The Most Exciting Thing About Bitcoin Isn't Bitcoin →

March 30, 2016 by Miles Kimball

If you click through, this is a nice graphic about blockchain technology.

Taehyun Nam: South Korea on the Road to a Cashless Society

March 22, 2016 by Miles Kimball

Link to Taehyun Nam’s Linked In homepage

I am pleased to host another student guest post, this time by Taehyun Nam. This is the 4th student guest post this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

Taehyun discusses South Korea’s goal to get to a “cashless society.” I want to emphasize that although abolishing cash might be a good idea, it is not necessary to abolish cash to eliminate the zero lower bound. My proposal for eliminating the zero lower bound would keep cash in the picture, but move cash further from the center of the monetary system. Abolishing cash is a separate decision from eliminating the zero lower bound.

The South Korean government should not falter becoming a cashless society that opens the underground economy, solves the circulation problem, prevents crimes, and provides more monetary policy options.

Bill Gross from Janus Capital once said, “The cashless society which appears over the horizon may come sooner than the demise of the penny.” My home country, South Korea, is no exception. Cash in Korea is slowly losing its presence and getting replaced by credit/debit cards. The Bank of Korea has recently announced its plan to become a “cashless society.”

According to the Bank of Korea’s survey with 2,500 Koreans with age of 19 or older in last August and September, Koreans are gradually carrying less cash. On average, they had $61.29 cash in their wallets. Senior citizens in their 50s carried $70.40 per person, whereas people in their 20s had only $41.41 cash per person in their wallets. In fact, even the seniors are now using debit cards more. In recent five years, the number of payment in debit card by people with age of 50s and 60s increased by four times, while the ratio of payment in cash plunged from 51% in the mid 2000s to 17% today. Moreover, 90.2% and 96.1% of survey participants carried credit and debit cards, respectively.

As cash is losing its popularity as a payment method, the government plans to eliminate coin by 2020 and achieve the “cashless society” afterwards. My first initial reaction to this news was, “Dr. Miles Kimball [professor for my Monetary and Financial Theory class] will be thrilled with this news!” On the contrary, the general public in Korea ranted.

Screen Shot of Comments on the Related Article on FacebookComment #1: It’s obvious that the stock prices of credit card companies would skyrocket. Korean companies have low respects for privacy. Seems like Korean politicians do not even know whether… — Screen Shot of Comments on the Related Article on Facebook
Comment #1: It’s obvious that the stock prices of credit card companies would skyrocket. Korean companies have low respects for privacy. Seems like Korean politicians do not even know whether seniors use cards or cash. - 217 Likes
Comment #2: This is unacceptable… Cashless society… This is totally unacceptable. - 606 Likes
#3: Why would they bother to change? Cards are for convenience. They are not essential. - 294 Likes

Such outrageous reactions are understandable. I also see some downsides of the cashless society, what I call them “5Cs”:

Confusion in the society and negative reaction from the public.
Card payment’s and fintech’s unfamiliarities to senior citizens.
Card transaction fee issue.
Concerns over security and privacy in Korea.
Contingency plan to temporary malfunctions of electronic money system is nonexistent.

With these pitfalls, however, I still argue that the Korean society should become cashless. The economic benefits are hard to be ignored.

1. Open the underground economy

Becoming cashless will legalize the underground loan market and prevent the related transactions of billions of dollars without proper tax payments. Moreover, because electronic transactions are tractable in the cashless society, significantly less number of people would get involved in illegal prostitutions. On average, each prostitute has approximately 5 clients per night, and some even have 20. In the cashless society, there will be less illegal cash transactions without proper tax payments in the prostitution market. Instead, the customers in this market will rather consume and invest on legal activities. In fact, McKinsey report says, “The cashless society will cut costs equivalent to between 0.1 and 1.1 percent of GDP.” The data present that countries with below 50% rate of payment in cash have the shadow economy taking only 12% of gross domestic product (GDP). In contrast, those with over 80% rate of payment in cash have the underground economy taking 32% of GDP. Therefore, by becoming cashless, not only the South Korean government can collect more tax, but also the Korean economy would be stimulated by higher consumptions and investments.

2. Solve the currency circulation problem

Since 2009, the Bank of Korea has issued 2.2 billion papers of 50,000-won notes (50,000 Korean Won = $42.04, as of March 14th 2016). However, 1.2 billion of them has not been returned yet. The total amount of currency not in circulation was near $310 billion in 2009, but it more than doubled to $718 billion in 2015. Once the society transitions into the cashless society, people will be forced to bring their slush funds out and make more consumptions and/or investments. Again, the government can assemble more tax and boost the economy.

3. Prevent crimes & Allow more monetary policy options

Many crimes involved with cash will dwindle considerably in the cashless society. These include tax evasion, violence or plunder over cash, tax evasion, and bribery. In addition, electronic money enables countries to adopt negative interest rates in order to spur the economic activities. Such monetary policy is not feasible in a cash society, as people might put their cash in their safes. More information about negative interest rates policy with electronic money could be found in Dr. Kimball’s blog post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”

Scott Sumner—The Media's Blind Spot: Negative Interest on Reserves

March 21, 2016 by Miles Kimball

Link to the original post on the Library of Economics and Liberty blog

Scott Sumner was one of the first people to suggest negative interest on reserves, back in early 2009. Although he has directed most of his energy toward promoting nominal GDP level targeting (which I discuss in “Optimal Monetary Policy: Could the Next Big Idea Come from the Blogosphere?”), Scott also argues forcefully that negative interest on reserves can stimulate the economy. I am grateful to Scott Sumner for permission to mirror this post here. Here is Scott:

The media has an agenda, which covers its reporting of negative interest on reserves (IOR). Let’s review the evidence:

In late January, the Bank of Japan cuts interest rates into negative territory and does a bit more QE. The yen plunges in value and the Nikkei soars higher. So negative IOR seems expansionary.

Here’s what happened next, according to commenter Mikio from Japan:

The story background is the same. There is a lot resistance in Japan against negative rates - and BOJ official soon after the decision started to “appease” critics of negative rates that “it’s not that bad, we are not really going to charge you interest, don’t worry, very little will change”.
Markets began to rally again only after BOJ Deputy Governor Hiroshi Nakaso on 12th Feb. in NY made clear that there is still “no limit” to QE and that BOJ can cut rates further into negative territory, and that those who think the BOJ has reached its limit are “wrong”.
In short:
1) Nikkei rose when the initial announcement was made
2) Fell when BOJ started blurring the message
3) Rose again when BOJ corrected the message
It’s funny how many people find it so difficult to see these things. That’s what’s “head-scratching”…

This all seems pretty clear to me, but just in case Mikio and I are wrong, let’s see how the European markets react to negative IOR.

European stocks soar and the euro falls on a 12:45 pm announcement by the ECB that the policy rate will be cut deeper into negative territory. Then at 1:56 Draghi seems to abandon his “whatever it takes” approach, and indicated that no further rate cuts were likely. The euro soars in value and stocks plunge. Then overnight, ECB officials rush to reassure investors that they are serious about monetary stimulus, and stocks soar the next day. Exact same story as in Japan.

But let’s say that even that is wrong. Early today the BOJ gives us another experiment, this time refusing to cut rates. The yen rises and Japanese stocks fall sharply. Zero Hedge suggested that the lack of rates cuts today was not a big surprise, but this was:

BOJ REMOVES LANGUAGE FROM ITS STATEMENT THAT IT WILL CUT INTEREST RATES FURTHER INTO NEGATIVE TERRITORY IF JUDGED

So all of these market moves suggest that negative IOR is clearly expansionary, just as economic theory would predict. But bankers don’t like negative IOR. So even as the markets are telling us (indeed screaming at us) that negative IOR is expansionary, the business press tells us the opposite, even though all of the natural experiments discussed above were accurately reported in the FT.

Today’s FT is an especially egregious example. Here’s the headline:

Equities slip as BoJ holds steady

When I see the headline I think to myself “Finally, the FT will get it right!”

The story starts off in a promising direction:

The yen is firmer, and stocks and commodity prices softer, after the Bank of Japan downgraded its view of the world’s third-biggest economy but made no change to monetary policy.

Then things start to go awry:

The central bank’s surprise move to push interest rates into negative territory on January 29 has had the opposite effect to what was desired for the yen.

What! Didn’t the yen plunge much lower on the January 29th announcement? Has the FT not heard of the Efficient Markets Hypothesis? The markets don’t react with a one-week lag to policy announcements. And didn’t today’s reaction to the lack of a rate cut further confirm that negative IOR is expansionary?

Then things start to get back on track:

Such fretting has boosted the “haven” yen, leaving it up more than 6 per cent for the year versus the US dollar.
OK, that’s good; the term ‘fretting’ clearly refers to Draghi’s suggestion that no more rate cuts are coming, and similar statements out of Japan.

But then everything falls apart:

“The empirical record indicates multiple episodes of central bank easing actions that resulted in large and opposite reactions to those intended. Those that succeeded either coincided with positive fundamental developments or were part of a package that led to expectations of such,” he said.

I’m sort of in a state of shock. Time after time after time the markets clearly signal that negative IOR is expansionary. Even the press can hardly fail to report the immediate market reaction to negative IOR. And yet they are somehow unable to actually report what is starring them in the face, and instead find Binky Chadha, who tells them that up is down and black is white.

P.S. I don’t know why Chadha is unable to see the obvious, but someone more cynical than me might note who employs him. If Upton Sinclair were alive today, he might have this to say:

It is difficult to get a man to understand something, when his salary depends on his not understanding it.

P.P.S. BTW, people often get confused by these posts. I’m not a big fan of negative IOR, or indeed any form of interest rate targeting. I prefer NGDPLT, or if not that then price level targeting, or if not that then QE. Negative IOR is way down my list.

HT: JP Koning

Let me add some more recent news that helps make Scott’s point about the effectiveness of negative rates, though fortunately not about media obtuseness. On March 18, 2016, Tom Fairless and Todd Buell reported in the Wall Street Journal

ECB President Mario Draghi surprised investors last week by saying he doesn’t expect to cut rates again, shortly after unveiling a major new stimulus. His comments caused the euro to spike against the dollar after initially falling and sent financial markets sprawling after they initially surged in response to the stimulus.‎
But on Friday, ECB Chief Economist Peter Praet said fresh rate cuts were still on the table. That sent the euro lower against the dollar.‎
“A rate reduction remains in our armory,” Mr. Praet said in an interview published on the ECB’s website Friday. “We have not reached the physical lower bound.”

Although our emphases are different, Scott and I are in basic agreement about many things. Here are some other posts on supplysideliberal.com that involve Scott Sumner:

I also have these links on supplysideliberal.com because I liked the posts so much:

How Negative Interest Rates Prevail in Market Equilibrium

March 15, 2016 by Miles Kimball

Many people have the intuition that even if paper currency were out of the picture, other things that pay a zero interest rate would still create a zero lower bound, so that an attempt to take the target rate into deep negative territory would fail. Among them is one of the greatest economics bloggers of them all: John Cochrane. In his Grumpy Economist post “Cancel Currency?” he writes:

Suppose we have substantially negative interest rates – -5% or -10%, say, and lasting a while. But there is no currency. How else can you ensure yourself a zero riskless nominal return?
Here are the ones I can think of:
Prepay taxes. The IRS allows you to pay as much as you want now, against future taxes.
Gift cards. At a negative 10% rate, I can invest in about $10,000 of Peets’ coffee cards alone. There is now apparently a hot secondary market in gift cards, so large values and resale could take off.
Likewise, stored value cards, subway cards, stamps. Subway cards are anonymous so you could resell them.
Prepay bills. Send $10,000 to the gas company, electric company, phone company.
Prepay rent or mortgage payments.
Businesses: prepay suppliers and leases. Prepay wages, or at least pre-fund benefits that workers must stay employed to earn.

My brother Chris and I answer this argument in “However Low Interest Rates Might Go, the IRS Will Never Act Like a Bank.” The set of things that can create a zero lower bound can be narrowed down considerably by the two key principles we explain there:

Giving a zero interest rate when market interest rates are in deep negative territory (say -5%) is a money-losing proposition. Private firms are unlikely to continue very long in providing such an above-market interest rate to individuals wanting to store money with them.
Anything that can vary in price cannot create a zero lower bound: negative interest rates will either cause its price to go up enough that expected depreciation gives it a negative expected return, or potential price variation will make its return risky enough it is clear there is no risk-free arbitrage to be had. This rules out things such as gold or foreign assets from creating a zero lower bound, unless a credibly fixed exchange rate or an established price of gold is in play.

What is left? The only other category I can see are opportunities to lend to a government within the central bank’s currency zone at a fixed interest rate. But even there, there is another logical proviso on what can create a zero lower bound. I explain in “How to Keep a Zero Interest Rate on Reserves from Creating a Zero Lower Bound”:

[3.]… a zero interest rate that only applies to a limited quantity of funds does not create a zero lower bound. The reason that our current paper currency policy creates a zero lower bound is that under current policy banks can withdraw an unlimited quantity of paper currencyand redeposit it later on at par. By contrast, within-year prepayment of taxes is possible but practically limited to the amount of the tax liability. (Between tax years a typically nonzero interest rate based on the market yield of short-term U.S. obligations applies.)

Thus, other than paper currency:

An unlimited option for banks to put funds in reserve accounts at a zero interest rate creates a zero lower bound. But if there is a ceiling of 101% of required reserves as I discuss in “How to Keep a Zero Interest Rate on Reserves from Creating a Zero Lower Bound,” an interest rate on reserves of zero does not create a zero lower bound.
An unlimited option for depositors to save in a government-run bank (such as Japan’s postal savings) at a zero interest rate creates a zero lower bound. But an option to get a zero interest rate on a monthly balance of only up to 1000 euros per person (or an asset value of something like 4% of annual GDP for the eurozone as a whole), as I recommend in “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies” does not create a zero lower bound.
An unlimited option to prepay taxes in a way unlimited by any relationship to one’s actual tax liabilities, earn a zero interest rate and then get a huge tax refund creates a zero lower bound. But an option to prepay within the tax year capped at a reasonable estimate of one’s actual tax liabilities (all the current US tax law offers) does not create a zero lower bound.

IRS interest rates between tax years are set by the Secretary of the Treasury in line with market short-term rates, such as the Treasury bill rate. They are no stickier than the Secretary of the Treasury wants them to be. It is true that a sufficiently determined Secretary of the Treasury could probably thwart a Fed move to negative interest rates by offering convenient saving at a zero interest rate through the tax system. But I don’t think the Fed would be likely to go to deep negative rates in any case without some degree of tacit backing from the Executive Branch. (I do think that with the Executive Branch’s tacit backing, the Fed might go to deep negative rates despite complaints in Congress if it thought that was necessary for the economy.)

Finally, suppose I am wrong about the willingness of private firms to lose money by continuing to offer a zero interest rate when many market rates have gone substantially negative. In “Banking at the IRS,” John Cochrane argues that private interest rates are sticky at zero. There is still a limit to how much a firm can allow individuals to store at an above-market zero interest rate without going bankrupt, and in practice, the quantity limit of how much value a firm will allow people to store at a zero interest rate is much tighter than that.

Let’s get more concrete about the sheer magnitude of the task of finding zero interest ways of storing one’s money when the central bank is bidding up the price–and therefore down the interest rate–of Treasury bills as far as it can before investors sell over the whole stock of Treasury bills. To make the calculations easier, let me imagine that before going to negative rates, that a central bank has done enough quantitative easing that most of the national debt in private hands is in the form of short-term Treasury bills that have a negative rate. In that case, the net debt-to-GDP ratio (based on government debt in private hands) puts a floor on how much in funds private individuals will be trying to shift into zero interest rate opportunities. Actually, to this should be added the paper currency to GDP ratio too, since under my proposal, paper currency carries a negative rate of return because of its gradual depreciation against electronic money. (It is only because paper currency would have a negative rate of return under my proposed policy that the discussion in this post even arises.) Here are a few interesting net debt/GDP ratios rounded to the nearest full percent as of the latest update of the Wikipedia article “List of countries by public debt” in 2012. I doubt many of these numbers have gone down since then:

Australia: 17%
Austria: 51%
Belgium: 106%
Canada: 37%
Denmark: 8%
Finland: -51%
France: 84%
Germany: 57%
Greece: 155%
Ireland: 102%
Israel: 70%
Italy: 103%
Japan: 134%
Netherland: 32%
Norway: -166%
Portugal: 112%
Spain: 72%
Sweden: -18%
Switzerland: 28%
United Kingdom: 83%
United States: 88%

Certainly, in the eurozone, Japan, the United Kingdom, the US and Canada, the task of finding zero interest rate opportunities for all the funds that start out in government debt is daunting. Countries like Norway that have a substantial sovereign wealth fund show that the amount of money the public holds in government bills and bonds–surely a positive number–can be larger than the government debt with assets netted out–in Norway’s case, a negative number. So the net debt to GDP ratios above are only the start of how much people might face a negative interest rate in that they are trying to escape.

