Leon Berkelmans: Why Can't Interest Rates Be Negative?

Dr Leon Berkelmans is Director, International Economy program at the Lowy Institute. Originally published on Lowy Interpreter, December 5, 2014. Republished with permission.

I appreciate Leon’s permission to mirror his post here. I will save my comments until after. Here is what Leon has to say. Some of the intro may be affected by the European Central Bank’s actions tomorrow, but the most important points will not:

Overnight, the European Central Bank once again opted for timidity, with interest rates remaining unchanged. The scale of the deflationary threat Europe faces is awesome. However, with no appetite to engage in quantitative easing, I fear that the bank is not willing to do ‘whatever it takes’ to save the single currency, as someone once said.

This reluctance appears to be fed by a distaste of government debt purchases. If only there were a way to loosen policy without crossing this monetary Rubicon, perhaps the political constraints to quantitative easing will be freed. Well, there is. It is radical, but inevitable. To soften you up to this radical alternative, let me tell you a story that, legend has it, took place in a British bathroom in September 1931.

A British Treasury official was taking a bath when apparently an aid burst into the room proclaiming 'We’re off the gold standard!’ In reply the stunned official said, 'I did not know that was possible’.

We look back patronisingly at this official – of course a currency does not need to be tied to gold. And going off gold was a good thing. When the US went off gold, industrial production grew at its highest rate ever. Keynes called the gold standard a 'barbarous relic’. I think we have another one today, namely the zero lower bound on interest rates.

As things stand, interest rates can’t go too far below zero because if they did, institutions and individuals will prefer to hold physical cash. This preference will cause problems. Banks will withdraw the money they have on deposit at the central bank, transferring it into cash. The consequences of this transfer for the interbank market, through which monetary policy is implemented, are uncertain but likely inimical. Moreover, if banks themselves start to offer negative interest rates to depositors, these depositors will also transfer to cash and banks will face a funding squeeze.

How do we get around this problem? Ken Rogoff of Harvard University has suggested completely abolishing physical currency. This may be feasible in some economies, but even in an economy as sophisticated as the US, vast swathes of the population are unbanked. That problem would need to be dealt with before abolition.

Miles Kimball of the University of Michigan has another idea: have paper money (or in Australia’s case, polymer money) trade at a discount to electronic money. In other words, one dollar in your pocket would no longer be worth one dollar in the bank, so there will be an exchange rate between paper money and electronic money. Then when interest rates are negative, the exchange rate could be set so that physical currency will depreciate in value over time, and there will no longer be an incentive to stuff money into a safe.

In other words, one dollar in your pocket would no longer be worth one dollar in the bank. Then when interest rates are negative, the exchange rate could be set so that physical currency will depreciate in value over time so that banks and depositors will no longer have an incentive to stuff money into a safe.

Kimball’s solution has the central bank setting the price. An alternative is to set the quantity of physical cash in the economy and let the market set the price. I quite like this idea, because then the speculators are speculating among themselves rather than against the government, just like in floating foreign exchange markets.

I’ve heard many objections to the idea of a paper money price. I’m not convinced by them. Will people get angry about having two different prices for their morning cup of coffee – a cash price and a card price? Probably less angry than a 40% youth unemployment rate, which they face in Italy. Besides, in many cases we already receive a discount if we pay cash instead of using our credit card. Will it confuse people? We see exchange rates every day in the news. This would just add one more. But it’s too radical! So was going off gold, at least for some, but the world did so and we were better off.

I think the benefits of breaking the zero lower bound are manifest. The immediate applicability to Europe is obvious, but we are kidding ourselves if we think Australia will forever be immune to these problems. One day we will have the systems available to implement negative interest rates, hopefully soon. Kimball has been taking his ideas around to many central banks, and apparently has received encouraging responses.

Nonetheless, any transition involving a paper money price will, to be sure, require transitionary arrangements. We can’t just flick the switch and have this happen tomorrow. If the government sets the price, careful thought is going to be needed on what the price should be. If the government sets the quantity, then various market conventions will need to be worked out. For example, how is the barista going to figure out what discount to give customers who pay in cash? Presumably the barista’s bank will provide a rate, but there may be other ways.

These are all interesting questions, and there are answers, we just need to get out of the bath and think about it.

Miles: I appreciate Leon’s vote of confidence for my proposal. Let me try to answer one of the questions Leon raises.

I think there is real convenience in having the exchange rate between paper euros and electronic euros (or between paper yen and electronic yen, …) be very predictable and slow moving. (There is even convenience to having the exchange rate be one to one–just not enough convenience to be worth the doldrums the world economy has been in for the last six years.) So I think it is better for the central bank to have a crawling peg for that exchange rate between paper currency and electronic money than to let it float.

Unlike other kinds of exchange rates, the crawling peg between the paper euro and electronic euro (or between paper yen and electronic yen, …) would be totally defensible because the same central bank, under the same authority can issue as much as needed of both paper euros and electronic euros. If people want to trade electronic for paper euros, the ECB can print as many paper euros as needed at the exchange rate peg; and if people want to trade paper euros for electronic euros, the ECB can create as many electronic euros as needed. 

Overall, my aim in designing the details of my proposal to have a proposal that (a) eliminates the zero lower bound and (b) is otherwise as close to the current system as possible. I think a slowly crawling peg satisfies that criterion. A -4% interest rate is a very low interest rate (when inflation is 2%) and probably a more powerful stimulus than would be needed. But even that only changes the exchange rate by 1% every quarter. There is plenty of time for people to get used to the level of the exchange rate at that sedate pace.

The other advantage of a slowly crawling peg over a floating exchange rate is that a slowly crawling peg makes for an easier transition back to par and then staying at par until the next big recession. In that period when it is again appropriate to have positive interest rates, the crawling peg simply stops crawling when it comes back up to 1.