The Exchange Rate Between 500 Euro Notes and Smaller Notes

Link to “High-denomination banknotes: Cash talk”

In “An Underappreciated Power of a Central Bank: Determining the Relative Prices between the Various Forms of Money Under Its Jurisdiction” I write:

It Isn’t the Face Value that Determines How Much Each Type of Paper Currency is Worth. To see this role of a central bank clearly, consider a case where not only direct access to the central bank, but access to the banking system in general is problematic: the criminal underworld. Think of the standard scene in American mob movies in which the mobster demands a suitcase full of cash in tens and twenties. Why tens and twenties? Using the banking system often increases the chance that a criminal will get caught. Money can be laundered, but it is easier to launder tens and twenties. So, at least near the point of money laundering, ten ten-dollar bills are worth more than one hard-to-launder hundred-dollar bill. That means that if you bring me a suitcase full of one-hundred dollar bills with the same face value as a suitcase full of tens and twenties, you are bringing me less value—you have cheated me.

I was intrigued to read in the Economist article “High-denomination banknotes: Cash talk” about the exchange rate between different denominations when transportation is the immediate issue rather than laundering:

A report from Europol recounts how criminals will sometimes pay more than face value for high-value notes because of how convenient they are to transport.

This is one more example showing that it is not the face value that determines the relative price of different forms of money, but the rate at which they can be exchanged, whether at the cash window of the central bank, at a private bank or in the relevant market. For central banks, the possibility of modifying the exchange rate between different denominations is not particularly important, but the possibility of modifying the exchange rate between paper currency and electronic money is very important because it makes it easy to generate a negative rate of return on paper currency to match negative interest rates in bank accounts, and thereby eliminate any effective lower bound for interest rates.

How and Why to Eliminate the Zero Lower Bound (Part 2)

History of Thought and Economic History

Q&A, Discussion and Rebuttal

Storified Twitter Discussions

Reactions

Why Financial Stability Concerns Are Not a Reason to Shy Away from a Robust Negative Interest Rate Policy

Because the Great Recession was triggered by the Financial Crisis of 2008, financial stability concerns have been high on the agenda of central banks. Indeed, some central bankers now worry about avoiding financial instability every bit as much as they worry about avoiding inflation and unemployment. So it is worth directly addressing financial stability concerns that some central bankers have about a robust negative interest rate policy. 

The particular concern many people have is that lower interest rates might increase financial instability. There are several possible mechanisms for this: 

  • The simplest is that lower interest rates might make asset prices go up and this allows households and firms to borrow more without exceeding legal or customary ceilings on leverage. Then if the asset prices ever go back down, bankruptcy could be near at hand.
  • The second is “reaching for yield” caused by institutional settings or psychological mindsets in which there is effectively a target expected return or “yield,” and the amount of risk bearing is adjusted in order to meet that expected return target. (See “Contra John Taylor” and “Reaching for Yield: The Effects of Interest Rates on Risk-Taking.”)
  • The third is that low interest rates magnify the importance of the relatively distant future on the present value of an asset. Opinions on the relatively distant future are likely to differ from investor to investor and to change quite a bit over time even for the same investor. Because there is so little to go on, the human penchant for responding to stories can have relatively free play. (See “Robert Shiller: Against the Efficient Markets Theory” plus “Dr. Smith and the Asset Bubble.”)
  • The fourth is that as interest rates fall, it becomes attractive to banks and other financial institutions to provide credit to people who previously were not considered creditworthy.   

Although these are genuine concerns, it would be a mistake to let these concerns paralyze monetary policy–as they easily could: in “Monetary Policy and Financial Stability” I argue that central transmission mechanisms for monetary stimulus work through pushing up asset prices and relaxing credit constraints for those who previously had a hard time getting a loan. 

As I discussed in “Meet the Fed’s New Intellectual Powerhouse,” to the extent that risk premia go down, showing a greater appetite for risk–or less fear of risk–it is appropriate to raise the safe interest rate; and conversely it is appropriate to lower the safe interest rate when risk premia go up–even aside from financial stability concerns. But I want to argue that if unemployment is high and inflation is low, it is appropriate to cut interest rates (even into the negative region) to stimulate the economy even if risk premia stay the same.    