The biggest single opportunity for getting a zero interest rate when rates in general are negative is typically tax system. I suspect that most countries have much less wiggle room for playing with the timing of tax payments than the US. For example, the rules for the timing of paying VAT taxes probably don’t have the same kind of wiggle room. And even in the US, the wiggle room on the timing of payments is probably much greater for households than for firms. In the US, tax revenue as a percentage of GDP is something like 27%. But shifting tax payments from being paid each month as the income comes in to being paid on January 1, say, only shifts that 27% forward by 6.5 months on average, since some of the payments are already early in the year. Or for those who pay quarterly, things might be shifted forward by 7.5 months. (7.5/12) * 27% is less than 17%. (This is composed of up to 27% of GDP at a zero interest rate at the beginning of the year, and much less at a zero interest rate toward the end of the year.)

That limit of 17% of annual GDP (averaged over the year) that can get a zero interest rate is far short of the 88% that individuals and firms in the US and abroad will want to find in zero US interest rates. Along the lines of “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies,” throw in bank account assets amounting to 4% of annual GDP in individual bank accounts exempted from a negative interest rate supported by subsidies through the interest on reserves formula. (The effective subsidy needed is not 4% of GDP, but the absolute value of the interest rate times 4% of a year’s GDP, say |-4%| per year times 4% of yearly GDP, or .16% of GDP on a flow basis.) Beyond the bank accounts subsidized to have a zero interest rate, then throw in a generous several percent of annual GDP worth of prepayment opportunities that the private sector will allow, and still those now holding government debt will fall far short of finding enough zero interest opportunities to shift their liquid assets into. When I say that is generous, remember that the flow that can be prepaid needs to be multiplied by the length of time it can be prepaid to get the stock of wealth that can be shielded from zero interest rates. Other than prepayment of mortgages–which is already a big issue even at positive interest rates–most opportunities to prepay are limited to about 90 days, which is much lass than in the tax system.

Even with substantial opportunities to get a zero interest rate, if individuals and firms have liquid assets left over that can’t get a zero interest rate, then the key market rates can go into deep negative territory as the central bank bids up the price of Treasury bills so that, say it costs $10,100 to buy a promise from the Treasury of $10,000 three months from now: a -4% annual yield.

So far, central banks that have gone to negative interest rates have done so tentatively. Still, interesting adjustments are beginning to happen. Here is a passage from Tommy Stubbington’s December 8, 2015 Wall Street Journal article “Less Than Zero: Living With Negative Interest Rates”:

Danish companies pay taxes early to rid themselves of cash. At one small Swiss bank, customer deposits will shrink by an eighth of a percent a year.
But it isn’t all bad. Some Danes with floating-rate mortgages are discovering that their banks are paying them every month to borrow, instead of charging interest on their home loans. …
… other peculiar consequences are sprouting. In Denmark, thousands of homeowners have ended up with negative-interest mortgages. Instead of paying the bank principal plus interest each month, they pay principal minus interest.
“Hopefully, it’s a temporary phenomenon,” said Soren Holm, chief financial officer at Nykredit, Denmark’s biggest mortgage lender by volume. Mr. Holm said the administration of negative rates has gone smoothly, but he isn’t trumpeting the fact that some borrowers get paid. “We wouldn’t use it as a marketing tool,” he said.
Negative rates have cost Danish banks more than 1 billion kroner ($145 million) this year, according to a lobbying group for Denmark’s banking sector.
“It’s the banks that are paying for this,” said Erik Gadeberg, managing director for capital markets at Jyske Bank. If it worsens, Jyske might charge smaller corporate depositors, he said, then maybe ordinary customers. “One way or another, we would have to pass it on to the market,” Mr. Gadeberg said.
In Switzerland, one bank already has. In October, Alternative Bank Schweiz, a tiny lender, sent letters to customers with some bad news: They were going to be charged for keeping money in their accounts.
The Swiss central bank has a deposit rate of minus 0.75%, and Martin Rohner, chief executive of ABS, decided enough was enough. The costs were eating up the firm’s entire profit, he said. He set a rate of minus 0.125% on all accounts.

Ezra Klein Interviews Ben Bernanke about Miles Kimball’s Proposal to Eliminate the Zero Lower Bound

March 13, 2016 by Miles Kimball

Photo of Miles telling Yang Liu and Ben Bernanke how good the hors d’oeuvres are and how to eliminate the zero lower bound when Ben Bernanke came to give a talk at the University of Michigan on January 14, 2013 — Photo of Miles telling Yang Liu and Ben Bernanke how good the hors d’oeuvres are and how to eliminate the zero lower bound when Ben Bernanke came to give a talk at the University of Michigan on January 14, 2013

In a December 15, 2015 episode of “The Weeds,” Ezra Klein asked Ben Bernanke about my proposal to eliminate the zero lower bound. See “Ezra interviews Ben Bernanke.” About the 34:50 mark the dialogue is as follows:

Ezra Klein: There is an idea out there, which is obviously politically unlikely. But I’ve always found it interesting as a thought experiment at the very least—and it is has been pushed by, among others, economist Miles Kimball. Which is, if you could have instead of the paper dollar being the store of value, sort of an electronic dollar, we could really move on somewhere to electronic money, then it would essentially be easy as a matter of technical, operational work to have negative interest rates as well as positive ones. Are you familiar with these proposals, and I’m curious what you think of them.
Ben Bernanke: Yeah, I think that something like that would work in the sense that it could help get interest rates negative, so it would give the Fed more ability to cut rates even when rates were started out at a very, very low level. But I–first of all it’s kind of Rube Goldberg in the sense that the simpler solution would just be to have reasonable fiscal policy, that—that acts at the appropriate time. And secondly, as you point out, I think that it’s not something that the American public would be too enthralled with. I think politically, it would be very, very difficult to get—get approval for that. So its not, you know—it’s not something that I see as high on the priority list, putting aside whatever it’s—whatever the theoretical costs and benefits might be, it doesn’t seem like something that politically is feasible anytime soon.

Miles: In response to Ezra’s description, let me clarify that what is important is for electronic money to provide the unit of account. There are many stores of value, but one main unit of account.

I have many reactions to what Ben Bernanke said:

Ben Bernanke agrees with Peter Sands and Larry Summers that, from a technical point of view, what I propose could do the job.He says: “I think that something like that would work in the sense that it could help get interest rates negative, so it would give the Fed more ability to cut rates even when rates were started out at a very, very low level.”
The details of the implementation I propose make it much more politically feasible than other modes of implementation. When I give a seminar to central bankers, they come in thinking it might be a nice idea in theory, but would never happen, and then go out of the seminar seeing that it can really be done. For example, my proposal is fully compatible with using the current paper notes. My more recent presentations–ever since I started presenting “18 Misconceptions about Eliminating the Zero Lower Bound”–have been even better at making this point.
The political path I foresee is an international one, as discussed in “Breaking Through the Zero Lower Bound” (pdf) and “Negative Interest Rate Policy as Conventional Monetary Policy” (pdf). I do not think the US is likely to be the first nation to use deep negative interest rates, but there is hope that some other country will have pioneered the needed monetary policy tools by the time the US needs them.
Many central banks can do what needs to be done to eliminate the zero lower bound without any new legislation. I am currently working with Peter Conti-Brown on an article for a law review discussing the legal situation in the US. We need to dig into the law a lot more, but so far, it looks as if the Fed might be able to do what needs to be done without any new legislation. In any case, one should not assume too quickly that new legislation is needed. The law gives the Fed a lot of discretion in monetary policy.
I disagree with Ben about the aptness of discretionary fiscal policy for stabilizing the economy. In my view, the difficulty in using discretionary fiscal policy to handle deep recessions is not a random stroke of bad luck during this past recession, but something likely to obtain quite generally for basic political economy reasons: short-run fiscal policy simply has too much resonance with long-run fiscal policy, which in turn goes to the heart of the ways in which major parties differ in many advanced countries. Therefore, developing monetary policy tools powerful enough for central banks to stabilize economies even if fiscal authorities are not very helpful seems the height of wisdom.

On Ben Bernanke’s general claim that there are other tools available besides negative rates, here is an abridged version of the section in How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide about other possible tools for stimulating the economy:

Comparison of Negative Interest Rates to Other Tools for Stimulating the Economy

With a Regulatory Regime That Freely Accomodates Housing Construction, Lower Interest Rates Drive Down Rents Instead of Driving Up the Price of Homes

March 09, 2016 by Miles Kimball

In my travels to the central banks of many countries, when I dig into concerns about financial stability, I often find that the biggest financial stability worry associated with low or temporarily negative interest rates is about the effect of low interest rates on the price of houses in the capital city or other major cities. Let me analyze this issue.

The simplest case is when the anticipated real interest rate r is constant from now on and there are no tax complications. Suppose also that the home will last forever if appropriately maintained, with anticipated Rent and Maintenance constant from now on. Then the price P based on these anticipated values should be

P = (Rent - Maintenance) / r

If no additional construction is allowed, and the economy is fairly static even after the interest rate changes (say because of a changed desire for saving), Rent and Maintenance should stay close to the same, so Price should go up when r goes down.

But if construction is freely allowed within certain parameters–say along the lines I propose in “Density is Destiny,” which makes land costs small relative to the physical cost of building, than in the long run, the price of a home must equal the cost of constructing, say, the floor of the building corresponding to that home. With P a constant, it is useful to rearrange the equation above to

Rent = Maintenance +r P

Thus, for example,

If, in the long run, the real interest rate is a small positive number in relation to the standard construction price of a home, than rent should be a little above maintenance.
In the limit, as the real interest rates goes down toward zero, rent should just equal maintenance.
If, in the long run, the real interest rate is negative, then the equation seems to say that rent should be below maintenance. But the equation doesn’t really work when the long-run real interest rate is negative, since if rent were below maintenance, the home would be a burden rather than a benefit, and no one would pay anything for it. In other words, the price is equal to the cost of building a home as long as it is worth someone’s while to build one. But if rent were below maintenance in the long run, no one would build one. On the other side, note that the interest rate on an infinite-term bond–a consol–can never be negative in equilibrium. If I give you money and can never demand anything back other than interest, having a negative coupon payment where I pay you would mean I have only give you money and you never give me anything back. I won’t do it. So at a minimum, negative interest rates must either be temporary or include either some return of the principal within finite time, or an option to demand the principal back at some finite time.

If the interest rate is expected to move around, the same essential principles apply. For fixed rent and maintenance–corresponding in my simple example to a prohibition against new construction–any path of lower interest rates raises the present value of a home, so the price of a home goes up. For a fixed price of a home–corresponding in my simple example to a policy very favorable to new construction–almost any path of lower interest rates will lead to more construction and lower rents.

Update, May 11, 2021: The experience in Japan helps prove my point. In the May 7, 2021 Wall Street Journal article “The Global House Price Boom Could Haunt the Recovery From Covid-19,” Mike Bird writes:

There have been a small number of successes in controlling and preventing house price booms to note. They bear much closer examination for policy makers in the rest of the world.

Japan’s case is the most obvious. The country’s lack of zoning restrictions and rent controls are regularly credited with the country’s flat home prices, particularly in Tokyo where the total population is still increasing.

Eric Lonergan and Miles Kimball Discuss the Transmission Mechanism for Negative Interest Rates →

March 09, 2016 by Miles Kimball

Do Negative Interest Rates Lead To Too Much Debt?

March 07, 2016 by Miles Kimball

One common objection to low interest rates–and even more to negative interest rates–is that it will lead to too much debt. It occurred to me that this is looking at things only from the standpoint of the borrower’s desires. But the amount of debt is determined in a market equilibrium in which the lender’s desires are also part of the picture. A similar one-sided logic would be to claim that low interest rates encourage too little lending. But with little lending, there would also be little debt. So which is it? Do low interest rates lead to more debt (because borrowers want more debt) or less debt (because lenders want to give them less and so borrowers can’t borrow and end up less in debt)?

If the central bank does its job well (better than existing central banks have managed so far), the economy would be near the natural level of output most of the time. Think of that as approximately the same state as if the economy had perfectly flexible prices and monetary policy had no effect on anything real. At the natural level of output, the level of national debt has to do with taxing and spending policy, while the level of private debt has a lot to do with heterogeneity–how different people are from one another in the sense of a wealth-weighted variance of preferences.

Starting from that benchmark, a positive output gap might mean there are more good-looking projects for which there would be both demand and supply of loans. So low central bank interest rates might lead to more debt simply because the economy then boomed, while high central bank interest rates might lead to less debt because the economy contracted and their were few projects for which there was both supply and demand for lending.

In this discussion, I haven’t yet adequately distinguished between debt in the sense of fixed-income securities and equity finance. This distinction matters. To the extent debt causes problems for financial stability, it is almost always fixed-income securities that are the problem. The easiest way to reduce debt is to have tight leverage limits–or equivalently, high equity requirements–for banks and other financial firms, for individual mortgages (with mortgage reform such as Andy Caplin’s share appreciation mortgages) and for any other type of firm that has shown a high propensity toward threatened bankruptcy. Even student loans can easily be put on a more equity-like and less debt-like basis by having some of the payment stated as a percentage of income instead of as a fixed amount.

If policy is trying to push arrangements toward more equity and less debt, negative interest rates can be quite helpful, because they make safety look like a loss, which makes potential lenders more willing to put their funds into securities that look like equity.

A related concern is the concern that negative interest rates might encourage people to take on too much risk. But if the risk is funded by equity instead of debt, risk can be taken on without seriously raising the probability of bankruptcy. And as long as bankruptcy probabilities are low because the fraction of equity-funding is high, risk-taking seems to me like a good thing, not a bad thing.

Now I may be missing something here. If so, I would be interested to here what. One question I have is whether junk bonds are enough like equity that what I said about equity can be applied to them, or whether junk-bonds sometimes occur in industries where the deadweight loss from bankruptcy is so high that there is a lot of inefficiency to having junk-bond financing instead of equity financing. One would hope that junk bonds would mainly be an attractive funding vehicle in equilibrium in industries where the deadweight loss from bankruptcy was especially low.

Suparit Suwanik: Putting Paper Currency In Its Proper Place

March 06, 2016 by Miles Kimball

Link to Suparit Suwanik’s Linked In homepage

I am delighted to be able to start another season of student guest posts with this guest post by Suparit Suwanik. The students in my “Monetary and Financial Theory” class are required to do 3 blog posts each weak during the semester. From among the best of these I choose some to be guest posts here. (You can see the class assignment and resource blog here, and links to student guest posts from previous semesters here.) I am impressed by Suparit’s level of understanding of what I have been proposing. Suparit’s post below is the 1st student guest post this semester:

Amid the growing popularity of the world’s newest monetary policy tool - negative interest rates, many newspapers, including the Wall Street Journal, are paying attention to the possibility of related changes in paper currency policy. The interesting editorial, “The Political War on Cash”, touches on how politicians and central bankers around the world are massively rallying to limit the use of cash, especially large-denomination bills. From Mario Draghi to Larry Summers, they are planning to get rid of the large notes, for example, €500 notes and $100 bills, which would mean it’s time to say goodbye to Benjamin Franklin. The author cites that “The real reason the war on cash is gearing up now is political: Politicians and central bankers fear that holders of currency could undermine their brave new monetary world of negative interest rates…” which suggests an unwarranted prejudice against negative interest rates. Also, he points out many reasons why paper currency shouldn’t be entirely eliminated (Yes, he’s going that far!). It’s such a pity he’s never taken a class with Prof. Miles Kimball of University of Michigan, a strong supporter of negative interest rate policy.

I take the liberty of crystallizing Kimball’ several posts, such as:

blended with my thoughts to counter argue the author’s reasons, point by point.

First, the Wall Street Journal editorial board argues that cash allows legitimate transactions to be executed quickly, without either party paying fees to a bank or credit-card processor. I somewhat agree that we need to pay fees to use credit cards, or electronic money, while we can use cash free of charge (cash earns zero interest rate). Yet, in the world of negative interest rates where the time-varying fee on cash deposits is additionally imposed, as Kimball suggested, cash, or paper currency has its value even less than electronic money. If you go buying something at a retail store, the shopkeeper will sell you at the higher price if you pay by the greenback than what it costs in electronic currency. That is, paying by cash even costs you more than (or equal to) paying by electronic currency, which includes fees to a bank or credit-card processor. This, in other words, means that the electronic currency is taking a role of “unit of account”, instead of the paper currency.

Second, the Wall Street Journal editorial board states that cash lets millions of low-income people participate in the economy without maintaining a bank account. This may be going too far since, according to Kimball, we will not entirely eliminate paper currency, at least, just yet. Subordinating paper money to electronic money as an economic yardstick is a big enough step for now; the question of whether to further demote paper currency can wait. We still keep the paper currency to function as “the medium of exchange” as it has always been doing, especially for low-income people that frequently use cash to buy relatively inexpensive necessity goods. Only one function of money, unit of account, will be given exclusively to the electronic currency.

Third, while there’s a chance of theft for cash, digital transactions are subject to hacking and computer theft. Again, this is going too far since, by the time when cash is going to be largely eliminated (but small bills are kept for those reasons mentioned above), the electronic system will have had large upgrades and enhanced security. Also, the security risk has long been presented, either you hold paper or electronic currency. So why are you so afraid as if it never existed?

