economics of Economic Growth

Growth theory faces a similar problem. It would be a lot easier to form a sensible probability distribution for future technological progress if one actually knew the technology already. Someday, economists studying the economics of other planets under the restriction of Star Trek’s (often violated) Prime Directive of non-intervention may be able to do growth theory that way. But we 21st century economists must do growth theory in ignorance of scientific and engineering principles that may be crucial to future economic growth. It would be nice to know the answers to questions such as how hard it is to make batteries more efficient, for example, or whether theoretically possible subatomic particles that could catalyze fusion exist or not. (My friend, theoretical physicist James Wells, has worked on the theory. The right kind of heavy, but relatively stable negatively charged particle could do it by taking the place of electrons in hydrogen atoms and making the exotic hydrogen atoms much smaller in size.) If it were all just a matter of getting experimental results, the economic model might be standard, but what if just thinking more clearly with the evidence one already has could make it possible to get to the answer with one decisive experiment instead of an inefficient series of 100 experiments. 

Just as with the standard approach to human capital, we often look at technological progress from the outside, in a relatively bloodless way: a shifter in the production function changes. But the inside story of most technological progress is that in some sense we were doing something stupid, but now have stopped being stupid in that particular way. I say “in some sense” because–while our finite cognition is painful–it is possible to be smart in recognizing our cognitive limitations and making reasonable decisions despite having to walk more by faith that we would like in making decisions that depend on technologies we don’t yet know exist.

Application 4: Locus of Control

A central life decision is whether to attempt to better one’s life by making an effort to do so. Information acquisition and learning how to process information are themselves costly, so the initial decision of whether to do the information acquisition and other learning that are a logical first step must be made in a fog of ignorance. Some people are lucky enough to have parents who instill in them confidence that effort to gain knowledge, learn and grow will be well rewarded in life, at least on average. It is good luck to have that belief, because it seems to be true for most people. But believing that it is true for you–that your efforts to better your life will be rewarded–must be an act of faith. For you are not exactly like anyone else. And even knowing that most people are similar in this regard is a bit of knowledge that might cost you dearly to acquire if you are not so lucky to as to have your parents, or someone else you trust tell you so.

If you decide that it is not worth the effort trying to better your life, you will not collect much evidence on the marginal product of effort, and so there will be precious little that could provide direct evidence to change your mind. In such a low-effort trap, it will not be hard evidence about your own marginal product of effort that switches you from believing in an external locus of control (outside forces govern outcomes with little effect of own effort) to an internal locus of control (own efforts have an important effect on quality of outcomes). If you escape the trap of believing in an external locus of control, it will be by believing some kind of evidence or reasoning that is much less definitive.

Conclusion

I do not believe in the supernatural. So for me, faith is not about the supernatural. Yet still we must walk by faith. Walking by the light of evidence is better, but such is not always our lot.

Not only must we sometimes walk by faith–whether we like or not–so must others. It matters what kind of faith we instill in those around us, to the extent we have any influence.

To me, faith in progress and human improvability–both individually and collectively–is a precious boon. It is not enough for us to have that faith. Many are caught in what I believe to be the trap of believing they can not better their lives. I believe it is important for them to have faith in progress and human improvability as well. If you believe in progress and human improvability as I do, let us together seek for better and better ways of transmitting that faith to those who do not yet believe.

Robert Graboyes on Enabling Supply-Side Innovation in Health Care

When my column “Don’t Believe Anyone Who Claims to Understand the Economics of Obamacare” appeared, Robert Graboyes sent me a link to his October 2, 2013 post in the Mercatus Center’s “McClatchy Tribune” blog also emphasizing the importance of innovation: “Paging Dr. Jobs.” (Here is a link to the article in the Dallas Morning News.) I liked it so much I asked to reprint it here. He kindly gave me permission. Here it is. One action Robert caused me to take is that I bought the Kindle edition of  “The Innovator’s Prescription” by Clayton Christensen, Jerome Grossman, and Jason Hwang.

American health care has no Steve Jobs or Bill Gates. No Jeff Bezos, Elon Musk, Burt Rutan, or Henry Ford. No innovator whose genius and sweat deliver the twin lightning bolts of cost-reduction and quality improvement across the broad landscape of health care. Why not? Either we answer that question soon and uncork the genie, or we consign our health care to a prolonged, unaffordable stagnation.