Three Arguments for a Robust Negative Interest Rate Policy Even in the Face of Financial Stability Concerns

1. High Equity Requirements are Powerful Enough to Mitigate Financial Stability Concerns. I view equity requirements (sometimes called “capital” requirements)–or equivalently leverage limits–as being powerful medicine to raise financial stability. If people are betting their own money by holding stock rather than borrowing money that someone expects back in full, any decline in the value of a bank, business, or other asset will be absorbed by the stockholders. Then there is no bankruptcy, no contagion, and no temptation for the government to do a bailout, because no debt is being defaulted on. I feel as passionately about the need for high equity requirements as I do about the need to have deep negative interest rates (including negative interest rates on paper currency) in the monetary policy toolkit. Here are links to some of what I have said about the importance of having high equity requirements: 

Why negative interest rates should be combined with high equity requirements: In times when unemployment is high, output is below its natural level, and inflation is coming down, low interest rates–and often negative interest rates–are called for. But negative interest rates are much safer in conjunction with high equity requirements. Conversely, when financial instability threatens, high equity requirements are called for, but they are safer when negative interest rates are ready to hand to deal with any negative aggregate demand effects of the high equity requirements. 

At the top of this post, I diagram the idea that high equity requirements have a big positive effect on financial stability, but some negative effect on aggregate demand, while negative interest rates (or more generally low interest rates) have a big positive effect on aggregate demand, but have some effect in reducing financial stability. This means that if high equity requirements and negative interest rates are combined, it is possible to get both more financial stability and more aggregate demand. Low interest rates can more than make up for the reduction in aggregate demand caused by higher equity requirements, while the high equity requirements more than make up for the reduction in financial stability from the negative interest rates. 

2. Negative Short-Term Interest Rates Raise Long-Term Interest Rates. Long-term interest rates matter more for asset prices than short-term interest rates. Therefore, those concerned about financial stability should worry most about low long-term interest rates. There are two reasons the ability to generate a brief period of deep negative short-term interest rates should raise long-term interest rates. The first is that a brief period of deep negative short-term rates is the path to economic recovery if the economy is in a deep recession or a potentially long-lasting slump. Businesses and households are much more eager to borrow when the economy looks healthy than when it looks sick. So interest rates tend to be higher when the economy is doing well than when it is doing badly. It may seem paradoxical that negative rates are the path to higher interest rates, but the paradox is dissolved when one realizes that economic recovery is in between. Because it is the long-term rates that matter most for asset prices, an extended period of years and years of zero interest rates is much more dangerous for financial stability than a brief period of deep negative rates followed by a return distinctly positive interest rates. One of the worst things for financial stability is an unending slump with the economy stuck at an unwisely maintained zero lower bound. 

The second reason having deep negative interest rates in the toolkit allows higher long-term interest rates is that eliminating the zero lower bound and thereby bringing the possibility of deep negative interest rates into the picture means that quantitative easing is no longer needed. As practiced in recent years in the US, the UK and Europe, quantitative easing has involved pushing down long-term interest rates relative to short-term interest rates. This gives a high ratio of pushing asset prices up (”asset price inflation”) relative to the aggregate demand it provides. I claim that cutting short-term rates has a better ratio of extra aggregate demand provided to effect on asset prices. (I owe you an entire post on this point.) 

3. Short of Monetary Policy that Allows a Perpetual Slump, the Medium- to Long-Run Real Interest Rate Situation is Not Affected by Monetary Policy. 

Because central banks operate in important measure by changing interest rates in the short-run, many people think that they determine real interest rates in the medium- and long-run. But unless a central bank allows a perpetual slump, with output continually below the natural level, what happens in the medium- and long-run in real terms is not much affected by what the central bank does. That includes not just what happens to economic growth in the medium- and long-run, but also what happens to the real interest rate. (See “Mario Draghi Reminds Everyone that Central Banks Do Not Determine the Medium-Run Natural Interest Rate.”) So whatever the effect of real interest rates in the medium- and long-run on financial stability, that effect real interest rates in the medium- and long-run is beyond the power of monetary policy to affect–except to the extent the central bank makes things worse for financial stability by allowing a perpetual slump or better for financial stability by escaping a perpetual slump (Argument 2 above). 

If medium- to long-run forces are causing financial instability, this must be fought with non-monetary tools. High equity requirements are the first line of defense. If greater financial stability is desired than high equity requirements (and perhaps a few complementary financial rules) alone can provide, another useful supplementary remedy is a contrarian sovereign wealth fund. (See “Roger Farmer and Miles Kimball on the Value of Sovereign Wealth Funds for Economic Stabilization.” Ever since I wrote “Q&A on the Financial Cycle” I have been aware that even if the economy is kept at the natural level of output at all times so that the business cycle has been stabilized, there would remain the issue of stabilizing the financial cycle if there are noise traders or other forces–such as some version Minsky mechanisms–that continue to cause a financial cycle even in the presence of high equity requirements.)

Conclusion

Negative interest rates are no panacea. They merely make it possible for decisive movements in short-term interest rates to accomplish the basic purpose of monetary policy: keeping the economy in medium-run equilibrium with output at the natural level. 

