The Federal Reserve System's Dysfunctional Governance in 1934
“Currie described the situation in a 1934 memo to Eccles: “Decentralized control is almost a contradiction in terms. The more decentralization the less possibility there is of control.” The problem was that “[e]ven though the Federal Reserve Act provided for a very limited degree of centralized control, the system itself by virtue of necessity was forced to develop a more centralized control of open market operations.” The ad hoc institutional development consisted of “fourteen bodies composed of 128 men who either initiate policy or share in varying degrees in the responsibility for policy.” (The fourteen were the twelve Federal Reserve Banks, the Federal Reserve Board, and the once powerful Federal Advisory Council, a group of bankers that advised the Federal Reserve Board.) These various bodies, and their governors and boards, made governance and public accountability a virtual impossibility. Currie glumly concluded that “[s]uch a system of checks and balances is calculated to encourage irresponsibility, conflict, friction, and political maneuvering” such that “anybody who secures a predominating influence must concentrate on handling men rather than thinking about policies.“”
Scott Sumner on Negative Interest Rate Policy
I am grateful to Scott Sumner for permission to mirror his post “Miles Kimball on Negative Interest Rates” as a guest post here. This will gives you an idea of what Scott thinks of one of my main emphases. Here is Scott:
David Beckworth did a very interesting podcast with Miles Kimball. You probably know that Miles is an economics professor at Michigan and blogs under the name “Supply Side Liberal” (a label not far from my own views.)
Here are some good points that Miles emphasized:
1. If the Fed had been able to do negative interest back in 2008, the average interest rate over the past 8 years would probably have been higher than what actually occurred. Lower in 2008-09, but then higher ever since, as the economy would have recovered more quickly. He did not mention the eurozone, but it’s a good example of a central bank that raised rates at the wrong time (in 2011) and as a result will end up with much lower rates than the US, on average, for the decade of the “teens”. Frustrated eurozone savers should blame German hawks.
2. He suggested that if the Fed had been able to do negative interest rates back in 2008-09, the financial crisis would have been milder, because part of the financial crisis was caused by the severe recession, which would itself have been much less severe if rates had been cut to negative 4% in 2008.
3. Central banks should not engage in interest rate smoothing. He did not mention this, but one of the worst examples occurred in 2008, when it took 8 months to cut rates from 2% (April 2008) to 0.25% (December 2008.) The Fed needs to be much more aggressive in moving rates when the business cycle is impacted by a dramatic a shock.
Although I suggested negative IOR early in 2009, I was behind the curve on Miles’s broader proposal (coauthor Ruchir Agarwal), which calls for negative interest on all of the monetary base, not just bank deposits at the Fed. To do this, Miles recommends a flexible exchange rate between currency and electronic reserves, with the reserves serving as the medium of account. Currency would gradually depreciate when rates are negative. Initially I was very skeptical because of the confusion caused by currency no longer being the medium of account. I still slightly prefer my own approach, but I now am more positively inclined to Miles’s proposal and view it as better than current Fed policy.
Miles argued that the depreciation of cash against reserves would probably be mild, just a few percentage points. Then when the recession ended and interest rates rose back above zero, cash could gradually appreciate until brought into par with bank reserves. He suggested that the gap would be small enough that many retailers would accept cash at par value. As an analogy, retailers often accept credit cards at par, even though they lose a few percent on the credit card fees.
If cash was still accepted at par, would that mean that it did not earn negative interest, and hence you would not have evaded the zero bound? No, because Miles proposes that the official exchange rate apply to cash transactions at banks. This would prevent anyone from hoarding large quantities of cash as an end run around the negative interest rates on bank deposits. So that’s a pretty ingenious idea, which I had not considered. Still, I think my 2009 reply to Mankiw on negative IOR holds up pretty well, even if I did not go far enough (in retrospect.)
Why is negative interest still not my preferred solution? Because I don’t think the zero bound is quite the problem that Miles assumes it is, which may reflect differing perspectives on macro. Listening to the podcast my sense was that he looked at macro from a more conventional perspective than I do. At the risk of slightly misstating his argument, he sees the key problem during recessions as the failure of interest rates to get low enough to generate the sort of investment needed to equilibrate the jobs market. That’s a bit too Keynesian for me (although he regards his views as somewhat monetarist.)