Finally, cash is the currency of gray markets because high taxes and regulatory costs drive otherwise honest businesses off the books. The author warns that governments may need to reconsider since it might destroy businesses and leave millions of people unemployed. To my thought, this is a fallacy: why do we need to keep those businesses avoiding tax underground? Is it a duty of government to ignore those unlawful businesses just for the reason that they stimulate economy?

I agree that the government may reduce the role of paper currency that greatly compromises the privacy of transactions, but try weighing between pros and cons of going “electronic” as the new economic yardstick, in order to have effective policy in preventing the economy from the recession. I see no reason to deny it.

The Storm and the Battle Ahead

March 03, 2016 by Miles Kimball

Decades of stagnating wages didn’t help, and the swift cultural changes brought on by technical change and globalization have occasioned many tough adjustments, but the timing and intensity of the political storm we see all around us owes a great deal to the Great Recession. The Great Recession in turn owes its depth and duration to not just a failure of financial stability policy, but to a monumental failure of monetary policy.

Many of the central bankers at the helm during the Great Recession acted heroically to make things better than they might have been–notably Ben Bernanke at the Fed, Mervyn King at the Bank of England and Mark Carney at the Bank of Canada–but even those heroic efforts fell far short of what common women and men had a right to expect from central bankers. The fault lies with the economics profession as a whole, which first did too little to insist on the high equity requirements that could have easily blunted or avoided the financial crisis that sparked the Great Recession, and second had not laid the intellectual groundwork to break through the zero lower bound in 2009 to stop the Great Recession in its tracks once it had begun.

Many artists documented the suffering in the Great Depression of the 1930′s. Seeing several of Maynard Dixon’s painting at the BYU art museum, including the one you see above, made me think of how that suffering was caused by that era’s monumental failure of monetary policy. What you and I are doing now to add to the tools available to central banks to fight recessions and escape the need for inflation is the least that people should expect of us in doing our duty. The hundreds of millions of people who depend on us should not suffer during the next recession because of any lack of diligence or courage on our part.

The people of the world, by and large, do not know exactly what went wrong to make the Great Recession as bad as it was. They do not know, by and large, what it will take to avoid a rerun of the Great Recession or the secular stagnation that Japan has suffered for the last 20+ years. Many of the people of the world may curse us for tools they don’t understand are the key to avoiding such dire outcomes. But they will curse economists in general–and central bankers in particular–much more if we fail to do our job of keeping the world economy on an even keel. Let us not shrink from the task before us, but press forward.

Many of you are already participants, in large and small ways, in the battle against the zero lower bound. This post is written in the first instance to honor you, to encourage you and to thank you for your efforts. For those readers newer to the idea that monetary policy can be reinvigorated by modifying traditional paper currency policy, take a look at “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”

Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates

March 01, 2016 by Miles Kimball

Link to the Wikipedia article on Mark Carney

I have called Ben Bernanke a hero many times for his actions to stem the hemorrhaging of the US economy during the 2008 Financial Crisis and the ensuing Great Recession (in “Four More Years! The US Economy Needs a Third Term of Ben Bernanke,” in “Ben Bernanke on Trial” and in my presentations to central banks around the world). But for his actions as Governor of the Bank of Canada that insulated Canada from the worst of the Great Recession, and his work as Chairman of the G20′s financial stability board, Mark Carney is every bit as great a hero. Although for the sake of financial stability, it is worth desiring even higher equity requirements for banks, those equity requirements are probably significantly higher and the international financial system significantly more stable than it would be without Mark Carney’s leadership.

In addition to my assessment of Mark Carney as a hero, I have to confess myself a fan. Along with Haruhiko Kuroda, he tops my list of central bankers I would like to meet in person, but haven’t yet. And I wrote “Could the UK Be the First Country to Adopt Electronic Money?” thinking of Mark Carney’s remarkable career move from the Bank of Canada to head the Bank of England.

But I take issue with Mark Carney’s inadequate analysis of the transmission mechanism for negative interest rates in his recent speech “Redeeming an unforgiving world.” It is the sort of thing people are saying these days, but it is incomplete and misleading. One could easily come away with the idea that unless regular households face negative interest rates in their deposit accounts that negative interest rates only work through the exchange rate channel, which is zero-sum from a global point of view. What Mark Carney meant might be much more sensible: except for small household accounts, if Mark Carney’s point is simply that more pass-through of negative interest rates is better than less, I wholeheartedly agree. (Fortunately, experience with negative interest rates in Europe suggests that–with the exception of household accounts, large and small–there is a great deal of pass-through.) But in any case it is important to deal with what Mark Carney said and how it might be misconstrued. To show that I am not off-base to worry about such a construal, consider this from George Magnus in Prospect:

To their credit, policymakers did note that monetary policy alone was no longer enough to deal with the problems in the world economy. Mark Carney, Governor of the Bank of England, had earlier criticised countries pursuing Negative Interest Rate Policies, or NIRP, by arguing that where retail customers were protected from the effects, countries were essentially pursuing a covert form of currency depreciation.

Of course monetary policy is not enough to deal with all the problems of the world economy: I said as much in “Governments Can and Should Beat Bitcoin at Its Own Game”:

But make no mistake: Giving electronic money the role that undeserving paper money now holds will only tame the business cycle and end inflation. Fostering long-run economic growth, dealing with inequality, and establishing peace on a war-torn planet will remain just as challenging as they are now. But every time one set of problems is solved, it allows us to focus our attention more clearly on the remaining problems. It is time to step up to that next level.

Monetary policy cannot solve all of our problems. But monetary policy–and full-scale negative interest rate policy in particular–is the primary answer to the problem of insufficient aggregate demand. It is a bad thing when world leaders say or seem to say the opposite. As the title of Martin Sandbu’s excellent column on ft.com proclaims: “Central banks cannot pass the buck.”

Mark Carney’s Description of the Transmission Mechanism for Negative Interest Rates

Here is the key passage from Mark Carney’s speech:

Central bank innovation has now extended to negative rates, with around a quarter of global output produced in economies where policy rates are literally through the floor.
Conceptually the more that effective policy rates can be reduced below equilibrium rates, the better the prospects for demand to grow faster than potential supply, promoting global reflation.
However, it is critical that stimulus measures are structured to boost domestic demand, particularly from sectors of the economy with healthy balance sheets. There are limits to the extent to which negative rates can achieve this.
For example, banks might not pass negative policy rates fully through to their retail customers, shutting off the cash flow and credit channels and thereby limiting the boost to domestic demand.7 That is associated with a commonly expressed concern that negative rates reduce banks’ profitability.
To be clear, monetary policy is conducted to achieve price stability not for the benefit of bank shareholders.
Nonetheless, when negative rates are implemented in ways that insulate retail customers, shutting off the cash flow and other channels that mainly affect domestic demand, while allowing wholesale rates to adjust, their main effect is through the exchange rate channel.
From an individual country’s perspective this might be an attractive route to boost activity. But for the world as a whole, this export of excess saving and transfer of demand weakness elsewhere is ultimately a zero sum game. Moreover, to the extent it pushes greater savings onto the global markets, global short-term equilibrium rates would fall further, pulling the global economy closer to a liquidity trap. At the global zero bound, there is no free lunch.8
For monetary easing to work at a global level it cannot rely on simply moving scarce demand from one country to another. Instead policy needs to increase primarily domestic demand, with the exchange-rate channel more a side effect that accompanies any monetary policy action.
In any given country, a monetary expansion aimed at boosting domestic demand will tend to reduce effective interest rates relative to their equilibrium level, generating an excess of domestic investment over domestic saving that must be met with a capital inflow from abroad.
But viewed from overseas, the corresponding capital outflow will tend to raise the short-term equilibrium rate (Chart 12), giving conventional monetary policy overseas more traction.
In this way, the rising tide of global demand would raise all boats.

Why It is OK for Regular Households to Be Insulated from Negative Deposit Rates

In “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies” I argue that it is not only OK for small deposits (say the first 1000 euros in average monthly balances per person) to be exempted by private banks from negative rates to the extent those banks choose to do so, but that this should be encouraged by an effective subsidy built into the central bank’s formula for interest on reserves. One reason this is OK is that most of the assets and liabilities in the economy are held by firms and a small share of the people, so there is plenty of transmission mechanism left if only large accounts and commercial accounts are subject to the negative interest rates. I do agree with Mark Carney that it is very helpful to encourage banks to pass along negative interest rates to large accounts and commercial accounts.

The kind of central bank subsidies I suggest in “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies,” combined with the encouragement to pass along negative interest rates to the large accounts and commercial accounts can go a long way toward maintaining bank profitability.

Negative Interest Rates Can Do Their Work Even Outside of the Foreign Exchange Markets

Let me set aside the foreign exchange markets for a moment by imagining that interest rates are being cut by 1 percentage point by all the central banks in the world. In some countries this would be a cut to a lower positive interest rate. In other countries, it would be a cut to a negative interest rate or to a deeper negative interest rate, which for countries already at significant negative interest rates might call for lowering the paper currency interest rate as well. (See “If a Central Bank Cuts All of Its Interest Rates, Including the Paper Currency Interest Rate, Negative Interest Rates are a Much Fiercer Animal.”) Since all countries would be cutting their rates by 1 percentage point in tandem, there should be only modest effects on international capital flows and hence only modest effects on exchange rates and trade balances.

The effects of this interest rate cut would be quite similar for countries that were cutting their rates in the positive region and countries that cut to a negative rate. As I wrote in “Negative Interest Rate Policy as Conventional Monetary Policy”:

As far as I know, very few economists have objected to permanently raising the inflation rate as a way to deal with the zero lower bound on the basis that this would not, in fact, allow any extra monetary stimulus. The reason is the fact I started with: standard models say it is the real interest rate that matters. But if it is the real interest rate that matters, lowering the nominal interest rate without raising inflation will stimulate the economy through totally standard mechanisms. It is not necessary to have full agreement on exactly how a lower real interest rate stimulates the economy. For all of those who agree that interest rate policy matters, a cut in the nominal interest rate will have much the same effect as an increase in inflation with the nominal interest rate held fixed. So if an increase in inflation operates through conventional means, so does a cut into negative territory of the full set of nominal government interest rates – target rate, interest on reserves, lending rate, between- tax-year rate, postal savings rate and paper currency interest rate. In that sense, a negative interest rate policy is a conventional monetary policy if having a target inflation rate of 2 per cent or 4 per cent instead of a target inflation rate of zero is a conventional monetary policy.

With a global cut in interest rates by 1 percentage point, different countries are getting to a low real interest rate in different ways–some in part by having had higher inflation to begin with, some by negative nominal interest rates–but the effects are similar.

But negative interest rates seem new enough, that it is worthwhile to review the wide range of transmission mechanisms by which lower interest rates increase aggregate demand. Here is the basic story: In any nook or cranny of the economy where interest rates fall, whether in the positive or negative region, those lower interest rates create more aggregate demand by a substitution effect on both the borrower and lender, while other than any expansion of the economy overall, wealth effects that can be large for individual economic actors largely cancel out in the aggregate.

The Principle of Countervailing Wealth Effects: It is easy to forget about some of the wealth effects. Applying the general principle that all the wealth effects cancel–other than overall expansion of the economy and differences in the marginal propensity to consume across economic actors can help in making sure one hasn’t missed a wealth effect, much as double-entry accounting helps in making sure one doesn’t miss something. An example of a particularly large wealth effect that is easy to miss is that a fall in interest rates raises the present discounted value of household labor income. The other principle that helps to avoid missing a wealth effect is to remember that there is always another side to every borrowing-lending relationship. If the economic actor on one side of the borrowing-lending relationship gets a negative hit to effective wealth, the economic actor on the other side will get a positive boost to effective wealth–again with the exception of the overall expansion of the economy.

The Effect of Redistributions: Redistributions from economic actors with a high propensity to consume to economic actors with a low propensity to consume might reduce the aggregate demand effect, but as an analysis like the one that Adrien Auclert does in “Monetary Policy and the Redistribution Channel.” shows that (a) the effects from such redistributions are modest (though definitely big enough to be worthy of Adrien’s effort at studying them) and (b) in the aggregate they tend to go in the same direction as the substitution effect. For understandable reasons, the modest overall size of the redistribution effects is not highlighted in the abstract but the fact that these redistributions act in the same direction as the substitution effect is. Note the word “amplify”:

This paper evaluates the role of redistribution in the transmission mechanism of monetary policy to consumption. Three channels affect aggregate spending when winners and losers have different marginal propensities to consume: an earnings heterogeneity channel from unequal income gains, a Fisher channel from unexpected inflation, and an interest rate exposure channel from real interest rate changes. Using a sufficient statistics approach, I show that the latter is plausibly as large as the intertemporal substitution channel in Italian and in U.S. data. A calibrated model reveals that this channel is particularly potent when asset maturities are short, and that the other two redistributive channels can also amplify the effects of monetary policy.

My proposals would have only a limited effect on redistribution channels. I can think of only two:

Effective subsidies through the interest-on-reserves formula to encourage banks to exempt small accounts from negative interest rates tend to make interest rate cuts more favorable for spending by avoiding taking funds from households likely to have a high marginal propensity to consume.
People using paper currency for tax evasion may well have a high marginal propensity to consume, but the more serious criminals who hold most of the rest of paper currency probably have a low marginal propensity to consume; laundering money into legitimate-enough businesses that it is safe to spend the money takes time, so for the most financially successful criminals consumption must often be deferred. (Think of the trouble the protagonists in “Breaking Bad” had in spending their money in the present without calling too much attention to themselves.) Lowering the paper currency interest rate is mostly a transfer from criminals of these two types to the central bank, where it either adds to central bank independence or is sent on to the remainder of the government. And in most countries, the rest of the government probably has a fairly high propensity to consume funds transferred to it from the central bank. (Indeed, in the US, there is an increasing and dangerous trend, not toward demanding the Fed generate more seignorage revenue, but toward demanding that the Fed hand over seignorage revenues it makes in the normal course of its businesses more quickly precisely because it is a way to spend more money without running afoul of anti-deficit rules.)

Why Wealth Effects Would Be Zero With a Representative Household: It is worth clarifying why the wealth effects from interest rate changes would have to be zero if everyone were identical. In aggregate, the material balance condition ensures that flow of payments from human and physical capital have not only the same present value but the same time path and stochastic pattern as consumption. Thus–apart from any expansion of the production of the economy as a whole as a result of the change in monetary policy–any effect of interest rate changes on the present value of society’s assets overall is cancelled out by the effect of interest rate changes on the present value of the planned path and pattern of consumption. Of course, what is actually done will be affected by the change in interest rates, but the envelope theorem says that the wealth effects can be calculated based on flow of payments and consumption flows that were planned initially.

Examples of Channels of Transmission of the Effects of Interest Rate Cuts to Aggregate Demand

Interest rates show up in many parts of the economy. Generally, interest rates move up and down together. Those where there is more risk of default or where money is locked up for longer periods of time tend to have a higher average level, so a move to negative short-term safe rates is likely to mean lower, but still positive rates for most consumer loans and bank loans, for example. It is worth taking a look at how, in each borrower-lender relationship, lower interest rates tend to stimulate aggregate demand overall. It is also good to notice how a loan done in a regular bank office is only a small share of all borrower-lender relationships.

Mortgages: Houses are easier to buy and to build when interest rates are lower. The effective wealth of those who own mortgages tends to go down when interest rates fall, especially when people use a prepayment option to refinance at a lower interest rate, but those who need to pay the mortgage get a corresponding improvement in their financial situation that enables them to spend more. Those who need to pay the mortgage typically have a higher propensity to consume.

Car Loans: Cars are easier to buy when interest rates are lower. This stimulates aggregate demand, and is mostly a substitution effect. Car buyers and car dealers benefit from lower interest rates. Their increased effective wealth makes up for the reduction in effective wealth of those who own securities backed by car loans who hope to roll over their existing loans into more car loans. Apart from the effects of that loss in effective wealth, those looking to roll over car loans they hold into more car loans have an incentive to shift the spending of what resources they have left toward the present over the future. That substitution effect also contributes to aggregate demand.

Venture Capital: It is easier and cheaper to get money for a startup when interest rates are low. This has a substitution effect toward more burn to write new software or develop a new medical treatment. There are wealth effects favoring those who have ideas over those who have a pile of money to invest. Those who have ideas tend to have a higher propensity to spend on making their ideas a reality (not consumption spending, but spending nevertheless) than the propensity of those with the pile of money to invest to spend on their own.

Commercial Paper: Those whose bank accounts would exceed the limit for being shielded from negative interest rates need to put their money somewhere. For large amounts of money, paper currency is not that attractive to begin with, and can be kept from being too attractive by keeping the paper currency interest rate equal to the central bank’s target rate (say the federal funds rate or a repo rate). So those who want to hold liquid wealth are still likely to want to have some version of money market funds, even when they have a negative interest rate. Or it may be that a new type of fund would arise serving the same function. Lower interest rates make it less costly for businesses to borrow in the commercial paper market and so make it easier for those businesses to make it from one month to the next without running out of funds. These businesses may even feel they can take a somewhat bigger risk in the direction of expansions. Those with part of their pile of funds invested in the commercial paper market suffer a loss in effective wealth, but that is made up for by the increase in effective wealth of those borrowing in the commercial paper market. Leaving aside those wealth effects, those with their funds invested in the commercial paper market have a bit of a substitution effect in favor of consuming more.