Negative interest rates are a marvelous solution to empowering monetary policy to do its job, but negative interest rates are no economic policy panacea because monetary policy can’t do everything. In addition to not being the answer to generating long-run economic growth, monetary policy alone can’t create financial stability except at the cost of a sluggish economy. High equity requirements and other approaches to gaining greater financial stability are needed in addition to monetary policy to get good results. Fortunately, since aggregate demand is no longer scarce when deep negative interest rates are available, any drag on aggregate demand from higher equity requirements is not a serious concern. So it is reasonable to push quite far toward higher equity requirements in order to ensure financial stability.

Update: “Long-Run” vs. “Long-Term.” In the discussion of interest rates in the medium- to long-run above, it would be easy to confuse “long-run” with “long-term” and to confuse “medium-run” with “medium-term,” which in turn would make the argument hard to understand. The “medium-run” as the economic concept I mean is a period from about 3 to 12 years out, while the “long-run” is a period beyond 12 years or so. Going toward brevity in my terminology, the short-run is a period from 1 to 3 years out, while the ultra-short run is a period from now to 1 year out.  

By contrast, according to the usual terminology in financial markets, “medium-term interest rates” might be interest rates available now covering a period from now to 2 years from now, or from now to 5 years from now. And interest rates available now covering a period from now to more than 5 years from now would typically be called “long-term” interest rates. Thus, most of the span covered by medium-term interest rates available now is what I would call the “short-run.” And the short-run is even an important part of the span covered by long-term interest rates available now. 

My claim is that short-term forward real (inflation-adjusted) rates from 3 to 12 years out, and certainly beyond 12 years out should be mostly unaffected by any predictable monetary policy unless the central bank is allowing a perpetual slump by not breaking through the zero lower bound.

The K-12 Roots of Moral Relativism

Link to the March 2, 2015 New York Times article “Why Our Children Don’t Think There are Moral Facts” by Justin P. McBrayer

When I was in college, I had many discussions over breakfast, lunch and dinner in Quincy House about whether there was any such thing as truth. My classmates were very quick to take a relativist line, while I argued that there was such a thing as truth. Justin McBrayer, in the article linked above, explains why not only my classmates, but most young adults are so well prepared to take the relativist line. He writes:

When I went to visit my son’s second grade open house, I found a troubling pair of signs hanging over the bulletin board. They read:

Fact: Something that is true about a subject and can be tested or proven.

Opinion: What someone thinks, feels, or believes. …

… students are taught that claims are either facts or opinions. …

Kids are asked to sort facts from opinions and, without fail, every value claim is labeled as an opinion. …

In summary, our public schools teach students that all claims are either facts or opinions and that all value and moral claims fall into the latter camp. The punchline: there are no moral facts. And if there are no moral facts, then there are no moral truths.

Thought of as abstract philosophy, this may not be a very deep position, but it may not seem much worse than many other areas of shallow teaching. But Justin argues that a simplistic belief in moral relativism can have a corrosive effect on moral judgments and even on behavior: 

The inconsistency in this curriculum is obvious. For example, at the outset of the school year, my son brought home a list of student rights and responsibilities. Had he already read the lesson on fact vs. opinion, he might have noted that the supposed rights of other students were based on no more than opinions. According to the school’s curriculum, it certainly wasn’t true that his classmates deserved to be treated a particular way — that would make it a fact. Similarly, it wasn’t really true that he had any responsibilities — that would be to make a value claim a truth. It should not be a surprise that there is rampant cheating on college campuses: If we’ve taught our students for 12 years that there is no fact of the matter as to whether cheating is wrong, we can’t very well blame them for doing so later on.

Indeed, in the world beyond grade school, where adults must exercise their moral knowledge and reasoning to conduct themselves in the society, the stakes are greater. There, consistency demands that we acknowledge the existence of moral facts. If it’s not true that it’s wrong to murder a cartoonist with whom one disagrees, then how can we be outraged? If there are no truths about what is good or valuable or right, how can we prosecute people for crimes against humanity? If it’s not true that all humans are created equal, then why vote for any political system that doesn’t benefit you over others?

The irony is that the urge to separate out facts from opinions or facts from values stems itself from an important value: the value on telling truth according to one’s best judgement of the science, even if telling the truth does not seem likely to move the debate about a political or moral issue in the direction one believes in. This in turn is grounded in the belief that involving many well-intentioned people who have different points of view in the attempt to grind out moral truth in a serious moral debate based on true facts is much more likely to home in on the relevant moral truth than short-circuiting the debate by deception in order to favor one’s own heartfelt views. In moral matters, telling the truth is a sign of respect for other human beings and the value of their views, too.