In my view interest rates are an epiphenomenon. The key problem is not a shortfall of investment, it’s a shortfall of NGDP growth relative to nominal hourly wage growth. I call that my “musical chairs model” although the term ‘model’ may create confusion, as it’s not really a “model” in the sense used by most economists. In my view, the key macro problem is the lack of one market, specifically the lack of a NGDP futures market that is so heavily subsidized that it provides minute by minute forecasts of future expected NGDP. If the Fed would create this sort of futures/prediction market (which it could easily do), then the price of NGDP futures would replace interest rates as the key macro indicator and instrument of monetary policy. Recessions occur when the Fed lets NGDP futures prices fall (or shadow NGDP futures if we lack this market). Since there is no zero bound on NGDP futures prices, we don’t need negative interest rates. However, in place of negative rates the central bank may need to buy an awful lot of assets. You could say there is a zero lower bound on eligible assets not yet bought by the central bank. Which is why we need to set an NGDPLT path high enough so that the central bank doesn’t end up owning the entire economy.
To conclude, although Miles’s negative interest proposal is not my first preference, put me down as someone who regards it as better than current policy.
PS. I was struck by how many areas we have similar views. For instance he thought blogging was really important because what mattered in the long run was not so much the number of publications you have, but whether you’ve been able to influence the younger generation economists (grad students and junior faculty).
PSS. I will gradually catch-up on the podcasts, and then do another post on the 2nd half of the Brookings conference on negative IOR.
You might also be interested in these other posts on my blog that involve Scott:
Dominic Chu Interviews Miles Kimball for CNBC about the Need for the Fed to Reverse Course More Often
Link to CNBC segment “Economist: Fed needs to be more flexible”
I was very pleased at how this interview turned out. Take a look. Both links above have the video. Only 6 minutes and 26 seconds!
Alex Rosenberg made this happen, and does an excellent summary in the accompanying article, which also discusses Narayana Kocherlakota’s column “The Fed Needs More Than One Direction.”
I learned an interesting fact along the way. I did this interview for free, but CNBC paid the University of Michigan $700 for the use of the video facilities and personnel and satellite link at the University of Michigan to do the videotaping.
Alex Rosenberg interviewed me on the phone the day before the videotaping. Don’t miss his other interviews of me, in these posts:
The Financial Times Endorses Negative Interest Rates
Link to “The wrong lesson to take from negative yields”
The Endorsement
On June 10, 2016, just four days after a remarkable Brookings conference on negative interest rates, the Financial Times gave a ringing endorsement of a vigorous use of negative interest rates. The subtitle, “Central banks should be pushing ahead with monetary stimulus,” aptly describes the tenor of the editorial. The strength of this editorial is in directly answering complaints by bankers about negative rates:
Predictably, banks and investors have renewed their complaints that a negative-rate environment is causing havoc with the financial system and risks a cataclysmic cascade of losses if prices fall and yields go up sharply. Some have explicitly blamed central banks such as the Bank of Japan and European Central Bank which have cut short-term interest rates below zero.
These criticisms are wrong-headed. Long-term yields are not heading below zero because central banks are arbitrarily planning to keep short-term interest rates down for years on end. They are reflecting expectations of anaemic nominal economic growth, with both real expansion and inflation strikingly low, for decades ahead.
The answer is not for central banks to abandon the negative-rate experiment but to continue to find every means possible to deliver the stimulus that will increase growth and, with it, inflation and yields.
Further on in the editorial, the Financial Times drives home the message that the need for negative rates is sad, but the negative rates themselves are part of the solution:
Negative short-term rates are not the problem. They are evidence of central banks’ determination to try to address the problem, which is the weak growth and inflation that is driving longer-term yields to zero and below. Investors and policymakers who fail to see this are making a serious mistake.
Bond yields at or below zero are a bad sign. Savers and banks suffering from them should recognise that throwing as much stimulus at the economy as possible is the answer, not raising short-term interest rates to the levels of earlier decades and imagining that the normality of the past will then return.
Right before that, the Financial Times even answers a potential objection that low rates could hurt financial stability:
If they are worried about the distortion in the financial system caused by low or negative rates, they should turn to their macroprudential tools, such as direct controls, to prevent excessive lending against housing, rather than holding rates higher than is warranted by the growth of nominal demand.