Firms with Cash Hoards: Farthest from needing any bank loan are companies that already have large liquid asset hoards that under current interest rates, they see as earning a better risk adjusted returns sitting and earning interest than if invested in a new factory, new machinery, or a new business venture. When interest rates go down, these firms will begin to pay a heavy price for simply earning interest with a liquid asset hoard, and those within the company who want to champion a new business venture will meet with more success in internal corporate deliberations. This is particularly valuable for the economy if firms were applying too high a hurdle rate for proposed projects even at the old higher interest rate as Clay Christensen and Derek van Bever argue in their Harvard Business Review article “The Capitalist’s Dilemma.” In this context, negative interest rates might help greatly in getting not only the CFO but also the production and sales side of the firm to realize that interest rates are low, and what that should mean for business decisions.

Governments and Treasury Bill Holders: Those who like to roll over their wealth in the form of short-term Treasury Bills are likely to be especially unhappy about low interest rates. But their loss is the government’s gain. And since lower interest rates on Treasury Bills show up as a reduction in conventional measures of the government budget deficit, this money is especially likely to be spent by the government. So the redistribution in this case tends to lead toward more aggregate demand.

Many people have been frustrated that the substitution effect for government investment is so low. Most governments seem to pay too little attention to interest rates in deciding whether an investment project such as refurbishing roads and bridges is a good idea or not. But it is unlikely that the logic that low interest rates make government investment projects a better idea will forever fall on deaf ears in every nation in which interest rates fall.

Governments and Holders of Long-Term Government Bonds: It may well be that negative interest rates in most countries are preceded by quantitative easing that shifts government financing decisively toward Treasury bills. But there are likely to be some long-term government bonds left. In this case, there is much less of a redistribution between the government and the bond-holders. The committed payments stay the same for some time. The market value of the long-term bonds will change, but the present discounted value of the tax revenues slated to be used to make the payments on those bonds will change in a similar way. For the taxpayers, that change in the present value of the tax payments is in turn cancelled out to an important extent by the change in the present value of the income out of which those tax payments will be made.

With less redistribution, it makes sense to focus on the substitution effect even more than in the other examples above. As mentioned above, the substitution effect for the government may be low (much lower than it should be), but the holders of the long-term bonds have reason to shift their consumption forward in time.

Central Bank Lending: Eric Lonergan is right to emphasize in his post “There is a lot more the ECB can do” the value of central banks lowering the central bank lending rate (such as the discount rate in the United States) as part of a negative interest rate policy. As Martin Sandbu points out in “Central bankers’ feigned impotence” on ft.com, this needs to be done along with the central bank lowering the other interest rates it controls–otherwise private banks can borrow from the central bank and then park the money at a higher interest rate in the repo market or their reserve accounts after enough reshuffling to provide a bit of a fig leaf to pretend to hide what they are doing. Note here that it is the rate on extra reserves that needs to be in line with the lending rate. As I discuss in “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies,” an effective subsidy by having a higher rate on inframarginal reserves is actually helpful.

If the central bank lending rate is in line with the target rate and interest on reserves, any redistribution is between savers and those banks borrowing from the central bank, with the central bank only a conduit and not itself subject to much of a wealth effect. But the positive wealth effect for banks is particularly important, since it helps preserve the bank capital needed for financial stability (hopefully in conjunction with a high capital conservation buffer that avoids the dissipation of scarce bank capital into dividends). And as in any other borrowing and lending relationship a lower central bank lending rate will have some substitution effect in favor of more spending–in this case through a certain amount of extra lending by the private banks that borrow from the central bank.

Returning to the Effects of Interest Rate Cuts on International Capital Flows and Exchange Rates

I hope the examples above show that the aggregate demand effects from lower interest rates–including negative interest rates–do not depend solely on international capital flows. It should be mentioned that even if all the nations in the world cut interest rates, there would be some interesting international effects. For example, China is a large holder of Treasury bills. If interest rates were to fall, there would be an important redistribution away from China toward the US. But let me now leave that aside.

The international effects Mark Carney is focusing on come from one country cutting its interest rates more than another. This leads to flows of funds from the now lower rate country toward other countries that have not cut their rates, as those funds seek a good return. As I discuss in “International Finance: A Primer,” the fact that foreign assets are purchased directly or indirectly by domestic currency then makes the rest of the world awash in domestic currency–more than the rest of the world outside the domestic currency zone wants. Exchange rates adjust until the domestic currency makes it way back to the domestic currency zone–primarily to pay for an increase in net exports.

Given the fact that negative interest rates would work for the whole world and so are not zero-sum, the fact that the early adopters get an extra kick from higher net exports is a feature, not a bug. As I argued in “Could the UK Be the First Country to Adopt Electronic Money?” and in my presentation “18 Misconceptions about Eliminating the Zero Lower Bound,” these international effects are likely to hasten the spread of negative interest rates as part of the monetary policy toolkit.

International effects can indeed be central for a small open economy such as Switzerland, Sweden or Denmark, and substantial even for an economy as large as the eurozone economy. And if a central bank gets enough extra aggregate demand quickly from international effects, it is unlikely to continue cutting interest rates far enough to see much action from the other channels. But if other central banks cut interest rates too in accordance with what their own economies need, then the central banks that started the round are more likely to find they need to cut interest rates far enough for the other channels to kick in in a big way.

When people ask about how effective negative interest rates are at stimulating aggregate demand, I always emphasize that interest rate cuts–in either the positive or negative region–should be judged by how much they do per basis point. One should not expect a 10 basis point (.1%) cut to have a huge effect simply because it is in the negative region. For those countries that choose as a matter of policy to keep their effective lower bound on interest rates by keeping the paper currency interest rate at zero, there may not be enough basis points to cut to have a big effect on aggregate demand. But for any central bank willing to go off the paper standard, there is no limit to how low interest rates can go other than the danger of overheating the economy with too strong an economic recovery. If starting from current conditions, any country can maintain interest rates at -7% or lower for two years without overheating its economy, then I am wrong about the power of negative interest rates. But in fact, I think it will not take that much. -2% would do a great deal of good for the eurozone or Japan, and -4% for a year and a half would probably be enough to do the trick of providing more than enough aggregate demand.

International effects do matter; such a salutary rate cut by the eurozone and Japan would probably mean the US and the UK would need to go to milder negative interest rates in order to stay on track itself. But if the US and UK did so, such rate cuts in the eurozone, Japan and the United States and the United Kingdom would bring about a big expansion of aggregate demand for the whole world.

On the transmission mechanism for negative interest rates, also see “On the Need for Large Movements in Interest Rates to Stabilize the Economy with Monetary Policy”

For links to everything I have written about negative interest rates, see “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”

Negative Interest Rate Policy as Conventional Monetary Policy: Full Text

February 29, 2016 by Miles Kimball

Links to pdf of “Negative Interest Rate Policy as Conventional Monetary Policy” and to the abstract page on the National Institute Economic Review website. Thanks to the National Institute Economic Review for permission to post the full text of… — Links to pdf of “Negative Interest Rate Policy as Conventional Monetary Policy” and to the abstract page on the National Institute Economic Review website. Thanks to the National Institute Economic Review for permission to post the full text of the paper here.

Abstract: As long as all interest rates move in tandem — including the rate of return on paper currency — economic theory suggests no important difference between interest rate changes in the positive region and interest rate changes in the negative region. Indeed, in standard models, only the real interest rate and spreads between real interest rates matter. Thus, in most respects, negative interest rate policy is conventional. It is only (a) what needs to be done with paper currency, (b) difficulties in understanding negative rates or (c) institutional features interacting with negative rates that make negative interest rate policy unconventional.

Keywords: monetary policy; negative interest rates; unconventional; stabilisation; transmission JEL Classifications: E52; E58; E42; E43; E41; E31

Author: Miles Kimball is Professor of Economics and Survey Research at the University of Michigan, a Quartz Columnist and Independent Blogger on Economics, Politics and Religion E-mail: zxkimball@gmail.com; Blog: http://blog.supplysideliberal.com. This paper builds on Agarwal and Kimball (2015).

It took a long time within mathematics for negative numbers to be fully accepted. To this day, negative numbers seem exotic to many people. So it will take a while for people to fully understand negative interest rates. But economic theory makes surprisingly little distinction between positive and negative rates. And the sophisticated business people and financiers who are key to the most important effects of interest rates will grasp the essentials of negative interest rates quickly. [1] Therefore, let me argue on both theoretical grounds and by spelling out some of the practical details that negative interest rate policy will turn out to be a more conventional type of monetary policy than people now realise.

In standard economic models, nominal interest rates don’t matter: only real interest rates and the spreads between them matter. The one seeming exception is not an exception at all: the opportunity cost of holding paper currency is closely related to the spread between the real interest rate on, say checking accounts, and the real interest rate on paper currency. Sometimes this equals the nominal interest rate because it has been traditional to have a zero nominal interest rate on paper currency, but it matters in the model because it is the spread between two real interest rates.

This essay is about how best to break with that restrictive tradition and engineer nonzero interest rates on paper currency when needed for economic stabilisation. If central banks take control over the paper currency interest rate, then it is possible to get paper currency out of the way of targeting any real interest rate — even deep negative rates — if necessary for economic stabilisation. But the principles of economic stabilisation and the monetary policy tools needed to achieve it — other than getting paper currency out of the way — are exactly the same as conventional monetary policy before the era of large-scale long-term asset purchases.

Building on Willem Buiter and Nikolaos Panigirtzoglou (2001, 2003) and Buiter (2004, 2007, 2009a,b,c) I have tried to figure out how to free up the paper currency interest rate in a way that is as close as possible to the current system in an effort to minimise the political cost to a central bank of getting paper currency out of the way of interest rate policy. I have taken the resulting specific proposal to on the whole receptive audiences at central banks around the world (listed in updated versions of Kimball, 2013a), and have made efforts to explain such a negative interest rate policy to the general public by blog posts on my blog ‘Confessions of a Supply-Side Liberal’, articles in online magazines such as Quartz and Slate, and by explaining negative interest rate policy to journalists. The blog posts and online magazine articles have included a children’s story (together with amateur rap, operatic, and read- aloud videos dramatising the story), an account of a conversation with my non-economist neighbour about negative interest rates, a quiz, and questions-and-answer posts answering such questions as “Is Electronic Money the Mark of the Beast?”. A regularly updated set of links to all of this material can be found in my regularly updated bibliographic post, ‘How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide’ (Kimball 2013b). Along with coauthors, I have several academic papers on negative interest rate policy in the works.

There have been at least five recent milestones for negative interest rate policy as a real-world policy tool:

The current mild negative interest rates in the euro zone, Switzerland, Denmark and Sweden (see, for example, Randow, 2015).
The boldly titled 18 May, 2015 London conference on ‘Removing the Zero Lower Bound on Interest Rates’, cosponsored by Imperial College Business School, the Brevan Howard Centre for Financial Analysis, the Centre for Economic Policy Research and the Swiss National Bank.
The 19 May, 2015 Chief Economist’s Workshop at the Bank of England, which included keynote speeches by Ken Rogoff, presenting ‘Costs and Benefits to Phasing Out Paper Currency’ (Rogoff, 2014) and my presentation ‘18 Misconceptions about Eliminating the Zero Lower Bound’ (Kimball, 2015). Ken Rogoff’s paper is also scheduled to be the keynote presentation at the 19–20 November Bank of Canada Conference on Electronic Money and Payments.
Bank of England Chief Economist Andrew Haldane’s 18 September, 2015 speech, ‘How low can you go?’ (Haldane, 2015).
Ben Bernanke’s discussion of negative interest rate policy on his book tour (for Bernanke, 2015), ably reported by journalist Greg Robb in his Market Watch article ‘Fed officials seem ready to deploy negative rates in next crisis’ (Robb, 2015).

I want to emphasise that I consider the policy I am proposing as a realistic policy option that could be implemented at any point by central banks that have had it under active consideration and so have done the necessary staff work, and within a matter of weeks if necessary by central banks that have been caught flat- footed by a crisis without yet having done any of the staff work to prepare.

The remainder of this essay has three parts: first, explaining some of the details of my proposal to engineer a nonzero paper currency interest rate and thereby eliminate the lower bound; second, pointing out all of the aspects of monetary policy that would be unchanged by getting paper currency out of the way; and third, discussing the politics of negative interest rate policy.

How to engineer a nonzero paper currency interest rate in a way that is at minimum distance from the current system

My goal in policy design has been to find the paper currency policy closest to the current system that fully removes any zero lower bound. If I have not succeeded, I welcome any suggestions of how to find an alternative closer to the current monetary system, provided it allows short-term interest rates to go as low as needed to revive an economy, without the help of other stimulative policies, even after a shock significantly larger than the one that threw the world economy into the Great Recession, and regardless of how low inflation is.

In addition to looking for a system close to the current monetary system in order to minimise the political costs for a central bank implementing the policy I suggest, another reason to look at options close to the current system is to help bring the policy within the current legal authority of many central banks. Thinking of monetary politics in the United States, I am alert to the question of what could be done by the Federal Reserve System with the support of only the Executive Branch and a blocking coalition in Congress – a situation that would preclude any new enabling legislation. I cannot fully address all the legal questions here. The answer to many legal questions about the authority of the Fed are simply unknown, particularly since the more serious a future crisis, the more a court is likely to defer to the Fed’s judgment. And detailing the legal authority of all the central banks that might be interested in engineering a nonzero paper currency interest rate would be a large task indeed. It is my understanding that a number of central banks have significantly more legal leeway than the Fed to act on their own authority.

In 1932, Robert Eisler anticipated the essential element of the policy I am advocating (and that Willem Buiter and Nikolaos Panigirtzoglou discuss): a time-varying exchange rate between paper currency and money in the bank. Nowadays, money in the bank is a number in a computer, so I refer to it as ‘electronic money’. [2]

In this sense of electronic money, most US residents use electronic dollars almost every day when they pay for things by credit card, debit card, cheque or electronic funds transfer. In his 18 September speech (Haldane, 2015), Andrew Haldane advocates extending official government-sponsored electronic money from reserve accounts at the central bank and government-run payment clearing systems to government-sponsored electronic accounts that any household or firm could use. Although this would be helpful in furthering an electronic money policy, I do not think it is necessary. High-powered electronic money in reserve accounts and in the payment clearing system, plus electronic money in government-insured bank accounts provides enough of a starting place to institute an electronic money policy of the sort I am advocating.

Central banks have the power to establish the relative prices of different forms of money under their jurisdiction, a fact which is missing from many current money and banking textbooks. Currently, the Federal Reserve System has fixed exchange rates between all of the different forms of money under its jurisdiction. Two $10 bills are worth one $20 bill because at its cash windows, the Federal Reserve System will give banks $10 bills in unlimited quantities in exchange for half the number of $20 bills, and conversely, the Federal Reserve System will give banks $20 bills in unlimited quantities in exchange for twice the number of $10 bills. It is this exchange rate between $10 bills and $20 bills at the cash windows of the Fed and not the numbers printed on the faces of the green pieces of paper that determines their relative values.

There is no reason to alter the exchange rate between $10 bills and $20 bills, but there is a reason to free up the exchange rate between an electronic dollar (e-$) and a paper dollar (p-$): eliminating the zero lower bound as an effective constraint. Unlike higher inflation while keeping the exchange rate between paper dollars and electronic dollars at par, a time-varying exchange rate between paper dollars and electronic dollars can generate extra ‘inflation’ relative to paper currency at those times — and only those times — when inflation relative to paper currency is needed, without generating extra inflation relative to electronic money.

The exchange rate between paper dollars and electronic dollars would move very gradually. Cutting paper interest rates 400 basis points to –4 per cent per year to match electronic interest rates of –4 per cent per year (both expressed in terms of electronic dollars) is quite a large cut in interest rates. But it corresponds to lowering the value of an electronic dollar by only 1 per cent over a 90-day period or so — about 1.1 basis points decline in the value of the paper dollar per day. In other words, p-$1000 worth e-$1000 on day one would be worth about e-$999.89 on day two. That 11 cent per day change in the value of 1000 paper dollars is slow enough that it would give people time to adapt.

The starting point for the policy I am advocating is to encourage economic actors to use the electronic dollar — or euro, yen, pound, peso, etc. — as the unit of account, and as the unit in which prices are expressed. (To fix ideas, from here on I will write about the ‘electronic dollar’, which should be read in each case as ‘the electronic dollar — or euro, yen, pound, peso, etc.’). It is not essential that all prices be expressed in terms of the electronic dollar, but it is important that prices for a significant fraction of expenditure be expressed in terms of the electronic dollar, and the electronic money system will work most smoothly if all but a small fraction of prices are expressed in terms of electronic dollars. The idea is that purchases paid for by credit card, debit card, cheque, or electronic funds transfer would look exactly like they do now, while for paper currency purchases, retailers would have the option of applying a storewide paper currency surcharge, assessed at checkout as sales taxes now are. If, however, vending machine items and a few convenience store items continue to have separately determined paper currency prices, that is fine.