Mario Draghi Reminds Everyone that Central Banks Do Not Determine the Medium-Run Natural Interest Rate

Link to the May 2, 2016 Wall Street Journal article “ECB Chief Mario Draghi Fires Back at German Critics” by Tom Fairless

Many complaints about central bank policy seem to assume that the medium-run natural interest rate is under a central bank’s control. It isn’t. 

In “The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate” I define the medium-run natural interest rate as follows:

  • medium-run natural interest rate: the interest rate that would prevail at the existing levels of technology and capital if all stickiness of prices and wages were suddenly swept away. That is, the natural rate of interest rate is the interest rate that would prevail in the real-business cycle model that lies behind a sticky-price, sticky-wage, or sticky-price-and-sticky-wage model.

In the standard view of monetary policy, which is the view that I take, other than keeping the long-run level of inflation low, a central bank’s principle and crucial job is to get the economy as close as possible to the medium-run equilibrium that corresponds to what an economy would do if all prices and wages were perfectly flexible. That is, a central bank’s job is to (1) keep the long-run inflation rate low and (2) do as much as possible to undo the effects of sticky prices and sticky wages on the real variables of the economy. 

By this definition of the medium-run equilibrium, the central bank no control over the real variables in the medium-run equilibrium, other than things such as real money balances in the medium-run equilibrium. And since there is only one level of aggregate demand the gets the economy to the medium-run equilibrium–that is, saying “medium-run equilibrium” already stipulates a level of aggregate demand–the role of real money balances in the medium-run natural equilibrium is quite unexciting.

Using this terminology, hardcore “Real Business Cycle Theory” posits that the economy is always in the medium-run equilibrium, because prices and wages are almost perfectly flexible. But in discussing the nature of the medium-run equilibrium, the question of whether this is true or not is actually immaterial. The medium-run equilibrium is what would happen if the Real Business Cycle Theorists were right, whether they are or not. But the medium-run equilibrium is also close to what would happen if a central bank did a truly excellent job of monetary policy–better than any existing central bank so far, but within the range of possibility.   

If output is below its medium-run equilibrium level, the medium-run natural interest rate is likely to be above the current level of the interest rate. The reason is that businesses and households don’t like to invest when the economy is in a slump. Getting out of the slump tends to raise the interest rate. As I explain in “The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate” and “On the Great Recession,” in a slump the path to raising the interest rate up to its higher medium-run equilibrium level is–somewhat paradoxically–through a path of cutting the interest rate in order to bring output up. Once output comes up, the interest rate will come up too. So Anyone who wants a higher interest rate should want the central bank to use a sharp reduction in interest rates for a few quarters in order to bring recovery and a sustainably higher interest rate. To try to go straight to a higher interest rate will push the economy into a worse slump and require lower interest rates to get on track–quite counterproductive from the point of view of those who want higher interest rates. 

Many people don’t understand the limitations of central banks. If they want higher interest rates, they think central banks can go there directly without serious side effects. That doesn’t work. In a slump, central banks need to get to higher interest rates by the proper path of cutting interest rates until the economy recovers; then interest rates can and should be raised. Raising interest rates first is like a sugar high for savers, that will lead to a crash when interest rates then have to be cut to stave off a double-dip recession.    

Just because central banks can’t affect the medium-run natural interest rate that is where things go if they do their jobs doesn’t mean there isn’t any reason to complain about low interest rates. In particular, low medium-run natural interest rates can be a symptom of a low rate of technological progress, which is definitely something to complain about–and something to do something about, by making sure that we fund basic research at a much higher level than we currently do and by making sure we don’t let regulations crush new firms doing new things in promising new ways. 

Less obviously a good thing, increases in government debt can raise the medium-run natural interest rate. And increases in the willingness to take risks can raise the medium-run natural interest rate, which I think is a good thing as long as people are really taking those risks themselves rather than angling to be bailed out by taxpayers. 

Draghi’s Speech

On his recent Asian trip, Mario Draghi, head of the European Central Bank (ECB), defended the ECB from attacks by the powerful argument that a central bank does not control the medium-run natural rate. Here are three key passages from the Wall Street Journal article linked at the top of this post:

1. “There is a temptation to conclude that…very low rates…are the problem,” Mr. Draghi said. “But they are not the problem. They are the symptom of an underlying problem.”

The global savings glut, Mr. Draghi said, is being perpetuated by economies in Asia and in the eurozone, notably Germany. “Our largest economy, Germany, has had a [current account] surplus above 5% of GDP for almost a decade,” Mr. Draghi said. 

2. In unusually blunt criticism last month, German Finance Minister Wolfgang Schäuble called for an end to easy-money policies … suggesting [the ECB’s] low interest rates had hurt savers.