America leads the world in health-care innovation — but not the innovation that sends costs plunging and unleashes previously undreamed-of quality improvements. That kind of innovation occurs only in isolated pockets of health care. In the aggregate, health care spending rises rapidly and relentlessly.

If implemented as planned, the Affordable Care Act ensures the health-care industry will never have the flexibility it needs to generate a Steve Jobs. Tightly constricted, top-down micromanagement will deprive health care of the oxygen essential to attract and incentivize cost-cutting innovators. This suffocating environment predated the ACA, but the law worsens things considerably by tightly controlling providers, patients, and employers.

Unfortunately, advocates of decentralized, market-oriented approaches have never offered the electorate convincing alternatives to centralized, bureaucratic command and control.

If the ACA crumbles, market-oriented health care reformers have one more chance to articulate a vision. A quick Internet search already churns up chatter (some gleeful, some mournful) about replacing a failed ACA with a single-payer system. Decentralizers will need to formulate and articulate — quickly — why American health care never produces a Steve Jobs and how markets could usher in cost-cutting innovation. Importantly, their narratives would need to ring true to people who are not already persuaded that markets can function in health care.

To illustrate the conceptual and rhetorical rut we are in, imagine if people in early 1964 had discussed computers the way we in 2013 discuss health care. (At that time, computers were mostly room-size mainframes costing millions in 2013 dollars, at least). Discussing computers as we today discuss health care, all the parties in 1964 would agree there is a “computer crisis” — out-of-control prices, a widening gap between haves and have-nots. Only rich companies, they fret, can afford computers.

Some would offer an array of solutions: The government could become the sole manufacturer of mainframes. Alternatively, the government could become the sole purchaser of mainframes — using its great market clout to force IBM to sell its mainframes for, say, $950,000 rather than $1 million. Or the government could tightly regulate mainframe manufacturers — prohibiting them, say, from charging more than $900,000 for a computer.

Others, conversely, would argue that the answer to the hypothetical computer crisis is a more open market. We need more stores, they say, in which to buy mainframes. Mainframe stores in every shopping mall — and a greater capacity to buy and sell mainframes across state lines.

Apolitical business end-users would seek to band together in purchasing cooperatives — demanding as one that IBM moderate its mainframe prices.

Meanwhile, the industry would still be mainframes, mainframes, mainframes all the way down. No minis, micros, laptops, or smartphones. In fact, in our allegorical world of 1964, everyone would agree to laws and regulations and institutions that virtually forbid the emergence of a Steve Jobs or Bill Gates.

Let’s return, now, to 2013 and health care. To unleash innovators, we have to recognize what leashes them in the first place. Consider some candidates: Medicare’s reimbursement formula muffles prices and distorts resource allocation in ways that impact private insurance. Tax laws effectively bind employees to their employers’ health plans. State regulations protect insiders through scope-of-practice regulations, protectionist licensing, and certificate-of-need requirements. The structure of medical education (heavily influenced by state regulations) locks obsolete management practices in place. Tort law discourages heterodox innovation. Even more challenging, fixing one of these at a time may not do the trick.

Building the case for market solutions in health care, then, demands that market advocates think large. For inspiration, they should look beyond their usual array of reading sources. Cost-cutting innovation, also known as “disruptive innovation” is brilliantly described in “The Innovator’s Prescription” by Clayton Christensen, Jerome Grossman, and Jason Hwang.

A key insight from that literature is that cost-cutting innovation almost always comes from the supply side, not the demand side. It emerges from the protean genius of previously unknown people who see our wishes and hopes before we ourselves do. Tellingly, most of today’s policy prescriptions from the left, right, and center focus on the demand-side incentives. But the problem is that consumers can’t visualize what the disruptive innovations in health care will be — any more than they could have known in 1964 how the laptop, smartphone, and internet would soon restructure their lives.

Message to market enthusiasts: The clock is ticking. One more chance to get health care right may be in the offing. There’s no time to waste. And you had best learn to persuade those who don’t already agree with you.

Monetary vs. Fiscal Policy: Expansionary Monetary Policy Does Not Raise the Budget Deficit

Monetary policy and fiscal policy are not equally good as ways to stimulate the economy. Traditional monetary policy (that is, lowering the short-term interest rate) has two key advantages over traditional fiscal policy:

  • It does not add to the national debt
  • Because many governments have–however controversially–been willing to let monetary policy be handled by an independent central bank, it is not doomed to be tangled up in politics to the same extent that discretionary fiscal policy inevitably gets tangled up in long-running political disputes about taxing and spending.