Arguably, the US and many other countries already have an electronic unit of account and electronic unit of price quotation in the sense of this thought experiment: suppose the exchange rate between paper currency and electronic money departed from par, but the central bank and the rest of the government maintained a studied neutrality about what the unit of account should be (including somehow making the two accounting systems equivalent as far as taxes go). I would bet that businesses would choose to do their accounting and their business-to-business transactions in terms of the electronic dollar instead of doing their accounting and business-to-business transactions in terms of the paper dollar. It is even more likely that electronic money would be the unit of account if, say, the announced policy of the central bank and the executive branch of the government was to favour the electronic dollar as much as existing legislation allowed. And if the electronic dollar were the unit of account in this sense, it is likely that it would also be the unit of price quotation at least for those retailers selling goods that are now mostly purchased with credit cards, debit cards, cheques or electronic funds transfers.

My view is that governments are big enough actors in the economy and in declaring focal points in multiple equilibrium situations (as the government does for Daylight Savings Time) that governments generally have control over what the unit of account is within their jurisdictions, except when there is an extremely high inflation rate or a history still burned into people’s memory of an extremely high inflation rate in that unit of account. Even nations that do lose control of their units of account are often able to partially restore that control with a newly created unit of account if policies are put in place to keep inflation rates in that new unit of account lower. And to the extent that prices in post- hyper-inflationary economies are still quoted in other units of account, it is usually associated with inflation that, while lower, is still high enough that the economy is far away from the zero lower bound. Here it is worth noting that the perception of extra inflation from paper currency’s depreciation itself is extra inflation relative to paper currency, which in any case the central bank is trying to make look unattractive as a unit of account. Electronic money is the hard money and paper currency is the soft money in this system. Thus, I think it likely that most governments could successfully declare an electronic unit of account, even when many people think of the status quo ante as a paper unit of account. To the extent that the electronic money policy is backed by the central bank and the executive branch while legislation is locked in place by legislative blocking coalitions in both directions – or by an unwillingness of the government to impose too high a political cost on members of parliament by an explicit parliamentary vote – I suspect that central bank and executive branch action alone is enough to establish an electronic unit of account.

What is a little trickier is the extent to which government control of the unit of account translates into control over the unit of price quotation. Actually, the key issue is the even more subtle one of whether current inflation inertia is carried over to electronic dollar prices or to paper dollar prices. During periods when the zero lower bound would otherwise be binding, I propose to have the value of a paper dollar in terms of electronic dollars fall very gradually according to a crawling peg exchange rate. If inflation inertia carries over to electronic goods prices, then the decline in the value of paper currency relative to electronic money can loosen the zero lower bound as much as needed, thus eliminating the zero lower bound as an effective constraint.

At the opposite extreme, if inflation inertia carries over in full to paper dollar prices, then the appreciation of the electronic dollar relative to the paper dollar implied by the depreciation of paper currency does nothing to loosen the zero lower bound.

If inflation inertia is carried over to some weighted average of the electronic dollar prices and paper dollar prices, there would be loosening of the zero lower bound. If the weights in the weighted average are relatively invariant, then it would still be possible to loosen the zero lower bound as much as needed (thus eliminating it as a binding constraint), though there would be a side effect of a short-run drift in the relative prices of goods and services priced in paper dollars relative to goods and services priced in electronic dollars.

I consider this mixed case most likely in the initial stages of putting into action a nonpar exchange rate between paper currency and electronic money – for an interesting reason. Under the current system, both paper currency payments and debit and credit card payments of different types are all accepted at face value at most retailers that accept more than one form of payment. Thus, it is likely that up to several per cent away from par in the exchange rate between the paper dollar and the electronic dollar, both electronic and paper prices would be set at the same number in relation to face values. In that case, it is likely that the unit of account would dominate price setting for this unified face value price. If so, that effectively makes inflation inertia carry over to the electronic dollar prices, and makes paper dollar prices effectively cheaper relative to those electronic prices than the way they would compare now – though in this initial period of time only within the band in which some customers choose to pay in paper while other customers choose to pay in electronic form: by credit card, debit card or cheque.

In terms of the effectiveness of interest rate policy, having both electronic dollar prices and face value paper dollar prices carry over the preexisting level of inflation inertia is fine at first. The most important transmission mechanisms are through the cost of purchasing durables and investment goods and international capital flows, all of which involve goods most likely to be purchased with electronic means of payments – by credit card, debit card, cheque or electronic funds transfer – and therefore most likely to have a price set in electronic dollars. (Note that many popular monetary policy models exclude this entire list of key transmission mechanisms for monetary policy by having only nondurable goods in a closed economy.)

In this section, I have emphasised the messy case. My claim is that it is very hard to come up with a plausible scenario in which depreciating the paper dollar relative to the electronic dollar at a sedate pace that creates a negative rate of return for paper currency (with the rate of return expressed in terms of electronic dollars) would not provide leeway vis à vis the zero lower bound. It is not plausible that all prices would be quoted primarily in paper dollars with inflation inertia carrying over to these pervasive paper dollar prices. It is simply too natural to set an electronic dollar price for one’s goods if one is a retailer selling predominantly goods purchased almost entirely by credit card, debit card, cheque or electronic funds transfer. And goods in this category are particularly important for the monetary transmission mechanism.

A great advantage of depreciating the paper dollar relative to the electronic dollar as compared to a policy of keeping paper at par but raising the inflation rate is that to provide leeway relative to the zero lower bound, the paper dollar only needs to depreciate gradually (say at 1.1 basis points per day) in periods when the central bank’s target rate is negative. When the central bank’s target rate is positive, the process can be reversed, with the paper dollar very gradually appreciating back up to par. By contrast, if one insists on keeping paper at par and raising inflation to provide leeway vis à vis the zero lower bound, it is not easy to bring inflation back down after one no longer needs higher inflation to provide leeway vis à vis the zero lower bound.

What remains the same about monetary policy

I propose changing one thing: instead of always treating the value of one paper dollar as equal to the value of one electronic dollar, the central bank should sometimes instruct the personnel at the cash window to treat the value of one paper dollar as less than one electronic dollar. This exchange rate at the cash window should change very gradually in order to create a safe nonzero rate of return for paper currency. By ‘safe’ return I mean a return that is safe in the short-term sense in which investing in the overnight fed funds market or the overnight repo market is safe. It is not necessary that this ‘safe’ overnight rate be perfectly predictable in the more distant future, any more than it is essential for monetary policy that the fed funds rate or the overnight repo rate in the more distant future be perfectly predictable.

Everything else about monetary policy can continue in a way very similar to the way things are done now. As under the current system, the interest rate on reserves should be lowered when the target rate is lowered. Also, as under the current system (at least for the US), the interest rate used in the tax system for money carried over between tax years should be lowered along with other interest rates (see Kimball and Kimball, 2015). Optionally, the central bank’s lending rate (discount rate in the US) can be lowered along with these other rates. When the target rate is raised, these other rates can be raised as well. The essential new feature of an ‘electronic money’ system is that when the target rate goes below zero, the effective rate of return for paper currency – the ‘paper currency interest rate’ – also goes below zero through the depreciation mechanism. And when the target rate goes above zero again, the paper currency interest also becomes positive through gradual appreciation of paper currency relative to electronic money, until paper currency reaches par again.

The one change of having a gradually changing nonpar exchange rate between the paper dollar and electronic dollar may affect the transmission mechanism for those goods and services that are purchased with cash, but the parts of the transmission mechanism from interest rate policy that work through goods and services that are purchased with credit cards, debit cards, cheques or electronic funds transfers remains. That includes most durable goods purchases, most investment goods purchases, and a large fraction of business-to-business purchases. In addition, because international capital flows and other asset market transactions are mostly handled in electronic form, the parts of the transmission mechanism from interest rate policy that involve the international exchange rate and wealth effects remain intact. That is more than enough to provide any needed level of aggregate demand by a large enough change in the target rate, with an accompanying adjustment in the paper currency interest rate, and accompanying adjustments in interest on reserves, the central bank’s lending rate, the interest rate for the tax system, and any other government interest rates fixed by government policy that private agents can avail themselves of in a more or less unlimited way (such as the postal savings rate in Japan).

Except for the paper currency interest rate, many nations already make all of these other rates comove closely with the central bank’s target rate. Having a nonzero ‘paper currency interest rate’ that can comove closely when desired with the central bank’s target rate is the new feature in an electronic money system. The nonzero ‘paper currency interest rate’ needed for such comovement is generated by gradual depreciation or appreciation of the paper dollar relative to the electronic dollar.

As far as I know, very few economists have objected to permanently raising the inflation rate as a way to deal with the zero lower bound on the basis that this would not, in fact, allow any extra monetary stimulus. The reason is the fact I started with: standard models say it is the real interest rate that matters. But if it is the real interest rate that matters, lowering the nominal interest rate without raising inflation will stimulate the economy through totally standard mechanisms. It is not necessary to have full agreement on exactly how a lower real interest rate stimulates the economy. For all of those who agree that interest rate policy matters, a cut in the nominal interest rate will have much the same effect as an increase in inflation with the nominal interest rate held fixed. So if an increase in inflation operates through conventional means, so does a cut into negative territory of the full set of nominal government interest rates – target rate, interest on reserves, lending rate, between- tax-year rate, postal savings rate and paper currency interest rate. In that sense, a negative interest rate policy is a conventional monetary policy if having a target inflation rate of 2 per cent or 4 per cent instead of a target inflation rate of zero is a conventional monetary policy. Having a nonzero paper currency interest rate may be a little exotic, but that is only getting paper currency out of the way. Once paper currency is out of the way, the heart of negative interest rate policy is lowering the target rate, which can by done by open market purchases of short-term Treasury bills, the most conventional of all tools.

It is worth noting that short-term Treasury bills are quite useful in explaining negative interest rates and the zero lower bound. Since a three-month Treasury bill only has a payment at the end of the three months, a negative interest rate for a three-month Treasury bill is simply a price for the Treasury bill above the face value that will be paid in three months. If one has to pay a higher nominal price than what one gets three months later, the nominal value of one’s money shrinks over those three months. The zero lower bound can then be expressed as the fact that (ignoring paper currency storage costs) few people would pay, say $10,100 for a Treasury bill with a face value of $10,000 to be paid in three months when one can obtain $10,000 three months from now for $10,000 now simply by storing the $10,000 in paper currency for those three months.

The difference in an electronic money system is that in this situation it would take paper currency with a face value of $10,100 to be worth $10,000 in electronic money three months from now. Even though what was initially $10,100 worth of paper currency would still have a face value of $10,100 three months from now, the exchange rate at the cash window of the central bank would make it worth less than its face value – not just because it could only be deposited for that amount, but also because anyone able to use the cash window of the central bank could withdraw $10,100 face value worth of paper currency at a cost of $10,000 in electronic money three months from now.

Cutting interest rates within the negative range is likely to have some effects on financial stability just as cutting rates within the positive range. (I can see two important differences: the side effects on the expected rate of repayment until traditional debt contracts adjust and the effect of the crumbling of the zero lower bound on financial market worries about ‘secular stagnation’.) In any case, the policy prescription I would offer is the same: a dramatic increase in equity requirements for financial firms and in equity requirements for individual mortgages through mortgage reform that leads to investors other than the homeowner putting up some of the equity for a mortgage. Financial firms will resist the loss of their implicit bailout subsidy, but from a social point of view, the only important downside to higher equity requirements is through aggregate demand effects. But when central banks become comfortable with negative interest rate policy, that can provide more than enough aggregate demand; since interest rates can go as low as needed, aggregate demand will no longer be scarce. Thus, negative interest rate policy and high equity requirements are highly complementary policies: the negative interest rates easily provide the aggregate demand that might be impaired somewhat by higher equity requirements, while the dramatically higher equity requirements provide in abundance the financial stability that might be somewhat impaired by negative interest rates.

Through experience, I know there are three aspects of this system that at first can be hard to wrap one’s head around. First, for some people, it seems very unnatural to take the electronic dollar as numéraire rather than the paper dollar. A numéraire is not the same thing as a unit of account: a numéraire serves as the yardstick only for a particular piece of economic analysis; a unit of account serves as the yardstick for real world accounting and transactions. I discussed issues involving the real-world unit of account at length above. If everyone is thinking correctly, changing the numéraire one uses to think about an electronic money system cannot change the implied real-world bottom line. However, while equivalent, the story ends up sounding much more complex if one insists on using the paper dollar as numéraire. Making the same analysis as above, but expressing it in terms of a paper dollar numéraire, the carrying over of inflation expectations to electronic dollar prices means that the inflation rate for electronic dollar prices – expressed in terms of paper dollars – goes up when the electronic dollar is made to appreciate gradually relative to the paper dollar by how electronic dollars are treated at the cash window of the central bank. Then the anchoring of inflation expectations for electronic dollar prices means that the inflation rate for electronic dollar prices – expressed in terms of paper dollars – can be brought down by making the electronic dollar depreciate gradually back to par with the paper dollar. Once the electronic dollar is back at par, leaving it there makes the inflation rate for both paper dollar and electronic dollar prices – as converted into paper dollar prices – again the same.

Second, it is hard for many to see how it is possible to avoid a financial arbitrage opportunity that subverts the system – akin to the opportunity to save in paper currency that creates the zero lower bound in the current system. By construction, if the rate of return on paper currency is always equal to the target rate, there can be no arbitrage relative to the target rate. Then, leaving aside storage costs, exactly the same thing would happen to the value of one’s funds in the fed funds market or the repo market as if one’s funds were entirely in paper currency. How can that be, when the paper currency continues to have the same face value, while electronic account statements are showing lower and lower numbers due to negative interest rates? The answer is that while interest rates are negative, or when paper is below par after a negative interest rate episode, the number of electronic dollars each paper dollar is worth is varied to keep the value of a pile of paper dollars equal to exactly what one would have if one kept the money in the fed funds market or the repo market. This is possible because an initial value for the exchange rate between paper dollars and electronic dollars, plus a stipulation that the rate of return for paper currency expressed in terms of an electronic dollar numéraire equal the target rate, yields a differential equation that implies an equivalent value for funds subject to compound interest in an electronic account and funds in paper currency subject to a time-varying exchange rate when their value is converted into an electronic dollar equivalent. And that equivalent value of the paper currency is not a fiction; it is exactly what the central bank would give for that amount of paper currency deposited at the cash window, and exactly the price in electronic dollars the central bank would ask for a withdrawal of that amount of paper currency. Keeping the rate of return for paper currency equal to the target rate while away from par leaves no degrees of freedom in the path away from and back to par. There is only one way to do it. But there is a sedate path for the exchange rate that does it.

Third, many people think that an electronic money system requires a change in what is ‘legal tender’. This is a misunderstanding of what ‘legal tender’ means. Once paper currency is long established, most countries do not feel the need to require that retailers accept paper currency. ‘Legal tender’ can have the much more limited meaning that paper currency can be used to settle debts at face value. But one does not have a ‘debt’ to a retailer until the retailer has agreed to sell a good, and the retailer can refuse to sell a good for an inconvenient means of payment, including paper currency if that is inconvenient. Indeed, I have been on more than one plane flight in which the crew clearly announced that they would only accept credit or debit card payment – not paper currency – for the food they were selling on the flight. In US law, ‘legal tender’ also means that, in theory, one can pay the government with paper currency. But there are many cases in which it would not, in practice, be easy at all to pay in paper currency. Try telling the tax authority that you would like to pay your income taxes in paper currency. You might ultimately be able to force them to accept the paper currency, but you would have a long and arduous battle before you succeeded. The reason that the ability to pay off debts in paper currency is a very real option is that it is the creditor that must take a debtor to court to enforce payment of a debt. So in the case of a debt, it is the creditor that pays the costs of pursuit. By contrast, at a minimum, even should the law be on his or her side, anyone trying to insist on a right to pay a resistant retailer or a resistant government agency in paper currency would pay the costs of pursuit.

The right of private agents to pay off a debt in paper currency may create an undesirable side effect of a below-par value of paper currency, but it does not create a zero lower bound. It doesn’t create a zero lower bound, because the right to pay off debt in below-par paper currency is limited to the value of one’s debts – and indeed only to the value of the payments one is able to make on one’s debts (including any prepayment option) during the time paper currency is below par. It is not an unlimited arbitrage. Analytically, if one ignored extra paper currency handling costs and assumed that all debt payments during the time paper currency was below par were made in paper currency, everyone who had debts would be at a corner solution, unable to pay off more debt in paper currency because every possible way to do so was already exhausted. The option to prepay an entire mortgage in paper currency is definitely big enough to be interesting, but the importance of the prepayment option for mortgages during times of declining interest rates is already so great that we know the system does not break down simply because of a flood of mortgage refinancings. In the overall scheme of things, adding a few per cent to the benefit of refinancing because of the option to pay off the mortgage with below-par paper currency is a modest wrinkle on the large benefits to refinancing that could arise simply because of the likely mortgage interest rate changes that would be engendered by the temporary negative interest rate policy.

Similarly, if the tax authority did have to accept payments in below-par paper currency, this would be an effective reduction in the tax rate, and an undesirable side effect also because of socially wasteful paper currency handling costs, but it would not create a zero lower bound. Once someone had paid all his or her taxes in paper currency, the opportunity would be exhausted.