Mr. Draghi directed criticism directly back at Berlin. “Those advocating a lesser role for monetary policy or a shorter period of monetary expansion necessarily imply a larger role for fiscal policy”

3. Mr. Draghi stressed that the ECB’s policies are helping savers, and said governments, not central banks, should address the underlying economic causes of low rates. He also urged savers in Germany to boost their returns by diversifying their investments, mimicking their counterparts across the Atlantic.

“U.S. households allocate about a third of their financial assets to equities, whereas the equivalent figure for French and Italian households is about one- fifth, and for German households only one-tenth,” Mr. Draghi said.

Let me interpret these statements. 1. Mario Draghi effectively says that medium-run international capital flows affect the medium-run natural interest rate. 2. Mario Draghi effectively says that to get the medium-run equilibrium requires closing the output gap either through monetary or fiscal policy. He criticizes German fiscal policy. But the criticism of German fiscal policy is not necessary for the point. The point is just that if fiscal policy doesn’t do it, then monetary policy needs to. As I have pointed out many times, monetary policy is more reliable, simply because it is not tangled up in politics. A sensible approach is to take what fiscal policy one can get politically (after whatever advice one wants to give), then do the rest of the job with monetary policy. 3. Mario Draghi effectively reminds savers that a healthy economy tends to raise interest rates compared to a slump, then makes the interesting point that expected rates of return can be raised by taking on more risk. There is a more subtle point Mario Draghi doesn’t make: if more people raised the expected rate of return on their savings by taking on more risks, then the risk-free rate for those who don’t want to take on those risks is also likely to be higher. The worst thing for savers is if they aren’t eager to take risks and no one else is eager to take risks either. Then everyone tries (unsuccessfully, given limited supply) to crowd into the risk-free assets and lowers their rate of return (or something even worse happens if the central bank doesn’t do its job of keeping the economy as close as possible to the medium-run equilibrium).  

The bottom line is that it is crucial to understand what central banks can and can’t do. Central banks can get the economy close to the medium-run equilibrum, which entails lowering interest rates to raise them (after recovery) and raising interest rates to lower them (after reining in an overheated economy). But central banks cannot determine the interest rate that prevails once they have done their job. To repeat, central banks cannot determine the interest rate that prevails in the medium-run equilibium any more than they can keep output permanently above its medium-run equilibrium. 

As I write in “The Deep Magic of Money and the Deeper Magic of the Supply Side,” the supply side is the place to turn to raise the natural level of output that prevails in the medium-run equilibrium. But those who agree about the supply-side roots of the natural level of output need to also remember that the supply side is the place to turn to raise the natural interest rate that prevails in the medium-run equilibrium. Monetary policy can’t do it. 

Note: The argument of this post is important in the later post “Why Financial Stability Concerns Are Not a Reason to Shy Away from a Robust Negative Interest Rate Policy.” In that later post, you may find the update at the end, “Long-Run” vs. “Long-Term” helpful.

Is the Swiss National Bank Ready to Limit Convertibility of Electronic Money to Paper Currency?

Link to May 2, 2016 Reuters article “SNB could seek to prevent banks hoarding cash if franc soars: Roubini group.”Thanks to Makoto Shimizu for pointing me to this article.

Yesterday, Reuters reported

The Swiss National Bank might seek authority to stop commercial banks converting reserves into cash if its current policy arsenal failed to prevent a major appreciation of the franc, economist Nouriel Roubini’s research group said [in a] report published by the group on Monday after a meeting with SNB officials …

One option would be to prevent banks from switching reserves into cash. That would require a new law, but the Roubini Global Economics report said SNB officials “were confident that the legislation could be changed …to give the bank this authority”.

I find this intriguing because the heart of my proposal to eliminate the zero lower bound is to generate a negative paper currency interest rate when necessary by having the exchange rate giving the value of paper currency relative to electronic money that applies at the cash window of the central bank gradually depreciate over time. So any change in the ability of private banks to exchange reserves for paper currency or paper currency for reserves at the cash window of the central bank is of great importance as a precedent. 

The most natural reading of the Reuters description is that banks would no longer be able to convert electronic reserves into paper currency. That is equivalent to making the “ask” price for paper currency at the cash window of the central bank prohibitively high. In all likelihood, forcing private entities to get paper Swiss francs (with a face interest rate of zero) from each other rather than the central bank would make the market value of paper Swiss francs in a negative rate environment rise above par. 

On problem with a policy that makes the value of paper currency go above par is that anticipation of this policy could lead to the very hoarding of paper currency that the actual institution of the policy is meant to inhibit. By contrast, my proposal of having the value of paper currency start at par and then gradually depreciate below par (both bid and ask prices for paper currency gradually going down) works fine, without any such side effects, even if fully anticipated. It is also less disruptive than making paper currency scarce. 