Discussion
Overall, this is a very strong endorsement of negative interest rate policy by the Financial Times editorial board, that bears comparison to, say, Narayana Kocherlakota’s strong endorsement of negative interest rates policy in these Bloomberg View columns:
One reason I think this comparison is apt is that, like the Financial Times editorial board, Narayana still wishes for fiscal policy help along with negative rates, while I argue that going further with negative rates is preferable to relying partially on fiscal policy. You can see my discussion of that here:
I also tend to think that the conventional monetary policy of negative rates should be used instead of relying partially on the term-premium compression of QE.
Once short-run output gaps are close by interest rate policy, then it will be clearer what the appropriate fiscal policy is from a long-run perspective, which I discuss in
- Discounting Government Projects
- One of the Biggest Threats to America’s Future Has the Easiest Fix
- Capital Budgeting: The Powerpoint File
- What to Do When the World Desperately Wants to Lend Us Money,
as well as what kind of financial market interventions along the lines of QE might be appropriate for medium-run or long-run reasons. On that last, see the links in my my post
Peter Conti-Brown: Central Bankers Are Humans
“… we really do want a central bank that will protect the currency from the winds of electoral politics, without losing the benefits of democratic legitimacy and without indulging the myth that all central bank policy is purely technocratic. We can and should be comfortable with the reality that central bankers, like everyone else, are people whose life experiences—including their technical training—give them an ideological frame of reference through which they evaluate the world. The key to reforming the Fed is to know as much about the values of those central bankers as possible.”
Peter Conti-Brown, The Power and Independence of the Federal Reserve.
Note that with the neutral usage Peter makes of the word “ideological,” the meaning is the same as if it said “give them a frame of reference through which they evaluate the world.''
Narayana Kocherlakota: Negative Interest Rates Are Nothing to Fear
I had a good chance to talk to Narayana Kocherlakota in person at the Brookings conference on negative interest rates on June 6, 2016, and you can see him on the video nodding when I said that we should be telling people that deep negative interest rates are possible if needed. And sure enough, on June 9, Narayana wrote about the possibility of eliminating the zero lower bound in his Bloomberg View column “Negative Rates Are Nothing to Fear.” Here is the relevant passage:
Negative interest rates could eventually become an even more powerful tool. Some economists – such as University of Michigan economist Miles Kimball, who presented at the Brookings conference – point out that central banks are capable of taking rates as far below zero as they deem necessary. To increase the cost of holding currency, for example, they could charge banks a fee to change it into electronic central bank money.
Economically useful as such an option would be, central bankers must recognize that the prospect of being charged, say, 6 percent a year just to hold cash could unsettle people. For such a policy to work as intended, officials would have to do a lot of explaining ahead of time – communication that could have the added benefit of ensuring that the public understands the central bank’s goals and supports its methods of achieving them.
The Brookings conference on negative interest rates was a milestone in many other ways as well. Let me go so far as to say that no journalist writing about negative interest rates is well informed unless they have watched that Brookings conference.
“Negative Interest Rate Policy as Conventional Monetary Policy” in German: “Negativzinspolitik als konventionelle Geldpolitik”
Link: “Negativzinspolitik als konventionelle Geldpolitik” (pdf)
Link to the English version: “Negative Interest Rate Policy as Conventional Monetary Policy”
Journal placement is not the only measure of the importance of an academic paper. I have had many papers published in the American Economic Review or Econometrica, but I have only had one academic paper translated into another language: “Negative Interest Rate Policy as Conventional Monetary Policy,” which is published in the National Institute Economic Review. I appreciate Werner Onken (editor) and Beate Bockting (translator) of the Zeitschrift fuer Sozialoekonomie (Journal for Social Economics) for making the translation happen, Angus Armstrong for arranging for permission from the National Institute Economic Review, and Tilman Borgers and especially Rudi Bachmann for checking the German translation with an eye to the cadence and the economic substance.
Let me also highlight the INWO, the Initiative fuer Naturliche Wirtschafts Ordnung (Initiative for Natural Economic Order). Here is INWO’s webpage on monetary reform, which among other things reports on several important negative interest rate conferences.