The politics of negative interest rates

Although the economics of cutting interest rates in negative territory are essentially the same as the economics of cutting interest rates in positive territory with a higher inflation rate, with a few wrinkles from what it takes to get paper currency out of the way, the politics of negative interest rates could be quite different from the politics of positive interest rates. One should not go overboard in saying this, however, since we now know that the mild negative interest rates in the euro zone, Switzerland, Denmark and Sweden have not unleashed a firestorm of political protest. To compare distinct events just to get an idea of political magnitudes, at the moment, people in the euro zone, Denmark and Sweden are much more concerned about the flood of refugees from the Middle East than they are incensed about central banks daring to have a nominal interest rate below zero. And in the past few years, the referendum that could have tied the Swiss National Bank’s hands was one meant to keep the Swiss National Bank from piling up too large a stock of foreign assets, not a referendum to prevent it from imposing negative interest rates.

Many of the people who argue most strenuously against negative interest rates are likely to be the same people who tend to argue for higher target rates and tighter monetary policy in other dimensions in almost every situation. However, monetary ‘hawks’ in this sense might be able to get regular people more concerned about cutting interest rates into the negative region than a similar cut in interest rates in the positive region – even if different inflation rates in the two situations made the economics essentially equivalent.

There are some basic arguments that can be used to defend negative interest rate policy. The first – and perhaps the most important – is to explain to people repeatedly, ideally long in advance of when negative interest rates are actually needed, that the economics of negative interest rate policy are entirely conventional, except for a few details about how paper currency would be handled.

Second, it is worth saying over and over again that even for savers, deep negative interest rates for a short time during a serious recession, bringing speedy economic recovery, are better than zero nominal rates that are 2 per cent below inflation for years and years, accompanied by a lagging economy for that longer time.

Third, the focus on savers, while deeply entrenched in political thought, should be put into perspective by pointing out the benefits of negative interest rates to borrowers.

Fourth, it should be noted that – except when the new policy looked like the current system – people who use paper currency would be earning the same effective interest rate as people who kept their money in electronic accounts, and so would not be treated unfairly. Moreover, the fact that paper currency would earn the same as money in electronic accounts would mean that there would be no incentive to underuse paper currency.

Fifth, it may be useful to point out that the central bank can easily subsidise the provision of zero interest rates to small checking and saving accounts by tying such provision to the amount of a bank’s reserves that is exempted from negative interest rates. (In addition to reducing political costs by encouraging banks to shield small accounts from negative interest rates, this can avoid undesirable effects on financial stability or bank lending from the strain on banks’ profits and balance sheets that might result from banks choosing to shield small accounts from negative rates for customer relations reasons despite the absence of any subsidy.)

Sixth, many of those who argue for higher interest rates also want lower inflation. With the zero lower bound vanquished, the target rate for inflation can be lowered, since inflation in the electronic unit of account is not necessary in order to steer away from the zero lower bound.

Also, for countries that, for good or ill, rely in an important way on seignorage revenue, seignorage revenue can be obtained by a paper currency interest rate below the target rate, regardless of the inflation rate in the electronic unit of account. Thus, inflation in the unit of account is not necessary for seignorage, removing one temptation towards higher inflation.

In the context of discussing seignorage, it may be worth trying to insist that a negative paper currency interest rate is not a tax if it simply equals the target rate. It is only a paper currency interest rate below the target rate that is a tax. Though we are used to it, a zero paper currency interest rate is a tax if the target rate is positive; but a negative paper currency interest rate is not a tax if the target rate is equally negative.

Seventh, the possibility of deep negative interest rates means that aggregate demand is no longer scarce. Thus – except perhaps for the nine-month or so lag before monetary policy takes hold – there is no need for any other means of affecting aggregate demand. With negative interest rates in play, fiscal policy can focus on the long run and getting good deals for taxpayers rather than aggregate demand stimulus. That in turn removes one important force leading to higher national debt. The possibility of deep negative interest rates makes quantitative easing unnecessary for aggregate demand management. And the possibility of negative interest rates means that many other things that people justify in part because they add to aggregate demand must stand on other merits, aside from any effects on aggregate demand.

Finally, the benefits of economic stabilisation should be emphasised. The Great Recession was no picnic. Deep negative interest rates throughout 2009 – somewhere in the –4 per cent to –7 per cent range – could have brought robust recovery by early to mid 2010. The output gaps the world suffered in later years were all part of the cost of the zero lower bound. These output gaps not only had large direct costs, they also distracted policymakers from attending to other important issues. For example, the later part of the Great Recession that could have been avoided by negative interest rate policy led to a relatively sterile debate in Europe between fiscal stimulus and austerity, with supply-side reform getting relatively little attention. And the later part of the Great Recession that could have been avoided by negative interest rate policy brought down many governments for whom the political benefits of negative interest rate policy would have been immense. And for central banks, it looks good to get the job done.

Footnotes

[1] As Ruchir Agarwal and I paraphrased in Agarwal and Kimball (2015), “Preliminary evidence for the pass-through and demand for cash at negative interest rates comes from Denmark (Danmarks Nationalbank, 2015). Since Feb 6, 2015 Danmarks Nationalbank’s rate of interest on certificates of deposit has been –0.75 per cent. The interest rate on certificate of deposits was lowered into negative territory to defend the Danish fixed exchange rate policy under which monetary policy rates are set solely to maintain a fixed exchange rate of the krone against the euro. The Danmarks Nationalbank study finds that the negative interest rates have not weakened the pass-through from Danmarks Nationalbank’s interest rates to money market rates. Moreover, consistent with the discussion above, they find that the negative interest rates have not been fully passed through to bank deposit and lending rates to households. However, large deposits from firms and institutional investors are extensively paying negative interest rates. Lastly, they find no evidence of any substantial change at the current level of interest rates in the way banknotes and coins (currency) in circulation are being used.”

[2] The overtones of Bitcoin and its ilk in the phrase “electronic money” are a mostly unfortunate distraction analytically, but are a plus in popularising this proposal for eliminating the zero lower bound.

References

Agarwal, R. and Kimball, M.S. (2015), ‘Breaking through the zero lower bound’, IMF Working Paper no. 15/224, available at http://www.imf.org/external/pubs/cat/longres.aspx?sk=43358.0.

Bernanke, B. (2015), The Courage to Act: A Memoir of a Crisis and its Aftermath, Norton.

Buiter, W.H. (2004), ‘Overcoming the zero bound: Gesell vs. Eisler; discussion of Mitsuhiro Fukao’s “The effects of ‘Gesell” (currency) taxes in promoting Japan’s economic recovery’, discussion presented at the Conference on Macro/Financial Issues and International Economic Relations: Policy Options for Japan and the United States, October 22–23, Ann Arbor, MI, USA. International Economics and Economic Policy, 2, Nos 2–3, November 2005, pp. 189–200. Publisher: Springer-Verlag GmbH; ISSN: 1612–4804 (Paper) 16124812 (Online).

— (2007), ‘Is numérairology the future of monetary economics? Unbundling numéraire and medium of exchange through a virtual currency with a shadow exchange rate’, Open Economies Review, Springer Netherlands; ISSN 0923–7992 (Print); 1573–708X (Online). Electronic publication date: Thursday, 3 May, 2007. See “Springer Website.”

— (2009a), ‘Negative interest rates: when are they coming to a central bank near you?’, ft.com/maverecon, 7 May.

— (2009b), ‘The wonderful world of negative nominal interest rates, again’, ft.com/maverecon, 19 May.

— (2009c), ‘Negative nominal interest rates: three ways to overcome the zero lower bound’, NBER Working Paper No. 15118. Buiter, W.H. and Panigirtzoglou, N. (2001), ‘Liquidity traps: how to avoid them and how to escape them’, in Vanthoor, W.F.V. and Mooij, J. (eds), Reflections on Economics and Econometrics, Essays in Honour of Martin Fase, De Nederlandsche Bank NV, Amsterdam, pp. 13–58.

— (2003), ‘Overcoming the zero bound on nominal interest rates with negative interest on currency: Gesell’s solution’, Economic Journal, 113 (490), October, pp. 723–46.

Danmarks Nationalbank (2015), Monetary Review, 2nd Quarter, Article 2.

Haldane, A.S. (2015), ‘How low can you go?’, speech given at the Portadown Chamber of Commerce, Northern Ireland, 18 September.

Kimball, C.E. and Kimball, M.S. (2015), ‘However low interest rates might go, the IRS will never act like a bank’, posted on Quartz, 15 April, available at http://qz.com/383737/however-low-interest-rates-might-go-the-irs-will-never-act-like-a-bank/.

Kimball, M.S. (2013a), ‘Electronic money: the powerpoint file’, originally posted 17 June 17 on the Tumblr blog “Confessions of a Supply-Side Liberal”, updated version accessible at http://blog.supplysideliberal.com/post/53171609818/electronic-money-the-powerpoint-file.

— (2013b), ‘How and why to eliminate the zero lower bound: a reader’s guide’, originally posted 30 September on the Tumblr blog “Confessions of a Supply-Side Liberal”, updated version accessible at http://blog.supplysideliberal.com/post/62693219358/how-and-why-to-eliminate-the-zero-lower-bound-a.

— (2015), ’18 misconceptions about eliminating the zero lower bound’, first presented 19 May at the Chief Economists’ Workshop at the Bank of England, updated Powerpoint file available at http://blog.supplysideliberal.com/post/119337047479/18-misconceptions-about-eliminating-the-zero-lower.

Randow, J. (2015), ‘Less than zero: when interest rates go negative’, Bloomberg View, updated 13 April, available at http://www.bloombergview.com/quicktake/negative-interest-rates.

Robb, G. (2015), ‘Fed officials seem ready to deploy negative rates in next crisis’, Market Watch, 12 October, available at http://www.marketwatch.com/story/fed-officials-seem-ready-to-deploy-negative-rates-in-next-crisis-2015-10-10.

Rogoff, K. (2014), ‘Costs and benefits to phasing out paper currency’, NBER Working Paper #20126.

Peter Sands and Larry Summers Say Deep Negative Interest Rates Are Feasible from a Technical Point of View

February 25, 2016 by Miles Kimball

*Link to Peter Sands and Larry Summers’s Washington Post op-ed “In defense of killing the $100 bill”*

Like me, Peter Sands and Larry Summers are not currently advocating negative interest rates for the United States. But they make a remarkable statement about the technical feasibility of the deep negative rates–not just the mild negative rates now seen in the eurozone, Japan, Switzerland, Sweden and Denmark. They write:

We take no position on the desirability of negative interest rates but are convinced by the arguments of JPMorgan, Miles Kimball and others that significantly negative rates can, if desired, be maintained without any limitation on currency through bank withdrawal fees. And we believe that for the foreseeable future there will be a role for cash in modern economies, though we would not be surprised if in many contexts its transactions costs come to exceed those of various electronic payment schemes.

Larry Summers was one of my professors as a graduate student at Harvard, so I take great pleasure in this affirmation. I sent him the link to my bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide” not long ago, and am pleased that he has read some of what I have written on negative interest rate policy. Larry would not have agreed to have the op-ed say what it says unless he had thought carefully about my proposal from a technical point of view, within whatever time constraints he faced.

I should note, though, that Peter and Larry’s emphasis on withdrawal fees is based on a desire to talk about JPMorgan and me in the same sentence. I have primarily talked about withdrawal fees in order to argue that time-varying deposit fees at the cash window of the central bank are better. On pages 6 and 7 of “Breaking Through the Zero Lower Bound,” Ruchir Agarwal and I write:

Short of stamped currency or the abolition of paper currency, the government can discourage paper currency storage in essentially three ways, corresponding to the three steps needed to earn an interest rate of zero minus storage costs from paper currency: it can attack withdrawal of paper currency, storage of paper currency, or redeposit of paper currency.
To attack withdrawal of paper currency, the government could implement a restriction or fee on paper currency withdrawals from bank accounts (or in the extreme, end the printing of new paper currency, forcing people to make do with the existing stock). There are several disadvantages to this approach. First, it prevents withdrawal for spending as well as withdrawal for storage. Second, the ability to withdraw paper currency has great option value for people, which restrictions or fees on withdrawal would damage. Third, whether a withdrawal fee of a given size is adequate to prevent massive paper currency storage depends crucially not only on how negative interest rates are, but for how long they will be negative, which is difficult to know in advance. Fourth, with quantity restrictions on withdrawals—or fees high enough that the corner solution of withdrawing zero is often attractive—the effective price of paper currency would likely follow a jagged diffusion process as information and expectations evolved. Finally, people would still have an incentive to hoard the paper currency already in their possession, and to withdraw as much as possible in advance of the imposition of a withdrawal fee. This makes it more difficult to openly discuss and debate the imposition of a withdrawal fee.
To attack storage, the government could attempt to make storage of paper currency costly by taxing or prohibiting storage. There is a limit to how effective this can be, since storage of paper currency can be done in low-tech ways by anyone. Moreover, criminals already have experience in secret storage of paper currency. Thus, while storage of paper currency can be driven underground, it is hard to fully prevent. The ease of small-scale storage of paper currency by households, in particular, could lead to fewer funds left in demand deposits or savings accounts and hence to significant disintermediation even if commercial-scale paper currency storage could be successfully blocked.
The third option for the government is to implement a temporary fee on deposit or re-deposit of paper currency at the cash window of the central bank. Such a fee, when implemented in a time-varying manner on net deposits, creates an effective exchange rate between paper currency and electronic money, and allows the government to avoid the disadvantages of the first two options discussed above. The next section describes this mechanism in further detail.

In the next version of the paper, we will also need to talk about the Bank of Japan’s inadequately detailed but fascinating potential policy of using the interest on reserves policy to charge interest on paper currency that I discussed in “The Bank of Japan’s New Tool to Block Massive Paper Currency Storage.”

One other thing I should mention is that, unfortunately, Peter and Larry link to website for “Negative Interest Rate Policy as Conventional Monetary Policy” where readers will hit a paywall if they try to download the paper itself. Here is a link to the paper itself, which, as part of my deal with the National Institute Economic Review, I have full permission to post in full on my own websites.

In “Going Off the Paper Standard” I wrote that the first of 18 steps toward a smooth implementation of an electronic money policy was

Announce that eliminating the zero lower bound is possible from a technical point of view.

Progress on this first step has been considerably faster than I expected.

Higher Inflation Is Not the Answer

February 24, 2016 by Miles Kimball

Because the Economist doesn’t appreciate the power of deep negative interest rates to revive an economy and return quickly to positive interest rates–in a way mild negative rates cannot guarantee–it has turned to many other questionable proposals instead in February 20, 2016 cover story “The World Economy: Out of ammo? Central bankers are running down their arsenal. But other options exist to stimulate the economy” and the related article “Fighting the next recession: Unfamiliar ways forward–Policymakers in rich economies need to consider some radical approaches to tackling the next downturn.” Yesterday, I argued that “Helicopter Drops of Money Are Not the Answer.” Today, let me argue that higher inflation is not the answer. I gave the long version of the argument in “The Costs and Benefits of Repealing the Zero Lower Bound … and Then Lowering the Long-Run Inflation Target.” Today, let me try to give the short version.

Inflation has many costs. Among those costs, some of the most important are messing up microeconomic price signals and confusing people. This is a cost of the unit of account that people use to think about prices changing its value. Unless we want to confuse people, we should avoid changes in the value of the unit of account. As Greg Mankiw points out in his textbooks, the idea that the unit of account should have a constant value–or as constant a value as we can reasonably make it have–is akin to the idea that we want a meter to stay the same length and a kilogram to stay the same weight from one year to the next. To alter our weights and measures every year would have many costs stemming from the confusion it would cause.

Similarly, having the unit of account change value has many costs stemming from the confusion it causes–not all of which are captured in the usual models of the costs of inflation. I worry, for example, that people saving for retirement will think they are on track to be better prepared for retirement than they really are because they are tempted to think in terms of asset returns that are unadjusted for inflation. I am sure this confusion doesn’t affect everyone, just as I am sure that it does affect some people–and I think, unfortunately many people. I know that inflation confuses the US Congress, since large parts of the tax code are unadjusted for inflation. Inflation even confuses aspects of the economic debate where one might have thought it wouldn’t matter. The income of the top 1% of the income distribution is a remarkably high fraction of the total however the calculation is made. But that fraction is somewhat overstated whenever the asset returns used in those income calculations are not adjusted for inflation–a mistake that is all too common. And as Thomas Piketty points out in Capital in the Twenty-First Century, inflation makes it hard for us to understand novels like those of Jane Austen, as monetary values that had a very clear meaning for people back then have no clear meaning for modern readers.

The bottom line is that we should avoid inflation in the unit of account. The interesting thing to realize is that those who are calling for higher inflation (Such as Paul Krugman, Larry Ball, Brad DeLong and the Economist) are not really calling for higher inflation in the unit of account. They are calling for higher inflation relative to paper currency. It is only if the paper dollar, or paper euro or paper yen is the unit of account that inflation relative to the unit of account and inflation relative to paper currency are the same thing. Once a central bank takes a nation off the paper standard, it is possible to have the good inflation relative to paper currency without any of the bad inflation. That is, it is possible to have “inflation” relative to paper currency without any inflation relative to an electronic unit of account. In other words, once the electronic dollar, or electronic euro or electronic yen is the unit of account, the value of that unit of account can be kept the same, while the value of a paper dollar, paper euro or paper yen is made to decline whenever necessary in order to allow negative interest rates. See “An Underappreciated Power of a Central Bank: Determining the Relative Prices between the Various Forms of Money Under Its Jurisdiction” for how this works.