One thing I have not emphasized enough about my proposal is that it can be seen as flooding the market with paper currency more and more over time, and thereby making the rate of return on paper currency lower. Thus, it is the opposite of a policy of trying to make paper currency scarce. My recommended policy would make paper currency abundant, but give it a low rate of return because of its gradually increasing abundance. There is a sense in which this is like a helicopter drop of paper currency to those who hold electronic money without any helicopter drop of electronic money. So as long as electronic money provides the unit of account, this helicopter drop creates the good “inflation”–inflation relative to paper currency–without creating any of the  bad inflation–inflation relative to the unit of account, which in this case is the electronic Swiss franc. This careful targeting of having higher “inflation” where needed to eliminate the danger of people pulling money out of banks and shifting into paper currency without all the disruption of true inflation (relative to the unit of account) is a great virtue of going off the paper standard.  

I have some hopes that Reuters, and perhaps the Roubini group, have misunderstood what the Swiss National Bank intends–and that they, in fact, intend to move in the direction of what I have proposed. Indeed, I have a genuine hope that the staff at the Swiss National Bank has studied carefully the things I have written about eliminating the zero lower bound that are collected in “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.” And I am hoping to arrange a second visit (my first was on July 15, 2014) to the Swiss National Bank sometime in Fall 2016 to discuss different approaches to eliminating the zero lower bound.  

Beyond Pro-Government and Anti-Government

In countries that manage to escape worse problems (such as serious ethnic divisions) and even in many that do have worse problems, the main political parties are often arrayed on a spectrum from lower-tax, lower-spending, less government regulation parties to higher-tax, higher-spending, more government regulation parties. In these countries, the unending struggle about long-run fiscal policy tends to interfere with short-run fiscal stabilization as well–one reason monetary policy unconstrained by a zero lower bound is so valuable. But the unending struggle between those for bigger vs. those for smaller government also often gets in the way of sound policy that would have the government act when it should and leave people alone when it should. Distinguishing when the government should act and when it should leave people alone is the central theme of John Stuart Mill’s On Liberty. In the 8th paragraph of the “Introductory” to On Liberty, he writes:

In England, from the peculiar circumstances of our political history, though the yoke of opinion is perhaps heavier, that of law is lighter, than in most other countries of Europe; and there is considerable jealousy of direct interference, by the legislative or the executive power, with private conduct; not so much from any just regard for the independence of the individual, as from the still subsisting habit of looking on the government as representing an opposite interest to the public. The majority have not yet learnt to feel the power of the government their power, or its opinions their opinions. When they do so, individual liberty will probably be as much exposed to invasion from the government, as it already is from public opinion. But, as yet, there is a considerable amount of feeling ready to be called forth against any attempt of the law to control individuals in things in which they have not hitherto been accustomed to be controlled by it; and this with very little discrimination as to whether the matter is, or is not, within the legitimate sphere of legal control; insomuch that the feeling, highly salutary on the whole, is perhaps quite as often misplaced as well grounded in the particular instances of its application. There is, in fact, no recognised principle by which the propriety or impropriety of government interference is customarily tested. People decide according to their personal preferences. Some, whenever they see any good to be done, or evil to be remedied, would willingly instigate the government to undertake the business; while others prefer to bear almost any amount of social evil, rather than add one to the departments of human interests amenable to governmental control. And men range themselves on one or the other side in any particular case, according to this general direction of their sentiments; or according to the degree of interest which they feel in the particular thing which it is proposed that the government should do, or according to the belief they entertain that the government would, or would not, do it in the manner they prefer; but very rarely on account of any opinion to which they consistently adhere, as to what things are fit to be done by a government. And it seems to me that in consequence of this absence of rule or principle, one side is at present as often wrong as the other; the interference of government is, with about equal frequency, improperly invoked and improperly condemned.

As examples of where it can sometimes be hard for people to distinguish appropriate government action form inappropriate action there are many very different types of rules that go under the heading of “government regulation,” some good, some bad. Part of what is called government regulation–such as high equity requirements for banks–is a matter of clearly delineating property rights. Other regulations simply spell out what terminology should be used so that people are not deceived by others they are selling to or buying from. Other government regulations are inappropriate meddling. And yet other regulations are even worse: they are government-enforced restraints on trade that boost profits at the expense of people getting what they want and need from robust competition. Here local governments are often the worst offenders. On this, see “John Stuart Mill: The Central Government Should Be Slow to Overrule, but Quick to Denounce Bad Actions of Local Governments.” 