Leon Berkelman’s Report on the Brookings Conference on Negative Interest Rate Policy
The Brookings (Hutchins Center) conference last Monday was another milestone for negative interest rate policy. I thought every minute of the conference was illuminating. This one is really worth watching. Here is Leon Berkelman’s reaction to watching the video, which he was kind enough to write up as a guest post:
A few weeks ago I gave a talk to some economics undergraduate students at the University of New South Wales. I told them I was ridiculously envious of them. When I was an undergraduate in Australia, it was impossible to know what the giants of the profession were discussing. Without physically attending a conference in the US, you could only rely upon word of mouth, or until someone wrote a book, to ponder their thoughts. Now, it’s different. To channel the Australian Prime Minister, there has never been a more exciting time to be a student of economics.
But I can’t complain too much. I get to reap the benefits now. And so it was with a gold-plated conference that the Brookings Institution ran on the 6th of June on negative interest rates. Soon after the conference finished, several hours of video were posted featuring the musings of rock stars like Bernanke, Kohn, and Slok.
Of most interest to me was Miles Kimball’s presentation. Miles has been discussing methods for overcoming the difficulties in implementing deep negative rates for a while now. Basically, if monetary authorities try to implement rates too far below zero, which they may want to do if the economy is depressed, we think that people and institutions will move away from assets earning negative rates, like deposits, into cash, which earns a zero return. We’ve heard rumblings about this recently in Germany and Japan. Such a move will cause many problems. For example, banks may see their deposit base disappear, but that’s far from the only problem.
The root of the issue is that physical cash maintains its nominal value. That places a limit on how low rates can go. But what if physical cash did not maintain its value? For example, what if you could somehow tax it? Well, then physical cash would be costly to hold, and the incentive to pile into it is gone. Problem solved.
Miles and others have suggested that you could devalue physical currency by having it depreciate. At the moment, a physical dollar is worth one dollar in the bank. However, you could break that one-to-one link, and you could have, say, one dollar in physical cash worth 90 cents in the bank. In the circumstances of a time-varying exchange rate between the two monies, if physical money was expected to depreciate, then once again the allure of physical cash is gone. It is again costly to hold physical cash. Again, problem solved. For the interested reader Miles’s website is a wonderful resource discussing how this idea would work, and some of the challenges it faces.
I’ve written and spoken about this idea before. I like it. However, as mentioned many times in the Brookings conference, the idea is politically toxic. My response is that it is then up to economists to advocate and educate. If economists think that such an idea can be useful, then shrugging our shoulders and saying that politics renders the idea a non-starter is not good enough. Economists consistently butt their heads up against a brick wall when arguing for cuts in fossil fuel subsidies, which are popular, but are economically and environmentally absurd. With strong enough advocacy, economists have chipped away and have had victories in the fossil fuel realm. Why not the Kimball solution too?
There are precedents of previously unthinkable monetary regime shifts. Going off the gold standard is one. Don Kohn, in his discussion during the conference, noted that these shifts involved changes in the relationship between money and goods (for example gold), rather than the relationship between monies. But we have seen different monies trade at different values before. For example, in the United States, before the Civil War, banks issued their own distinct private banknotes that traded at different rates. People did not riot in the streets then. Are we less able to cope with a small degree of complexity than we were in the 1850’s? I don’t think so.
Miles made the comment during the conference that monetary historians can be very useful right now in helping us to think through debates about our monetary system. They know the way things have worked before, and so they know what was politically feasible before. I suspect political feasibility is a more elastic concept than many appreciate.
Peter Conti-Brown on the Complexity of the Idea of “Independence” of a Central Bank,
“… Fed insiders and interested outsiders form relationships using law and other tools to implement a wide variety of specific policies. To understand more, we need to specify the insider, the outsider, the mechanism of influence, and the policy goal.”
On Gradualism in Negative Interest Rate Policy
Noah Smith does a service by reviewing the debate on negative interest rate policy in his Bloomberg View column “Maybe We Shouldn’t Be So Positive About Negative Rates.” Despite the title, which I suspect (based on my own experience as a Quartz columnist) was chosen by Noah’s editor rather than by Noah himself, Noah sums it up in this rather positive way:
So while Miles is an important and visionary thinker on monetary policy, and his ideas will be very useful if another crisis comes, I’m personally a bit wary about deploying them in relatively normal times.
This is not an uncommon view. Indeed, you can see it evidenced by several luminaries at the Brookings conference on negative interest rates on Monday in reaction to my talk and the panel discussion afterwards.