My subtitle “Expansionary Monetary Policy Does Not Raise the Budget Deficit” is a quotation from Alan Blinder’s October 25, 2010 Wall Street Journal op-ed “Our Fiscal Policy Paradox,” where Alan also points to the political difficulties of using discretionary fiscal for macroeconomic stabilization:

The practice of monetary and fiscal policy is fraught with difficulties, but the central concept is straightforward, compelling and, by the way, 75 years old: The government should push the economy forward when unemployment is high and slow it down when inflation threatens.
To do so, governments normally have two principal sets of weapons. Fiscal policy means moving some taxes or elements of public spending up or down to either propel or restrain total spending. In the United States, such decisions are made politically, by Congress and the president. Monetary policy normally (but not now) means lowering or raising short-term interest rates to either speed up growth or slow it down. That power, of course, resides in the technocratic Federal Reserve….
There are plenty of powerful weapons left in the fiscal-policy arsenal. But Congress is tied up in partisan knots that will probably get worse after the election….
But what about using monetary policy? Chairman Ben Bernanke and his Federal Reserve colleagues are not paralyzed by politics. They have not fallen victim to misleading advertising claiming that past policies have not helped. And expansionary monetary policy does not raise the budget deficit. So why the hesitation?

Monetary Policy. My view is that we need tools for macroeconomic stabilization that (a) can be applied technocratically and (b) do not add greatly to national debt when they are used to stimulate the economy. Monetary policy fills that bill, once it is unhobbled by eliminating the zero lower bound. Here is what I wrote in my column “Why Austerity Budgets Won’t Save Your Economy”:

For the US, the most important point is that using monetary policy to stimulate the economy does not add to the national debt and that even when interest rates are near zero, the full effectiveness of monetary policy can be restored if we are willing to make a legal distinction between paper currency and electronic money in bank accounts—treating electronic money as the real thing, and putting paper currency in a subordinate role….
Without the limitations on monetary policy that come from our current paper currency policy, the Fed could lower interest rates enough (even into negative territory for a few quarters if necessary) to offset the effects of even major tax increases and government spending cuts.

The Costs of National Debt. That column is also important in giving some of the best arguments I know for worrying about the national debt now that it is hard to argue that national debt slows economic growth. (On the effect of national debt on economic growth, see my two columns with Yichuan Wang “After Crunching Reinhart and Rogoff’s Data, We Found No Evidence High Debt Slows Growth” and Examining the Entrails: Is There Any Evidence for an Effect of Debt on Growth in the Reinhart and Rogoff Data? and the other work they flag.) Here is what I had to say about the costs of debt in "Why Austerity Budgets Won’t Save Your Economy“:

…lenders are showing no signs of doubting the ability of the US government to pay its debts. But there can be costs to debt even if no one ever doubts that the US government can pay it back.
To understand the other costs of debt, think of an individual going into debt. There are many appropriate reasons to take on debt, despite the burden of paying off the debt:
  • To deal with an emergency—such as unexpected medical expenses—when it was impossible to be prepared by saving in advance.
  • To invest in an education or tools needed for a better job.
  • To buy an affordable house or car that will provide benefits for many years.
There is one more logically coherent reason to take on debt—logically coherent but seldom seen in the real world:
  • To be able to say with contentment and satisfaction in one’s impoverished old age, “What fun I had when I was young!”
In theory, this could happen if when young, one had a unique opportunity for a wonderful experience—an opportunity that is very rare, worth sacrificing for later on. Another way it could happen is if one simply cared more in general about what happened in one’s youth than about what happened in one’s old age.
Tax increases and government spending cuts are painful. Running up the national debt concentrates and intensifies that pain in the future. Since our budget deficits are not giving us a uniquely wonderful experience now, to justify running up debt, that debt should be either (i) necessary to avoid great pain now, or (ii) necessary to make the future better in a big enough way to make up for the extra debt burden. The idea that running up debt is the only way to stimulate an economic recovery when interest rates are near zero is exactly what I question… If reforming the way we handle paper currency made it clear that running up the debt is not necessary to stimulate the economy, what else could justify increasing our national debt? In that case, only true investments in the future would justify more debt: things like roads, bridges, and scientific knowledge that would still be there in the future yielding benefits—benefits for which our children and we ourselves in the future will be glad to shoulder the burden of debt.