Scott Adams on Donald Trump's Powers of Persuasion →

Even those who hate what Donald Trump stands for–or doesn’t stand for–should study and understand his techniques. (Of course, any decision to actually use his techniques should be subjected to very careful ethical deliberation.) ‘Dilbert’ creator Scott Adams is a longtime student in the powers of persuasion, and he believes Trump has been 'pitch-perfect’ so far in deploying those powers. 

David Pagnucco: The Eurozone and the Impossible Trinity

Link to David Pagnucco’s Linked In homepage

I am pleased to host another student guest post, this time by David Pagnucco. This is the 13th student guest post this semester, rounding out the semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

European Union countries considering to join the Eurozone must evaluate the major risk of forgoing their sovereign monetary policy before adopting the euro.

Joining the Eurozone poses numerous risks and benefits for European Union countries outside the zone. In Rick Lyman’s article, leaders from non-Eurozone countries evaluate the risks they face in joining the Eurozone. Some of the major recent factors countries are assessing include political attitudes, the Greek crisis, and domestic fiscal set backs. In order to weigh these risks and benefits, the impossible trinity can be used to describe them. The impossible trinity illustrates that a nation cannot have free capital flows, a sovereign monetary policy, and a fixed exchange rate at the same time. They must choose a position and sacrifice one of the policies.

For example, Eurozone members are at position a in which their single currency allows them to have free capital flows and a fixed exchange rate. On the other hand, European Union members not in the Eurozone are at position b, in which their differing domestic currencies allow them to have free capital flows and a sovereign monetary policy. One of the main goals in creating the European Union was to create a single unified market with free capital flows, and all European Union members share this aspect. However, with the creation of the euro, Eurozone members lose control of their domestic monetary policies. This is the greatest risk facing non-Eurozone members, as they no longer can change their money supply to stimulate or slow down their economies’ growth according to their own preferences.

The European Central Bank creates the central monetary policy for Eurozone members, and a governing council member, Philip Lane, stated that the ECB will continue to increase its government bond purchases. This will ultimately increase the supply of the euro and decrease interest rates, resulting in lower borrowing costs for households and firms that will help stimulate the economy. If the ECB sets the monetary policy for all Eurozone members, what happens if a country within the Eurozone does not want the ECB’s particular policy? This is a major dilemma for countries considering to join the Eurozone. Countries outside the Eurozone may have differing preferences on interest rates, inflation, and unemployment than the ECB’s established policy. For example, consider if Poland were to adopt the euro. If the ECB is using the expansionary monetary policy described by Philip Lane, Poland will be required to partake in it. If Poland does not want this policy, they will ultimately need to counter the ECB’s policy in a more complex way such as increasing taxes to deter economic growth.

Non-Eurozone countries, besides Britain, must adopt the euro at some point in the future, and the timing of the decision is critical because these countries’ economies must be stable and have basic economic convergence to have a successful change over to the euro. They need convergence in areas such as debt levels, GDP, and unemployment to ensure that the ECB’s policies are effective. Overall, the decision to switch to the euro is a major change, and new members must be sure their economies are ready for the switch.

Andrew Cuatto: Deus Ex Helicopter—Not

Link to Andrew Cuatto’s Linked In homepage

I am pleased to host another student guest post, this time by Andrew Cuatto. This is the 12th student guest post this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

Greg Ip is overstating the effectiveness of helicopter money as a tool for jump-starting the economy.

With world economies still sluggish, more and more people are claiming that central banks are out of ammo in their fight against recessions. This has lead to an increase in calls for adopting less conventional monetary policy; something the Fed did when it used quantitative easing in response to the Great Recession. In a recent article in the Wall Street Journal Greg Ip explains how one of these policies, helicopter money, could be a viable solution for countries struggling with slow growth and looming deflation. However, Mr. Ip completely ignores the presence of the zero lower bound and overstates the effectiveness of helicopter money as a practical tool for jump-starting an economy.

Renowned economist Milton Friedman first coined the term “helicopter money” and simply put, it is a way of giving money directly to citizens. It works by the government issuing bonds to the central bank, which buy them using newly printed money. The central bank then promises never to sell the bonds or withdraw the newly created money from circulation. The government gives that money to its citizens and the central bank returns the interest earned on the bonds to the government.

As Miles clarified in “Helicopter Drops of Money Are Not the Answer,”

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
Here is the same equation, with the usual policy names attached:
helicopter drop = standard open market operation + tax rebate

Understanding helicopter money as a tax rebate financed by a standard open market operation makes it easier to see the limitations of this tool. Near the effective lower bound–the interest rate at which paper currency is a very close substitute for Treasury bills, even after accounting for storage costs , standard open market operations are not effective because they cannot push the interest rate any lower to stimulate spending. This means that a helicopter drop is now essentially just a tax rebate, and while tax rebates do impart some stimulus they are not nearly as effective as desired because not everyone spends the windfall.