Let me discuss Noah’s perspective in the context of the US, Japan, and the Eurozone, then conclude by talking more generally about the set of nations and regions that conduct independent monetary policy.
Negative Rate Policy in the United States: To get the record straight, I do not currently advocate even mildly negative interest rates for the United States. So to the extent that “relatively normal times” refers to the current economic situation in the United States, I have no disagreement. I have said that deep negative rates would have been appropriate for the United States in 2009. But I hope no one classes 2009 as “relatively normal times.” Whatever the uncertainties about what side effects such a policy might have had, shouldn’t we wish now that we had tried the experiment of a deep negative interest rate policy (along the lines I have recommended) in 2009? The reason we didn’t was the intellectual framework had not been laid out for such a move at that time. My hope is that by the time the next severe recession hits the United States, that we can be ready.
I think it is very important to fight the idea that the United States had an acceptable monetary policy performance during the Great Recession. As I have said many times, Ben Bernanke is a hero for doing what he did toward making US monetary policy as good as it was during the Great Recession. I don’t underestimate the difficulty of developing and getting consensus for new monetary policy tools in real time during a crisis. But in absolute terms, US monetary policy during the Great Recession is totally unacceptable as something to repeat. To speak ethically, anyone who encourages complacency about our monetary policy toolkit by suggesting that we should simple handle the next serious recession with the monetary policy tools the US used during the Great Recession alone will have to bear a portion of the guilt for the likely poor outcome if this course is, in fact, pursued.
Negative Rate Policy in Japan: After more than two decades of slow growth and deflation or near-deflation, Japan can be characterized as being in “normal times” only if one is willing to give up and accept “secular stagnation” as the new normal. Back in 2012, before I had realized the potential of negative rate policy, I remember an exchange with Noah in which we both agreed about the virtues of being willing to do big experiments. Inspired by that exchange, I wrote “Future Heroes of Humanity and Heroes of Japan” recommending that the Bank of Japan try massive asset purchases of roughly the magnitude they have in fact tried. They deserve a great deal of honor for trying that bold experiment. But it is not at all clear that it is enough. The Bank of Japan has begun gingerly experimenting with mild negative rates as well.
Japan is a difficult case for negative interest rate policy because the fraction of transactions carried out in paper currency is currently very high. So though there is real tradeoff if one delays urgently needed stimulus, gradualism in negative interest rate policy may make sense for Japan. But it is becoming clear that the Bank of Japan will probably need to go to lower negative rates than its current -.1% to get the Japanese economy to the level of economic activity it ought to have. So if it chooses not to move more quickly, the Bank of Japan should gradually reduce the key interest rates it controls, 10 basis point (.1%) at a time, while keeping a close eye on data to watch for side effects and gradually introducing either a very small negative paper currency interest rate with the depreciation mechanism that Ruchir Agarwal and I recommend in our IMF working paper “Breaking Through the Zero Lower Bound,” or gradually introduce policies from the a la carte menu of alternative policies to defang paper currency as a barrier to low interest rates that Ruchir and I laid out in our Brookings presentation on Monday. There is a lot more to say about that kind of gradualist path for Japan that I will leave to another post.
Negative Rate Policy in the Eurozone: Because the Eurozone has already experimented with deeper negative rates than Japan, and as a whole uses paper currency for a smaller fraction of transactions, it should be able to go to deeper negative rates more quickly than Japan. Still, although speed does have benefits, I have no objection to a considered judgement by those who actually bear the weight of monetary policy decision-making to go down step by step, 10 or 20 basis points (.1% or .2%) at a time. And indeed, given how much expectations matter, it would be very powerful for the European Central Bank to announce that it would continue to reduce rates by 10 basis points at each meeting–or even 5 basis points every other meeting–until either (a) it appeared there was a danger of overshooting the ECB’s inflation target of 2% or (b) other serious side effects emerged (that could not be managed by appropriate complementary policies). I think that this is, in fact, how negative interest rate policy will develop.
Conclusion: A cogent argument can be made that the world does too little macroeconomic experimentation. I believe the economies of countries that are reasonably well-run to begin with (say the OECD countries plus some others) are robust enough that they will not fly to pieces from a bit of experimentation. If they were likely to fly to pieces from a bit of experimentation, they would fly to pieces with every other unavoidable shock of any size that hit them.