Indeed, under the kind of electronic money system I recommend, even inflation relative to paper currency would normally be a temporary thing. Thus, whatever minor costs it had (minor because the paper dollar or euro or yen would not be the unit of account), would be borne only during economic emergencies and for a time thereafterward. By contrast, those who advocate a higher inflation target without realizing it is possible to go off the paper standard are advocating paying the costs of the much more serious inflation relative to the unit of account every year, on and on indefinitely.

With all of this in mind, consider how unpleasant the Economist’s recommendation is compared to brief periods of going off the paper standard coupled with deep negative interest rates. “The World Economy: Out of ammo? Central bankers are running down their arsenal. But other options exist to stimulate the economy” sets out this idea:

Another set of ideas seek to influence wage- and price-setting by using a government-mandated incomes policy to pull economies from the quicksand. The idea here is to generate across-the-board wage increases, perhaps by using tax incentives, to induce a wage-price spiral of the sort that, in the 1970s, policymakers struggled to escape.

Moreover, the economist doesn’t seem to realize that this is at cross-purposes with a much better set of proposals to improve the supply-side of the economy:

Deregulation is another priority—and no less potent for being familiar. The Council of Economic Advisors says that the share of America’s workforce covered by state-licensing laws has risen to 25%, from 5% in the 1950s. Much of this red tape is unnecessary. Zoning laws are a barrier to new infrastructure. Tax codes remain Byzantine and stuffed with carve-outs that shelter the income of the better-off, who tend to save more.

Wonderful areas for improvement! But they need to be coupled with negative interest rates. Here is why: most supply-side improvements tend to reduce prices. As long as one can use deep negative interest rates, a reduction in prices is no problem. But if a central bank insists on staying on the paper standard, a lower growth rate of prices makes it harder to stimulate the economy.

I would choose supply-side improvements coupled with negative interest rates to ensure enough aggregate demand for all of the extra output any day before I would choose a higher inflation target our unit of account as a ham-handed way to do the work that should be done by going off the paper standard.

See links to everything I have written on negative interest rate policy organized in my bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”

Helicopter Drops of Money Are Not the Answer

February 23, 2016 by Miles Kimball

Links to “The World Economy: Out of ammo? Central bankers are running down their arsenal. But other options exist to stimulate the economy” and “Fighting the next recession: Unfamiliar ways forward–Policymakers in rich economies need to consider som… — *Links to* *“The World Economy: Out of ammo? Central bankers are running down their arsenal. But other options exist to stimulate the economy”* *and* *“Fighting the next recession: Unfamiliar ways forward–Policymakers in rich economies need to consider some radical approaches to tackling the next downturn”*

Among major news outlets with a print component, I am happy to say I have had occasion to praise negative interest rate reporting in the Wall Street Journal and in the Globe and Mail:

Unfortunately, Negative Interest Rate Reporting is Still in the Dark Ages at the Economist

The subtitle for the cover story for the February 20-26, 2016 Economist states their overall take quite clearly:

“The World Economy: Out of ammo? Central bankers are running down their arsenal. But other options exist to stimulate the economy”

To give a further sense of that take on things, here are some key passages from that article:

One fear above all stalks the markets: that the rich world’s weapon against economic weakness no longer works. Ever since the crisis of 2007-08, the task of stimulating demand has fallen to central bankers. …
… Despite central banks’ efforts, recoveries are still weak and inflation is low. Faith in monetary policy is wavering.

In this article, negative interest rates are dismissed with this one sentence:

Negative interest rates in Europe and Japan make investors worry about bank earnings, sending share prices lower.

(On negative interest rates and bank earnings, see my posts “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies” and “If a Central Bank Cuts All of Its Interest Rates, Including the Paper Currency Interest Rate, Negative Interest Rates are a Much Fiercer Animal.”)

The one other appearance of the word “negative” is in simply remarking

Borrowing has never been cheaper. Yields on more than $7 trillion of government bonds worldwide are now negative.

The Economist is wrong to dismiss negative interest rates. Indeed, I think the Economist will be unlikely to continue to dismiss negative interest rates as a powerful policy tool once one of their reporters takes the time to interview me, as they may sometime soon.

In the related article in the same issue, “Fighting the next recession: Unfamiliar ways forward–Policymakers in rich economies need to consider some radical approaches to tackling the next downturn,”the Economist says several negative things about negative rates without a change in paper currency policy, ignores the now well-heralded possibility of a negative paper currency interest rate (see how to deftly achieve a negative paper currency interest rate at the links in “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide”) and has this to say about negative interest rates with the alternative paper currency of abolishing paper currency:

Since the existence of cash is a limit on how low interest rates can go, Andy Haldane, the chief economist of the Bank of England, and Ken Rogoff of Harvard University have proposed abolishing it altogether. But even if such radicalism were to prove feasible in a few countries, its effects might be limited. Savers would find alternative stores of value, such as precious metals or foreign banknotes, or pass on the cost of having money in the bank to others by making payments early.

The Economist, like John Cochrane (1, 2), is totally wrong about this. As my brother Chris and I point out in “However Low Interest Rates Might Go, the IRS Will Never Act Like a Bank,” it is almost impossible for anything but an unlimited opportunity to lend to the government at a zero interest rate to create a zero lower bound either or both because

most possible assets have a fluctuating price and therefore cannot provide a safe return, nor is there anything to prevent the price being big up high enough to generate a negative expected return, and
all other opportunities to earn a zero interest rate in a negative interest rate environment would be exhausted long before investors had found a home for all of the assets they wanted a safe zero interest rate for.

And as for foreign assets, as I discuss in “Could the UK Be the First Country to Adopt Electronic Money?” the desire to purchase foreign assets when domestic assets are earning a negative return is part of the transmission mechanism, since it induces capital flows that in turn generate additional net exports. This is a feature of negative interest rate policy, not a bug. And in any case, it is not a concern for the world as a whole, to the extent the world as a whole turns to negative interest rates.

The Economist Turns to Fiscal Policy

Instead of monetary policy, the Economist looks in important measure to some form of fiscal policy to provide economic stimulus, writing

The good news is that more can be done to jolt economies from their low-growth, low-inflation torpor (see Briefing). Plenty of policies are left, and all can pack a punch. The bad news is that central banks will need help from governments. Until now, central bankers have had to do the heavy lifting because politicians have been shamefully reluctant to share the burden. At least some of them have failed to grasp the need to have fiscal and monetary policy operating in concert. Indeed, many governments actively worked against monetary stimulus by embracing austerity.

I am not so positive about fiscal policy. In “Narayana Kocherlakota Advocates Negative Rates and Criticizes the Conduct of US Fiscal Policy,” conscious of the power of deep negative interest rates to stimulate the economy, I write:

I tend to think that monetary policy should be used to stabilize the economy, not fiscal policy. Once monetary policy does its job, if the medium-run natural rate of interest is still low, then we should undertake more government investment. (See “The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate.”) And we should undertake crucial government investments even if interest rates are high after the economy recovers. But it is just too hard to time government investment effectively in order to stabilize the economy.
Monetary policy has a lag of 6 to 12 months in its effects. Even so, it is much nimbler than government investment. Private investment and imports and exports can’t turn on a dime; hence the 6 to 12 month delay in the effect of monetary policy. But government investment typical takes even longer than that to turn around.
Using monetary policy as it should be used, aggregate demand is no longer scarce. Monetary policy can provide all the firepower needed.

Why Helicopter Drops Big Enough to Make People Think that the Government Will Go Bankrupt Unless There is Massive Inflation are Not the Answer

The Economist has a long list of policy prescriptions, among which using deep negative interest rates (combined with an appropriate paper currency policy) is conspicuously missing. But among all of the policy prescriptions, a helicopter drop of money takes pride of place as the first to get a full paragraph treatment:

The time has come for politicians to join the fight alongside central bankers. The most radical policy ideas fuse fiscal and monetary policy. One such option is to finance public spending (or tax cuts) directly by printing money—known as a “helicopter drop”. Unlike QE, a helicopter drop bypasses banks and financial markets, and puts freshly printed cash straight into people’s pockets. The sheer recklessness of this would, in theory, encourage people to spend the windfall, not save it.

The Economist discusses a helicopter drop further in the related article “Fighting the next recession: Unfamiliar ways forward–Policymakers in rich economies need to consider some radical approaches to tackling the next downturn”:

One way to raise expectations of inflation and boost aggregate demand is for a central bank and its finance ministry to collude in printing money to pay for public spending (or tax cuts). Such shenanigans are not possible in the euro zone, where the ECB is forbidden by treaty from buying government bonds directly. Elsewhere they might work as follows: the government announces a tax rebate and issues bonds to finance it, but instead of selling them to private investors swaps them for a deposit with the central bank. The central bank proceeds to cancel the bonds, and the government withdraws the money it has on deposit and gives it to citizens. “Helicopter money” of this sort—named in honour of a parable told by Milton Friedman, a famous economist—is as close as you can get to raining cash from a clear blue sky like manna from heaven, untouched by banks and financial markets.
Such largesse is, in effect, fiscal policy financed by money instead of bonds. It is conceivable that a bond-financed fiscal tax cut might in fact be cheaper to finance: although cash has a zero yield, medium-term bonds in Japan and in much of Europe have negative yields. But the unaccustomed drama—indeed, the apparent recklessness—of helicopter money could increase the expected inflation rate, encouraging taxpayers to spend rather than save. It is not something to rush into, or to try prophylactically; but in the midst of a global financial crisis, or a deep recession, it would have much to recommend it. If it were co-ordinated by a group of rich countries, all the better.
A related idea is to cancel a portion of the sovereign bonds purchased by central banks, ostensibly cutting public debt at a stroke. It would have the drawback, as would helicopter money, of leaving the central bank technically bankrupt, since its liabilities (money) would exceed its assets (bonds). But since most central banks are backed by national treasuries, this ought not to matter much. A bigger worry is that it is hard to know in advance what effect monetisation would have. Bond markets could panic about an inflationary surge, driving yields through the roof. Or they might just shrug the whole thing off. After all, the central bank could issue fresh bonds to soak up the excess money if things eventually got out of hand.

The Economist points clearly to the one case in which a massive helicopter drop might be called for: if it became necessary to have the government give away so much money that people would be convinced there was no way the government could ever sell enough bonds to soak that money up. But this is clearly a drastic measure. Convincing the markets that the government will surely go bankrupt and have to explicitly default on its debt unless their is massive inflation is a counsel of desperation. By contrast, despite all of the hyperventilating reporting, once it is coupled with an appropriate paper currency policy, negative interest rate policy is, in its main effects, simply conventional monetary policy continued into the negative region. (See my National Institute Economic Review paper “Negative Interest Rate Policy as Conventional Monetary Policy” and “If a Central Bank Cuts All of Its Interest Rates, Including the Paper Currency Interest Rate, Negative Interest Rates are a Much Fiercer Animal.”)

Why Helicopter Drops the Government Can Afford are Not the Answer

What about helicopter drops that won’t lead to government bankruptcy or runaway inflation? Here the Economist also provides a clue to why such helicopter drops are an inferior policy. Printing money and sending it to people is equivalent to printing money to buy Treasury bills and then selling those Treasury bills to raise funds to send to people. Written as an equation:

printing money and sending it to people =

printing money to buy Treasury bills

+ selling Treasury bills to get funds that are sent to people

This is an interest equation, because each of the terms in the equation has a name. Here is the same equation, with the usual policy names attached:

helicopter drop = standard open market operation + tax rebate

This equation takes some of the mystique out of helicopter drops. Let’s see what it means. First, this equation is consistent with the discussion above. If the aim is to create doubts about the government’s ability to pay its debts without massive inflation, then the easiest way to sell enough Treasury bills to get funds for a big enough tax rebate to do so is by printing money and having the central bank buy those Treasury bills.

On the other hand, if the size of the tax rebates is an amount the government could borrow enough for even without central bank financing, then adding standard open market operation of printing money to buy Treasury bills may or may not add much. If printing money to buy 3-month Treasury bills stimulates the economy, then the central bank can simply do this as what everyone considers totally standard monetary policy, without the tax rebate. If at any point printing money to buy 3-month Treasury bills ceases to do much of anything, then the extra stimulus beyond that totally standard monetary policy action is the effect of a tax rebate.

National Lines of Credit Strictly Dominate Tax Rebates

To the extent a helicopter drop has the same effect as a tax rebate because (a) the amount at issue is affordable and (b) open market purchases of Treasury bills have little stimulative effect, the question then is how attractive tax rebates are. The answer is: not attractive at all. I have argued at length that tax rebates are strictly inferior a policy I call “National Lines of Credit.” I introduced this policy in a working paper heralded by a blog post of the same name:

Getting the Biggest Bang for the Buck in Fiscal Policy

Here is the abstract for that paper:

Abstract: In ranking fiscal stimulus programs, it is useful to focus on the ratio of extra aggregate demand to extra national debt that results. This note argues that (because of repayment after the end of a recession) “national lines of credit”–that is, government-issued credit cards with countercyclical credit limits and favorable interest rates—would generate a higher ratio of extra aggregate demand to extra national debt than tax rebates. Because it involves government loans that are anticipated in advance to involve some losses and therefore involve a fiscal cost even after efforts to minimize losses, such a policy lies between traditional monetary policy and traditional fiscal policy.

Here are some other blog posts (with the most important at the top) on “National Lines of Credit” (which in the US context I also call “Federal Lines of Credit”):

Most Important Posts about National Lines of Credit

Less Important Posts in Relation to National Lines of Credit

The Globe and Mail Gets It Right on Negative Interest Rate Policy, Thanks to Ian McGugan

February 22, 2016 by Miles Kimball

Link to “Negative Rates: Recipe for Growth or Desperate Gimmick” (paywalled)

Link to Ian McGugan’s author page at the Globe and Mail

Ian McGugan of Canada’s premier newspaper, the Globe and Mail, interviewed me last Tuesday evening, February 16, 2016. That interview is reflected in his article “Negative Rates: Recipe for Growth or Desperate Gimmick” (paywalled). Ian gives an excellent treatment of the issues surrounding negative interest rate policies, quite appropriately emphasizing the current controversy as a “brawl.” On my side, which views negative interest rates as a crucial part of the monetary policy toolkit, he first quotes Narayana Kocherlakota’s blog post that I discuss in “Narayana Kocherlakota Argues That Negative Interest Rates Should Be Seen as Part of Conventional Monetary Policy. ” Ian McGugan sets up the quotation from Narayana thus:

Defenders of NIRP insist the program simply needs time to take hold. The real problem, they maintain, is the timid way that subzero policies have been rolled out.
Central banks, according to these proponents, should trumpet negative rates. Policy makers should vow – loudly and aggressively – to stick with NIRP until expectations have been reshaped and the economy is booming once again.
“Here’s the wrong way [for central banks] to communicate: Keep saying that negative is a purely emergency setting that will be abandoned shortly,” writes Narayana Kocherlakota, a former president of the Minneapolis Federal Reserve Bank who now teaches economics at the University of Rochester. “Here’s the right way to communicate: Keep saying that all available tools, including negative interest rates, will be used as is needed to return employment and inflation to desirable levels as rapidly as possible.”

Later, on the pro side, Ian quotes Nick Rowe:

“There has never been anything wrong in theory with charging negative rates,” says Nick Rowe, a professor of economics at Carleton University and an authority on monetary policy. “The objection was always this notion that people would just withdraw their money from the bank and go to cash, which pays zero interest but at least doesn’t impose a negative rate.”
However, a rush to paper money hasn’t materialized in the countries that have imposed negative rates, perhaps because the rates have been only mildly negative. …
Economists acknowledge that it’s administratively tricky to impose negative rates, but they don’t see the problems as insurmountable. Prof. Rowe argues that the important factor for any lender is the spread between its deposit rates and its lending rates, not whether those rates happen to be negative or positive.

Finally, on the pro side, Ian quote me:

“It’s relatively simple for a bank to adjust its business model to still make money with negative rates,” agrees Miles Kimball, a professor of economics at the University of Michigan. A long-time advocate for negative rates, he argues that policy makers should be far more aggressive in pushing down lending costs.
He says banks should realize their real enemy is the current new normal of anemic growth. The failure of the global economy to revive after years of zero-rate therapy is conclusive evidence that stronger medicine is necessary, he argues. “If you don’t take the right dosage of a drug, it doesn’t work.”
Both Europe and Japan should immediately push rates even lower, he says. While negative rates of, say, minus 2 per cent or even lower might shock observers at first, they would be in keeping with what history tells us is necessary.
In the past, central banks have often dropped rates by six percentage points or more to bring about recoveries. The only way to achieve a similar effect in today’s low-rate environment would be to take rates strongly negative.
Wouldn’t that unfairly punish ordinary mom-and-pop savers? Not at all, he says. “Savers would be far better off if we had brief periods of deep negative rates that would quickly restore growth, rather than long periods – like now – of near-zero rates, where nobody makes any real return for years.”
To be sure, not everyone might welcome the details of how Prof. Kimball plans to lower interest rates far below zero. To avoid the possibility that savers would flock to cash rather than take a beating on the “electronic” currency in their bank account, he would impose a discount on folding money.
“Paper currency could still continue to exist, but prices would be set in terms of electronic dollars (or abroad, electronic euros or yen), with paper dollars potentially being exchanged at a discount compared to electronic dollars,” he writes.
A situation where paper money might not be worth its face value would be disturbing for most people and it’s not the only disquieting aspect of a subzero strategy. …
Prof. Kimball acknowledges that there are big psychological barriers to negative rates, and suggests there would be ways to get around the worst side effects. Ideally, he says, negative rates would apply mostly to institutional and business accounts while leaving most ordinary savers and borrowers untouched. “Our monetary system does change every 50 years or so, so change is possible,” he says. “People never thought we would go off the gold standard, but we did.” As disruptive as negative rates might seem, he argues they are vital to restart growth. Most of Bay Street would bitterly disagree. Whichever side wins this argument is likely to shape the course of monetary policy for years to come.