As explained by a 2009 survey done by UM’s Matthew Shapiro:

Only one-fifth of respondents to a rider on the University of Michigan Survey Research Center’s Monthly Survey said that the 2008 tax rebates would lead them to mostly increase spending. Almost half said the rebate would mostly lead them to pay off debt, while about a third saying it would lead them mostly to save more. The survey responses imply that the aggregate propensity to spend from the rebate was about one-third, and that there would not be substantially more spending as a lagged effect of the rebates. Because of the low spending propensity, the rebates in 2008 provided low “bang for the buck” as economic stimulus.

What’s troubling is that despite the limitations of helicopter money, limitations that even Mr. Ip acknowledges, it seems to be gaining traction as a potential policy. European Central Bank chief Mario Draghi has said

… helicopter money is an interesting idea currently being explored by various economists. While this is certainly not an endorsement, he is not dismissing the possibility of helicopter money due to the perception that their latest attempt, negative interest rates, is already failing.

Rather than explore this radical and less efficient option, the ECB should work to strengthen their negative interest rate policy by, as our Miles suggests, establishing the electronic euro as the unit of account and introducing an exchange rate between paper and electronic currency. That way the negative rates can affect paper money as well and there will be no place to hide from the negative interest rates other than through physical investment or abroad–which would increase net capital outflows and in turn increase aggregate demand as desired.

Luckily there seems to be some growing consensus that negative interest rates can be a very powerful and effective instrument for monetary stimulus. Just last week International Monetary Fund Chief Christine Lagrande said that while we should closely monitor the potential side effects of negative interest rates these subzero rates are in fact a net positive for the global economy. This means that with negative rates it is possible to have an overall boost in world aggregate consumption as opposed to the very small bump given by helicopter drops.  

In theory, helicopter money would work, but it is not the most efficient option central banks have for battling recessions. Once people realize that powerful tools necessary to stabilize the economy are there, in the form of negative interest rates, helicopter drops will no longer get so much attention.  

Suparit Suwanik: Hope for a Phase-out of the 500 Euro Note

Link to Suparit Suwanik’s blog “Through the Eyes of a Central Banker”

I am pleased to host another student guest post, this time by Suparit Suwanik. This is the 11th student guest post this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link. This is Suparit’s second guest post. Don’t miss “Suparit Suwanik: Putting Paper Currency In Its Proper Place.”

With the world still suffering from the economic slowdown, it is good to see many major central banks, including the European Central Bank, implementing negative interest rates. This creates wide speculations on change in related policy, that is, paper currency. The change in cash policy is a necessary condition to release the power of negative interest rates. From what I wrote in “Putting Paper Currency In Its Proper Place”, stating that from Mario Draghi to Larry Summers, they were planning to get rid of the large notes, for example, €500 notes and $100 bills, until today, here is another development: the German central bank, the Bundesbank, supports a gradual phaseout of the €500 bank note!

Bundesbank President Jens Weidmann once said “the current discussion over [the €500 note] must be kept clearly separate from this monetary policy-motivated discussion on the abolition of cash.” However, in my humble opinion, this is a big step closer to cashless society in the Eurozone. And here are the reasons:

First, it is the Bundesbank, the most influential central bank in the Eurozone, which is normally perceived as very conservative. Its president remains a key player in crafting Eurozone monetary policy at the ECB. If the idea is supported by the Bundesbank, the rest of the central banks in the Eurozone are likely to follow.

Second, it is Germany, where cash payments remain very common and people place a high premium on individual privacy. According to a recent Bundesbank study, 79% of payments in Germany are made in cash – compared with only 48% in Britain. Even among 14- to 24-year-olds, two-thirds say they prefer paying in cash to electronic means. Of course, resistance is expected to be fierce against any change in paper currency. But the resistance will be much lighter if the change is at a gradual, yet steady, pace. In order to unleash the powerful effect of negative interest rates, it is the right time to start changing the policy.

Finally, it remains in doubt whether terrorists or criminals can really be stopped because large notes are eliminated, though it is claimed that the change in paper currency policy will be significant help in hindering money laundering and organized crime. In general, the criminal world tends to use small notes to avoid suspicion from authorities. Though I’m a supporter of negative interest rates, I agree with a German professor, Max Otte, who is strongly against the change in cash policy, that the elimination of the €500 note is becoming ever more likely and constitutes the start of the elimination of cash.

All in all, the sooner the change in cash policy is in effect, the better the economic effect of negative interest rates which the ECB is really hoping for. May the transition to electronic money society be smooth and glorious for the Eurozone!