Even seeing if the economy will fix itself if we do nothing, however “nothing” is defined, is worth trying. But in the realm of macroeconomic stabilization, I view “nothing” as something that–to a reasonable approximation–has been tried and has failed. Anything one does has consequences. There is no true “inaction.” There is only “Do A” or “Do B.”
It is a good thing when nations try a variety of policies among the set of policies that can be easily reversed. Louis Brandeis famously called US states “laboratories of democracy.” The many nations and regions with independent monetary policy constitute “laboratories of monetary policy.” It is a good thing, deserving of honor, for central bankers in different nations to make their own judgments about what experiments are worth trying. And it is a good thing if central bankers make some effort to carefully test novel approaches when well-worn approaches do not seem to be working well.
Enabling Deeper Negative Rates by Managing the Side Effects of a Zero Paper Currency Interest Rate: The Video
Yesterday, I participated in a Brookings Conference on negative interest rates. My talk is the first 20 minutes of the video above. My talk is followed by a panel discussion between Ben Bernanke, Narayana Kocherlakota, Beth Hammack and Jamie McAndrews, moderated by the redoubtable David Wessel, is above. And you can find the rest of the information for the conference and a video of the morning session at this link for the website pictured below.
In the morning session, I raised my hand to challenge the idea legal obstacles were likely to prevent central banks from instituting a robust negative interest rate policy. My coauthor, Ruchir Agarwal challenged Torsten Slok for claiming confidence had declined as a result of negative interest rates without having any measure of confidence other than the international capital flows that would result from an interest rate cut even in the absence of any fall in confidence. In discussions with Torsten between the morning and afternoon session, I was suggesting that minute-by-minute analysis around negative rate announcements of inflation expectations from market prices would tell if the markets had some confidence that the ECB’s moves to lower rates would raise inflation over the next few years as the ECB intends.
Ruchir and I had many other great interactions with participants. There were quite a few current and former central bankers from abroad who are as eminent for their own central banks as Ben Bernanke and Narayana Kocherlakota are for the Fed. The two of us hope to highlight some of their presentations in future posts.
Here is a Powerpoint file of my slides for this 20-minute talk.
Last Friday, I gave an 80-minute talk at the IMF, European Division. Here is the most recent version of the 80-minute “Enabling Deeper Negative Rates by Managing the Side Effects of a Zero Paper Currency Interest Rate.”
Update: Here is the 106 page “uncorrected transcript” of the conference (pdf).
Enabling Deeper Negative Rates by Managing the Side Effects of a Zero Paper Currency Interest Rate: The Powerpoint File
Link to the Wikipedia article on the International Monetary Fund
The European Department of the IMF is understandably quite interested in negative interest rate policy. I was invited to give two presentations there today. In addition to my standard presentation
which I will give in the afternoon, I am giving a brand new presentation in the morning, that is the kernel of a new paper with Ruchir Agarwal and also the inspiration for my much shorter presentation at the Brookings Institution (Hutchins Center on Fiscal & Monetary Policy) conference on negative rates on Monday:
Enabling Deeper Negative Rates by Managing the Side Effects of a Zero Paper Currency Interest Rate
You might be interesting in taking a look at this Powerpoint file I am linking to immediately above.
I gave a presentation on negative interest rate policy at the IMF once before, on May 4, 2015, but it was a different presentation to a different group.
Peter Conti-Brown on the Incompleteness of the Law
“Law in practice differs in sometimes surprising, contradictory ways from law on the books. The argument is not that law is irrelevant; it is that the law is incomplete.”
What is the Effective Lower Bound on Interest Rates Made Of?
Update, June 5, 2019: On this topic, be sure to check out this more recent blog post: “Ruchir Agarwal and Miles Kimball—Enabling Deep Negative Rates to Fight Recessions: A Guide.” The paper of that title expands on the idea that, except for the concern about disintermediation or “debanking,” it is quite speculative to think we are anywhere close to an effective lower bound on interest rates. An effective lower bound other than a concern about debanking would require essentially the conversion of the entire national debt into paper currency. For the US, that would require the storage of something on the order of $20 trillion as paper currency, which is a Herculean task. Long before that, the Fed would be worried about the consequences to the banking system. It is those worries about the consequences of deep negative rates for the banking system to form the effective lower bound.