(Bay Street is Canada’s counterpart to Wall Street.)

Ian’s article is a great source for many of the arguments against negative rates as well. Ian does not stint in reporting those con arguments. I should deal with those arguments more on another occasion. For now, let me emphasize that I have responded to the worry that negative interest rates will hurt bank profits in my “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies” and again in “If a Central Bank Cuts All of Its Interest Rates, Including the Paper Currency Interest Rate, Negative Interest Rates are a Much Fiercer Animal.”

Finally, for those of us who get remarkably little Canadian news because our reading focuses on news outlets in Canada’s neighbor, the United States of America, let me note this from Ian’s article:

Stephen Poloz, Governor of the Bank of Canada, delivered a speech in December in which he mulled the potential for taking Canada’s key rate to minus 0.5 per cent, although he emphasized such a move wasn’t imminent.

Ian covers a lot of ground in his article. It sets a very positive example for negative interest rate journalism.

Makoto Shimizu Reports on the Bank of Japan’s New Tool to Block Massive Paper Currency Storage

February 21, 2016 by Miles Kimball

Link to Makoto Shimizu’s Twitter homepage

Link to supplysideliberaljp.tumblr.com

Link to Makoto Shimizu’s Japanese language book “Negative Interest Rate Policy: Defeating Deflation by Breaking Through the Zero Lower Bound”

I owe a great debt to Makoto Shimizu. Without any compensation, he has maintained the Japanese language version of this blog–including arranging for translations and doing the bulk of the translation himself. I know that Makoto does this because he believes as I do that appropriate negative interest rate policy is the way for Japan to escape its version of secular stagnation and for other nations to avoid falling into secular stagnation.

With Makoto’s permission, I want to bring you in on an email he sent me giving an important perspective on the Bank of Japan’s new paper currency policy of effectively giving a negative interest rate to cumulative net cash withdrawals by private banks from the Bank Of Japan’s cash window. I posted “The Bank of Japan’s New Tool to Block Massive Paper Currency Storage” on that paper currency policy on February 8, 2016. I strongly recommend that you read “The Bank of Japan’s New Tool to Block Massive Paper Currency Storage” before trying to understand what is below in today’s post. You will need the background. In an update to “The Bank of Japan’s New Tool to Block Massive Paper Currency Storage,” I wrote:

Update 1: A reader points out that the Bank of Japan’s statement of its policy above can easily be interpreted as applying only to a bank’s own holdings of paper currency, which would not include paper currency it passed on to customers. (Many people have, in fact, interpreted it that way.) In that case, this would be a charge for storage of paper currency rather than a charge for cumulative net withdrawals of paper currency by banks. If that is the right interpretation, I am glad I misunderstood the statement so I could see the interesting possibility of a charge on cumulative net withdrawals. But I am also glad to be corrected about what the actual current policy is.
In the event, if a bank made large paper currency withdrawals to pass paper currency on to customers, I suspect the Bank of Japan would try to do something to discourage that flow. Since the Bank of Japan is making the policy itself (and there is a tradition in Japan of administrative discretion) a private bank should worry about what the Bank of Japan would do if the private bank became a conduit for a large amount of paper currency to customers.

But Makoto gives an account more in line with my first interpretation. Here is what he wrote to me, very lightly edited:

Hi, Miles. Most of the responses in the Japanese media to BOJ’s negative interest rate policy including from academic economists were negative as I anticipated (and I guess somewhat you may, too).
Soon after the BOJ’s announcement and before reading your post “The Bank of Japan’s New Tool to Block Massive Paper Currency Storage,” I had a meeting with the former Deputy Governor of BOJ (2003-2008), Kazumasa Iwata at the Japan Center for Economic and Research. Now he is the president of the center, and the most active supporter for the negative interest policy in Japan as far as I know.
http://www.jcer.or.jp/eng/about/index.html
In the meeting, I talked about negative interest rate policy with him and other staff members at the center. One thing I pointed out related to the effective negative rate on cumulative cash withdrawals that you wrote about was that it would promote negative interest rates on private deposits since the private banks would try to influence any cash withdrawals their depositors made.
At the time, took the BOJ statement to refer to “cash holdings.” Then, Ikuko Samikawa, a staff member pointed out that it is hard for the BOJ to know the exact cash holdings in the private bank since there is no distinction between cash and other cash equivalents in the financial statement. So it will be difficult for the negative interest rate to “apply only to a bank’s own holdings of paper currency.” Kazumasa Iwata said what the BOJ does would be to monitor the net cash withdrawal at the cash window. I think this was similar to what you argue in the post.
After the meeting, I made an inquiry through the Bank of Japan’s website BOJ about this paper currency policy. Takuto Ninomiya of BOJ answered me. He said something like: “There are no exact figures in the scheme so far.” He also attached a file giving an official statement saying the same thing. So it does not sound like a policy “rule.” The Bank of Japan seems to be making a vague statement–maybe even a bluff–to discourage private banks from withdrawing too much paper currency.
On reflection, I think the effective negative interest rate on cumulative net paper currency withdrawals from the cash window is similar to a withdrawal fee at cash window since the banks face a negative interest rate for cash that would prevent a profitable arbitrage of borrowing to stock up on paper currency. However, an effective negative interest rate on cumulative net cash withdrawals is better than a withdrawal fee since the payment is more appropriate. Although the scheme is similar to the deposit fee you propose in having an appropriate payment for additional cash withdrawals, it doesn’t cover cash already in circulation.

JP Morgan’s Michael Feroli, Malcolm Barr, Bruce Kasman and David Mackie On Board for Negative Rates

February 18, 2016 by Miles Kimball

Link to Mark Melin’s ValueWalk article “Negative Interest Rates Could Go as Low as 4.5%: JPMorgan Shocker”

In Japan, the Bank of Japan failed to prepare the public adequately for negative interest rates. They would have had more public understanding if they had already begun referring journalists and the Japanese public to the translations of my key posts into Japanese that Makoto Shimizu has posted on supplyideliberaljp.tumblr.com. The Bank of Japan should begin pointing Japanese language readers to supplyideliberaljp.tumblr.com immediately.

By contrast, in the US, the famed investment bank JP Morgan is already helping to prepare the American public for negative interest rates that may still be years off in the future. JP Morgan analysts Malcolm Barr, Bruce Kasman and David Mackie of JP Morgan wrote a remarkable report I would love to get in my hands but so far only know from news accounts. And JP Morgan’s Chief Economist Michael Feroli gave a fascinating interview on camera with Bloomberg Business about negative rates that you can see at the top of the piece linked here, and immediately below:

Link to “How Low Can Central Banks Go? JPMorgan Reckons Way, Way Lower” by Simon Kennedy

Here are some key quotations from the JP Morgan report that are drawn from Mark Melin’s ValueWalk article “Negative Interest Rates Could Go as Low as 4.5%: JPMorgan Shocker” showing how bullish JP Morgan now seems to be about negative rates:

… the incentive to move into cash will be influenced not only by the level of the policy rate but also by how long negative rates are expected to persist. This suggests that the lower nominal bound is below zero, with the exact level determined by the perceived costs and benefits of moving into cash. …
There has been no sign of banks or others starting to hoard physical cash in order to avoid a negative interest charge. …
… [there] has not been a huge asymmetry in the pass through of lower policy rates to retail deposit and lending rates. …
[negative interest rates] could open up a powerful new tool for monetary policy.

Malcolm Barr, Bruce Kasman and David Mackie’s read on the substantial success of European banks in passing through lower interest rates to both deposit and lending rates is important in the light of recent controversies about the effect of negative interest rates on bank profits. In addition, any serious reporting on the effect of negative interest rates on bank profits needs to mention my proposal in

How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies

that central banks use the details of their formulas for interest on reserves to effectively subsidize banks for continuing to keep zero interest rates for small household accounts while encouraging banks to pass on negative rates to commercial accounts and large personal accounts. Because most households have relative small bank balances, it is easy to have 80 to 90% of all households shielded from negative rates, while 80 to 90% of all funds are subject to negative rates.

The aggregate demand effects of negative interest rates do not depend in any important way on regular households seeing negative interest rates on their deposits. The oomph from negative interest rates comes from bring down interest rates for auto loans, mortgages, and business loans, and from encouraging businesses that are sitting on large piles of cash to pursue new business projects with that cash on pain of seeing those piles of cash sitting around doing nothing shrink if they don’t. I wrote a children’s story a while back on how it works:

Gather ’round, Children, Here’s How to Heal a Wounded Economy.

If a Central Bank Cuts All of Its Interest Rates, Including the Paper Currency Interest Rate, Negative Interest Rates are a Much Fiercer Animal

February 14, 2016 by Miles Kimball

Link to pbs.org page for “Wolverine: Chasing the Phantom”

In “The Swiss National Bank Means Business with Its Negative Rates,” I wrote

There is a world of difference between a central bank that cuts some of its interest rates, but keeps its paper currency interest rate at zero and a central bank that cuts all of its interest rates, including the paper currency interest rate. If a central bank cuts all of its interest rates, including that paper rate, negative interest rates are a much fiercer animal.

At the top, I have tried to make this metaphor even more vivid with a still from a wonderful PBS documentary “Wolverine: Chasing the Phantom.” Wolverines, the mascot of the University of Michigan, are animals designed for snow and ice, and as tough as they come. The economic winter the world is struggling to get out of calls for an economic policy as tough as the wolverine.

Current negative interest rate policies lower other electronic interest rates while keeping the paper currency interest rate constant at zero. This incomplete policy of lowering some short-term interest rates under the central banks control while leaving another–the paper currency interest rate–fixed, causes predictable problems. In particular, not lowering the paper currency interest rate is hard on banks, since banks then have to worry that customers will pull money out of the bank as cash if the bank imposes a negative deposit rate. Storing large amounts of cash may be difficult and costly, but households can easily store modest amounts of cash at home instead of leaving that money in the bank. This strain on banks can be avoided by lowering the paper currency interest rate as well. For the mechanics of how to lower the paper currency interest rate, see “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”

That said, the current worries about the effect of negative interest rates on bank profits seem to be overblown. As an example of those worried, consider this from Jon Hilsenrath’s February 11, 2016 Wall Street Journal article “Yellen Says Fed Should Be Prepared to Use Negative Rates if Needed”:

Ms. Yellen was greeted with widespread skepticism, particularly among Republicans. Negative rates would “crush net interest margins for banks,” said Sen. Pat Toomey (R-Pa.) “It would put the us deep in the midst of a global currency war.”
“The Fed really has no real ammunition left,” said Sen. Bob Corker, (R-Tenn.)

Let me deal with each point in turn.

Will Negative Rates Crush Bank Profits? The first is Pat Toomey’s claim that negative rates will “crush net interest margins for banks.” In addition to what I said above about cutting the paper currency interest rate in tandem with other rates to help preserve bank margins, let me say:

It is likely that central banks will, in the future, effectively provide subsidies to private banks to defray the cost of provide above-market zero interest rates to small accounts, as I discuss in “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies.
In Switzerland, Denmark, Sweden and the eurozone, there has been relatively little problem in passing on negative interest rates to commercial accounts and large accounts.
Deeper negative rates would lead to quicker recovery of the world economy, which would be a big help to bank profits. It is much better for banks to have -3% for one year, than -0.3% for many, many years, particularly since -3% would be dramatic enough that they could easily explain to their customers the need for some pass-through of those negative rates.

Will Negative Rates Put Us Deep in the Midst of a Global Currency War? Interest rate cuts do indeed have an effect on exchanges rates, but that doesn’t make it a “global currency war.” The essence of a “war” is that it is zero-sum or negative sum: what I get, you lose, with some extra destruction along the way. That is not the way interest rate cuts work. If all countries cut their interest rates, that is a global monetary expansion and stimulates the whole world economy. If the world economy needs stimulus, that is a good thing–hardly what the phrase “global currency war” seems to suggest. So this is a very misleading phrase–totally inappropriate to the reality of what is happening.

It is possible to have a global currency war. Cutting rates just isn’t it. The way to have a global currency war is for each country to sell its own Treasury bills to get funds to buy other countries’ Treasury bills. This is often called a currency intervention. If all countries do this, it is easy to see that everything cancels out and nothing is accomplished. You sell yours to buy mine, I sell mine to buy yours, and we are back at the starting block.

So selling one’s own Treasury bills to buy the Treasury bills of other countries is a zero sum endeavor and qualifies as an opening shot in a currency war. The way to avoid a global currency war of this type is to insist that central banks actually cut interest rates if they want to stimulate their economies, instead of just buying safe short-term foreign assets.

Have Central Banks Run Out of Ammunition? No. Not if they stand ready to cut the paper currency interest rate as well as other interest rates.

Narayana Kocherlakota Argues That Negative Interest Rates Should Be Seen as Part of Conventional Monetary Policy

February 11, 2016 by Miles Kimball

My first economic journal article on negative interest rate policy is entitled “Negative Interest Rate Policy as Conventional Monetary Policy.” So it is delightful to see Narayana Kocherlakota arguing that negative interest rate policy should be treated as conventional monetary policy in his post “The Potential Power of Negative Nominal Interest Rates.” Here is the heart of Narayana’s argument:

Here’s the wrong way to communicate: keep saying that negative is a purely emergency setting that will be abandoned shortly. The impact of policy depends on the expected path of interest rates over the medium and longer term. The central bank’s communication means that its expanded policy space will have little influence on those medium and longer term expectations. Note that even if the central bank actually keeps rates negative for many years, this ongoing communication will systematically rob the policy of its effectiveness (as well as hurting central bank credibility).
Here’s the right way to communicate: keep saying that all available tools, including negative interest rates, will be used as is needed to return employment and inflation to desirable levels as rapidly as possible. This communication means that the public and markets know that the new policy space can be used to buffer the economy against any adverse shock.

I agree with everything above. But part of the reason Narayana argues this way is that he thinks there is some limit below which interest rates cannot go, because of paper currency. But the paper currency problem is well on its way to being solved. (See How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”) For any central bank that knows what it is doing, there is no lower bound to interest rates other than the risk of overheating the economy by too much monetary stimulus.And increasingly, central banks do know how to break through any lower bound created by paper currency. In particular, I have personally explained how to deal with the paper currency problem in the following presentations (a list copied over from “Electronic Money: The Powerpoint File” as of today):

Bank of England, May 20, 2013
Bank of Japan, June 18, 2013
Keio University, June 21, 2013
Japan’s Ministry of Finance, June 24, 2013
University of Copenhagen, September 5, 2013
National Bank of Denmark, September 6, 2013
Ecole Polytechnique (Paris), September 10, 2013
Paris School of Economics, September 12, 2013
Banque de France, September 13, 2013
Federal Reserve Board, November 1, 2013
US Treasury, May 19, 2014
European Central Bank, July 7, 2014
Bundesbank, July 8, 2014
Bank of Italy, July 11, 2014
Swiss National Bank, July 15, 2014
Society for the Advancement of Economic Theory Conference in Tokyo, August 20, 2014
Princeton University, October 13, 2014
Federal Reserve Bank of New York, October 15, 2014
New York University, October 17, 2014
European University Institute (Florence), October 29, 2014
Qatar Central Bank and Texas A&M University at Qatar joint seminar, November 17, 2014
International Monetary Fund, May 4, 2015
London conference on “Removing the Zero Lower Bound on Interest Rates” sponsored by the Imperial College Business School, the Brevan Howard Centre for Financial Analysis, the Centre for Economic Policy Research (CEPR) and the Swiss National Bank, panel on Economics, Financial, Legal and Practical Issues, May 18, 2015
Bank of England: Keynote Address for “Chief Economists’ Workshop– The Future of Money,” May 19, 2015
Bank of Finland, May 20, 2015
Sveriges Riksbank, May 21, 2015
Uppsala University, May 25, 2015
Norges Bank, May 28, 2015
Bank of Canada, June 11, 2015
Reserve Bank of New Zealand, July 22, 2015
New Zealand Treasury, August 5, 2015
Lake Forest University, September 1, 2015
Federal Reserve Bank of Chicago, September 3, 2015
American Economic Association Meetings, San Francisco, January 4, 2016

That won’t be the end of my itinerary.