National Lines of Credit: I write about the importance of stabilization policy that can be applied technocratically, without getting tangled up in politics in the context of my other main proposal for stabilization policy: National Lines of Credit (or equivalently "Federal Lines of Credit”). The key post there is “Preventing Recession-Fighting from Becoming a Political Football.” In any case, I think National Lines of Credit would get less tangled up in politics than regular traditional fiscal policy, but it would also be possible to set them up so that they were initiated in an explicitly technocratic way. Here is the relevant passage from my working paper “Getting the Biggest Bang for the Buck in Fiscal Policy”:

The lack of legal authority for central banks to issue national lines of credit is not set in stone. Indeed, for the sake of speed in reacting to threatened recessions, it could be quite valuable to have legislation setting out many of the details of national lines of credit but then authorizing the central bank to choose the timing and (up to some limit) the magnitude of issuance. Even when the Fed funds rate or its equivalent is far from its zero lower bound at the beginning of a recession, the effects of monetary policy take place with a significant lag (partly because of the time it takes to adjust investment plans), while there is reason to think that consumption could be stimulated quickly through the issuance of national lines of credit. Reflecting the fact that national lines of credit lie between traditional monetary and traditional fiscal policy, the rest of the government would still have a role both in establishing the magnitude of this authority and perhaps in mandating the issuance of additional lines of credit over the central bank’s objection (with the overruled central bank free to use contractionary monetary policy for a countervailing effect on aggregate demand).

Though not as good as monetary stimulus, National Lines of Credit are also much better than traditional fiscal policy in yielding a high ratio of stimulus to the amount ultimately added to the national debt.

National Rainy Day Accounts. There is a related mode of stabilization policy that I consider superior to National Lines of Credit. The National Rainy Day Accounts described in this passage of my working paper “Getting the Biggest Bang for the Buck in Fiscal Policy” would not add to the national debt at all: 

It is also worth pointing out that, in principle, national lines of credit in times of low demand could be superseded in the long run (at least in part) by a modest level of forced saving in times of high demand,  with the funds from these “national rainy day accounts” released to households in time of recession (and also perhaps in the case of one of a well-defined list of documentable personal financial emergencies).

The National Rainy Day Accounts also have household finance benefits for people who have difficulty saving for emergencies without some external discipline. The main limitations of National Rainy Day Accounts as stabilization policy is (a) that they require advance preparation and (b) the resources of National Rainy Day Accounts might sometimes be exhausted before getting enough stimulus.

Top 40 All-Time Posts and All My Columns Ranked by Popularity, as of October 14, 2013

8 of my top 10 columns and 2 of my top 10 posts are totally new since the last time I made a list of my biggest hits, so it is time to make a new list. You can see my explanation of the rankings and other musings after the lists. 