Once the convenience of electronic money for a large fraction of transactions (especially large transactions and business to business transactions) is recognized, the key to enforcing the zero lower bound in many stark formal models that assume a traditional paper currency policy is the emergence of some equivalent to money market mutual funds backed by paper currency. That is, in the models, it is the “electrification” of paper currency by funds that have paper currency as their key asset and an electronic means of exchange as their key liability that creates the zero lower bound.
But in the real world, the business model for money market mutual funds backed by paper currency is not that promising, given the danger that the government is likely to be annoyed at such funds thwarting a negative interest rate policy, and is likely to act against such funds. Some things are relatively easy to do in opposition to a government, but setting up a money market mutual fund with access to the electronic payments system is not one of them. Even Bitcoin is much more vulnerable to any government action against it than some of its enthusiasts think. And something trying to look as much as possible like a regular money market mutual fund, but backed by paper currency is much more vulnerable to the government than Bitcoin.
Thus, when a central bank lowers its target rate and interest rate on reserves, it is not large scale paper currency storage by the equivalent of money market mutual funds backed by paper currency that is the first symptom of the effective lower bound kicking in, but expanded small-scale storage of paper currency by households and businesses keeping more of their liquid balances as paper currency instead of in bank accounts, or the fear by banks of such a shift into paper currency. That is, the first symptom of the effective lower bound kicking in is disintermediation or fear of disintermediation.
One can debate just how important banks are to the functioning of the economy, but given how much economic activity currently runs through banks, it seems likely that trying to move all of that economic activity outside of banks within too short a time period is likely to be disruptive. So sudden disintermediation is probably something to be avoided. And banks’ fear of households and businesses shifting toward small-scale paper currency storage is likely to lead them to cut deposit rates less than the extent to which other interest rates fall when the paper currency interest rate is kept at zero in a traditional paper currency policy. This could lead to a reduction in the net interest margins that are a mainstay of bank profits.
If banks are extremely well capitalized going into a period of negative interest rates (that is, with a lot of equity on the liability side of their balance sheets), a strain on bank profits and consequent effect on equity levels will have very little effect on the probability of insolvency. But if banks go into a period of negative interest rates with relatively low levels of equity, the strain on profits could lead to more serious undercapitalization, with a consequent heightened probability of insolvency. And low bank profits can be a political problem even in situations where they are not a serious economic problem at all.
One solution to the strain on bank profits and consequent reduced capitalization is to subsidize banks. This is the approach I discuss in “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies.” But the other approach is to lower the paper currency interest rate, to avoid most of the problem of a profit squeeze on banks in the first place. That is the approach I discuss 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.” In other words, if a central bank begins to see the particular strains on bank profits that are symptoms of the effective lower bound in action, it should consider eliminating the effective lower bound itself by lowering the paper currency interest rate, as discussed in “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”
Peter Conti-Brown: The Standard Account of Fed Independence Doesn't Work
“The problem is that the standard account of Fed independence—the story of Ulysses and the sirens, of the dance hall and the spiked punch bowl—often doesn’t work. Sometimes politicians whip up popular sentiment in favor of taking away the punch bowl—precisely the opposite of what we expect in a democracy. Sometimes the central bankers make headlines not for being boring chaperones but for bailing out the financial system. And in every case the creaky, hundred-year-old Federal Reserve Act leaves a governance structure that makes it so we barely know who the chaperone is even supposed to be.
… I argue that each of the five elements of that standard account—that it is law that creates Fed independence; that the Fed is a monolithic “it,” or more often an all-powerful “he” or “she”; that only politicians attempt to influence Fed policy; that the Fed’s only relevant mission is price stability; and that the Fed makes purely technocratic decisions, devoid of value judgments—is wrong.”
Peter Conti-Brown on Walter Bagehot
Link to Wikipedia article on Walter Bagehot
Here is Peter Conti-Brown’s description of Walter Bagehot, from the Preface to his marvelous book The Power and Independence of the Federal Reserve:
Finally, a word about the book’s epigraphs, all taken from the great Walter Bagehot. Bagehot—pronounced BADGE-it in American English, BADGE-ot in Britain, a shibboleth of sorts in central banking circles—is widely viewed as the intellectual godfather of modern central banking. Whether his world has much to say to ours is an open question, but there are few wordsmiths in financial history quite as able as he. He is the author of magnificent sentences, very interesting paragraphs, and sometimes frustratingly indeterminate books. But because of the power of those sentences, I borrow liberally from his iconic 1873 book, Lombard Street: A Description of the Money Market, for the epigraphs that introduce each chapter (except for chapter 4, which comes from his other famous book, The English Constitution). Bagehot obviously had nothing to say about the Federal Reserve System, which was founded decades after his death. And he barely had more to say about the U.S. financial system (he wasn’t very impressed with nineteenth-century U.S. finance). But his turns of phrases are too applicable and felicitous to pass by, even if the reader must change some of the proper nouns to make them relevant.
On Making the Fed’s Governance Constitutional
In his book “The Power and Independence of the Federal Reserve,” Peter Conti-Brown argues that Federal Reserve Bank Presidents are, in effect, important government officials, by virtue of voting on monetary policy, and so (a) should be chosen in a democratically accountable way and (b) to accord with the constitution, should be either appointed by the President of the United States and confirmed by the Senate, or treated as “inferior officers.”
I am like Justin Fox and many others at a 2015 Brookings event that Justin reports on in thinking that the Federal Reserve Bank Presidents voting on monetary policy in a way close to the way things are now is good for monetary policy. In particular, it helps in allowing a diversity of views to make its way into monetary policy. Crucially, each Federal Reserve Bank President has the staff to really investigate different angles on monetary policy. And indeed, one of the most valuable reforms would be to give more staff and more independence of the Governors in Washington DC from the Chair of the Fed–as well as higher salaries more in line with the Federal Reserve Bank Presidents so that they would be less tempted to quit as Governors after only a few years.
Despite thinking that the current de facto status of Federal Reserve Bank Presidents is good for monetary policy, and that indeed that the Governors’ status should be raised by giving them some of the attractive job characteristics that the Federal Reserve Bank Presidents have, I take the constitutional issue seriously. I wrote to Peter by email of an idea of how to make the Fed’s governance structure constitutional by clarifying that the Federal Reserve Bank Presidents’ are indeed inferior officers, de jure, and indeed making their appointment more consistent with being inferior officers, but otherwise keeping the role of Federal Reserve Bank Presidents essentially the same as now. Here is what I wrote, with a few words added for clarification:
I think it would be very interesting to investigate the extent to which–even without new legislation–a strong Chair, working with the Fed’s Chief Counsel, could implement the “Federal Reserve Bank Presidents as inferior officers” reform.
As far as removal goes, I think a legal report could take your line that constitutionally, as inferior officers, the bank presidents must be removable by the board–whether the statute said so or not–and that that was the legal position of the board would take to the extent the question of whether the presidents were inferior officers or whether a president was removable ever came up. This would presumably be associated with reassurances that the board had no intentions of removing any president any time soon. It would cause some kerfuffle, but that would die down reasonably soon after repeated assurances that the board had no intention of actually removing any president any time soon, but that it was just forced to the conclusion of its ability to do so by the law.
As far as appointment goes, the rules already give the board a substantial role in the appointment process. As I understand it, it already requires both the assent of the Board of Governors and the assent of the board of the particular federal reserve bank to make a president. The Board of Governors could easily be much more assertive in this process than it is. And indeed I think the trend is in that direction. For example, I heard that the FRB took a big role in the selection of the SF Fed Bank’s current president. Of course, the place to start would be for the Board of Governors to be extremely assertive in the choice of the president of the NY Fed.
I disagree with you about bank presidents voting on the FOMC. Because they have their own staffs and an attractive job that they will continue in for some time, they provide important diversity in viewpoints–both on the hawkish side and on the dovish side. I think greater Board of Governors assertiveness in the selection of bank presidents solves the most important institutional design problem from the standpoint of good policy outcomes, while simply asserting that the constitution overrides the statute so that the Board of Governors can remove bank presidents if it comes to that solves the constitutional problem.
Let me add this: if, to smart lawyers, this interpretation of the law seems right, one can imagine the chief lawyer of one of the regional Feds replying to a query from its president by saying:
I have good news and bad news.
The good news is that you are constitutional.
The bad news is that you can be fired.