All Quartz Columns So Far, in Order of Popularity

  1. There’s One Key Difference Between Kids Who Excel at Math and Those Who Don’t
  2. The Hunger Games is Hardly Our Future: It’s Already Here
  3. The Complete Guide to Getting into an Economics PhD Program
  4. The Case for Gay Marriage is Made in the Freedom of Religion
  5. After Crunching Reinhart and Rogoff’s Data, We Find No Evidence That High Debt Slows Growth
  6. The Shakeup at the Minneapolis Fed and the Battle for the Soul of Macroeconomics
  7. Human Grace: Gratitude is Not Simple Sentiment; It is the Motivation that Can Save the World
  8. Larry Summers Just Confirmed That He is Still a Heavyweight on Economic Policy
  9. An Economist’s Mea Culpa: I Relied on Reinhart and Rogoff
  10. Examining the Entrails: Is There Any Evidence for an Effect of Debt on Growth in the Reinhart and Rogoff Data
  11. How to Avoid Another NASDAQ Meltdown: Slow Down Trading (to Only 20 Times Per Second)
  12. Benjamin Franklin’s Strategy to Make the US a Superpower Worked Once, Why Not Try It Again?
  13. America’s Big Monetary Policy Mistake: How Negative Interest Rates Could Have Stopped the Great Recession in Its Tracks
  14. Gather ‘round, Children, and Hear How to Heal a Wounded Economy
  15. Show Me the Money!
  16. QE or Not QE: Even Economists Needs Lessons In Quantitative Easing, Bernanke Style
  17. Don’t Believe Anyone Who Claims to Understand the Economics of Obamacare
  18. The Government and the Mob
  19. How Italy and the UK Can Stimulate Their Economies Without Further Damaging Their Credit Ratings
  20. Janet Yellen is Hardly a Dove: She Knows the US Economy Needs Some Unemployment
  21. Four More Years! The US Economy Needs a Third Term of Ben Bernanke
  22. Why the US Needs Its Own Sovereign Wealth Fund
  23. One of the Biggest Threats to America’s Future Has the Easiest Fix
  24. Could the UK be the First Country to Adopt Electronic Money?
  25. Optimal Monetary Policy: Could the Next Big Idea Come from the Blogosphere?
  26. Get Real: Bob Shiller’s Nobel Should Help the World Improve Imperfect Financial Markets
  27. Actually, There Was Some Real Policy in Obama’s Speech
  28. Read His Lips: Why Ben Bernanke Had to Set Firm Targets for the Economy
  29. More Muscle than QE3: With an Extra $2000 in their Pockets, Could Americans Restart the U.S. Economy?
  30. How Subordinating Paper Money to Electronic Money Can End Recessions and End Inflation
  31. That Baby Born in Bethlehem Should Inspire Society to Keep Redeeming Itself
  32. Three Big Questions for Larry Summers, Janet Yellen, and Anyone Else Who Wants to Head the Fed
  33. Judging the Nations: Wealth and Happiness Are Not Enough
  34. Yes, There is an Alternative to Austerity Versus Spending: Reinvigorate America’s Nonprofits
  35. John Taylor is Wrong: The Fed is Not Causing Another Recession
  36. Why Austerity Budgets Won’t Save Your Economy
  37. Monetary Policy and Financial Stability
  38. Make No Mistake about the Taper—the Fed Wishes It Could Stimulate the Economy More
  39. Off the Rails: What the Heck is Happening to the US Economy? How to Get the Recovery Back on Track
  40. Talk Ain’t Cheap: You Should Expect Overreaction When the Fed Makes a Mess of Explaining Its Plans
  41. Obama Could Really Help the US Economy by Pushing for More Legal Immigration
  42. Does Ben Bernanke Want to Replace GDP with a Happiness Index?
  43. How to Stabilize the Financial System and Make Money for US Taxpayers
  44. How the Electronic Deutsche Mark Can Save Europe
  45. Al Roth’s Nobel Prize is in Economics, but Doctors Can Thank Him, Too
  46. Symbol Wanted: Maybe Europe’s Unity Doesn’t Rest on Its Currency. Joint Mission to Mars, Anyone?
  47. Meet the Fed’s New Intellectual Powerhouse
  48. Governments Can and Should Beat Bitcoin at Its Own Game (on Slate, no data yet)
  49. Why George Osborne Should Give Everyone in Britain a New Credit Card (in The Independent, no pageview data)

Top 40 Posts on supplysideliberal.com:

  1. Contra John Taylor 7010
  2. Dr. Smith and the Asset Bubble 6442  
  3. Scott Adams’s Finest Hour: How to Tax the Rich 4361
  4. Balance Sheet Monetary Policy: A Primer 4264
  5. The Medium-Run Natural Interest Rate and the Long-Run Natural Interest Rate 4186
  6. Noah Smith Joins My Debate with Paul Krugman: Debt, National Lines of Credit, and Politics 3761
  7. Isaac Sorkin: Don’t Be Too Reassured by Small Short-Run Effects of the Minimum Wage 3698
  8. What is a Supply-Side Liberal? 3653
  9. Sticky Prices vs. Sticky Wages: A Debate Between Miles Kimball and Matthew Rognlie 3457
  10. The Logarithmic Harmony of Percent Changes and Growth Rates 3150
  11. The Deep Magic of Money and the Deeper Magic of the Supply Side 2737
  12. Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy 2454
  13. You Didn’t Build That: America Edition 2333
  14. The Egocentric Illusion 2328
  15. Two Types of Knowledge: Human Capital and Information 2191
  16. Books on Economics 2003
  17. No Tax Increase Without Recompense 1999
  18. How Conservative Mormon America Avoided the Fate of Conservative White America 1973
  19. Getting the Biggest Bang for the Buck in Fiscal Policy 1912
  20. Why I am a Macroeconomist: Increasing Returns and Unemployment 1847
  21. Why Taxes are Bad 1792
  22. Milton Friedman: Celebrating His 100th Birthday with Videos of Milton 1744
  23. The Shape of Production: Charles Cobb’s and Paul Douglas’s Boon to Economics 1705
  24. Let the Wrong Come to Me, For They Will Make Me More Right 1689
  25. Jobs 1683
  26. Three Goals for Ph.D. Courses in Economics 1662
  27. Scrooge and the Ethical Case for Consumption Taxation 1640
  28. Teleotheism and the Purpose of Life 1638
  29. The Mormon View of Jesus 1637
  30. Kevin Hassett, Glenn Hubbard, Greg Mankiw and John Taylor Need to Answer This Post of Brad DeLong’s Point by Point 1592
  31. Is Taxing Capital OK? 1520
  32. Inequality Aversion Utility Functions: Would $1000 Mean More to a Poorer Family than $4000 to One Twice as Rich? 1490
  33. Corporations are People My Friend 1486
  34. When the Government Says “You May Not Have a Job” 1447
  35. Leveling Up: Making the Transition from Poor Country to Rich Country 1380
  36. Thoughts on Monetary and Fiscal Policy in the Wake of the Great Recession: supplysideliberal.com’s First Month 1380
  37. Is Monetary Policy Thinking in Thrall to Wallace Neutrality? 1379
  38. Avoiding Fiscal Armageddon 1366
  39. For Sussing Out Whether Debt Affects Growth, the Key is Controlling for Past Growth 1361
  40. Mark Thoma: Laughing at the Laffer Curve 1315

Explanation of the rankings

The top 40 posts on supplysideliberal.com listed below are based on Google Analytics pageviews from June 3, 2012 through midday, October 13, 2013. The number of pageviews is shown by each post. Not counting Quartz pageviews and pageviews from some forms of subscription, Google Analytics counts 327,807 pageviews during this period but, for example, 101,669 homepage views could not be categorized by post.  

I have to handle my Quartz columns separately because that pageview data is proprietary. My very most popular pieces have been Quartz columns, so I list them first. Since there are less than 40, I have listed them all, with the ones with no data (yet) listed at the bottom. (To avoid duplication, I have disqualified companion posts to Quartz columns from the top 40 blog post list, since they eventually get recombined with the Quartz columns when I repatriate the columns. For these columns, the ranking is by pageviews at a point where things have settled down. For later posts, that is standardized to pageviews during the first 30 days when Quartz has an exclusive.  

I plan to update the list of columns as new columns appear, but the list of posts is locked in place until the next time I do a post like this. 

You might also find other posts you like in this earlier list of top posts. This post and that one cover everything that has ever been on one of most popular lists so far. 

Musings: 

  • Five of the top ten columns are coauthored: 1, 3 and 6 with Noah Smith, 5 and 10 with Yichuan Wang. It helps to have a top-notch coauthor. 
  • Three of the top ten are about Reinhart and Rogoff. Levels of interest for understanding Reinhart and Rogoff’s was extraordinary.
  • Three of the top ten–2, 4 and 7–are relatively recent columns with a strong religious or moral tone to them. I am glad to see that my efforts to articulate religious and moral themes find an audience as well as what I have to say about economics. 
  • There is a clear time trend in the data. Later columns and posts have an advantage over earlier columns and posts of equal quality.
  • "Contra John Taylor“  edged out ”Dr. Smith and the Asset Bubble“ for the top spot among the posts. 
  • The 2 new blog posts in the top 10 are ”The Medium-Run Natural Interest Rate and the Long-Run Natural Interest Rate“ in the 5th spot and ”Sticky Prices vs. Sticky Wages: A Debate Between Miles Kimball and Matthew Rognlie“ in the 9th spot. In general, posts that have something new to offer for undergraduate and graduate education (including self-education) are doing very well.
  • The mini-bio for me on Quartz says I blog about "economics, politics and religion.” I am glad to see that my religion posts (collected in my Religion Humanities and Science sub-blog) are getting some attention. Religion is represented by four posts in the top forty, in spots 14, 18, 28 and 29. Since the presidential election, I actually haven’t written that much about politics–other than in very close connection to policy, so I am not surprised that politics doesn’t make much of an appearance in either of the lists above. The major exception is “That Baby Born in Bethlehem Should Inspire Society to Keep Redeeming Itself."