I had a very interesting email discussion with JP Koning about negative interest rate alternatives. I appreciate his having given permission to make this public.

JP Koning: Let’s say central banks adopt your crawling peg idea and drop rates to -5%. However, retailers continue to set almost all prices in terms of paper dollar rather than switching to the electronic dollar. Why is this a bad thing? Why does the success of a crawling peg hinge on retailers make the switch to the electronic dollar as unit of account?

One way I have been trying to puzzle this out is by thinking about Marvin Goodfriend’s idea of a suspension of payment in paper, which you refer to in your paper ‘Breaking though the zero lower bound’. Under Goodfriend’s scheme, if retailers continue to set prices in terms of paper currency rather than electronic dollars, each ratcheting down in interest rates below 0% by a central bank will cause a one- time jump in the value of paper dollars, or deflation, which would be a dangerous thing. If retailers had already been encouraged to switch the unit of account to electronic dollars, the problem would be fixed. However, I’m not sure if this particular justification for the necessity of retail adoption of electronic dollars as the unit of account transfers over to your crawling peg scheme.

So why is it so necessary that retailers make the unit of account switch?

Miles Kimball: This is a deep question that I have not yet fully plumbed, but here are the considerations that make me go around saying that the electronic unit of account is important. 

1. If inflation is sticky in relation to a paper unit of account, then there is still an effective zero lower bound, since the paper currency earns a zero interest rate in the unit of account, which with (let’s say) low sticky inflation leads to a high real interest rate.

2. (This is a post I have been planning to write for a long time:) The changing exchange rate with electronic money does lead to a large increase in the money supply relative to the paper dollar numeraire that will credibly not be reversed, since ultimately the central bank expects people to switch to the electronic dollar numeraire. Suppose that does create inflation relative to the electronic dollar numeraire. Until people do switch to the new electronic dollar numeraire, that inflation relative to the paper dollar numeraire causes the usual costs: distortions of relative prices, menu cost expenditure, confusions, variance. 

Thus, it is much better if people can be encouraged to use the electronic dollar numeraire. As I say in my presentations, I think the government can make that happen. After all, for all we know, we are already on an electronic dollar standard. It is hard to know what the private markets would do without a nudge if the paper dollar goes off par. With nudges such as tax accounting in electronic dollars, other accounting standards in electronic dollars–and if needed–a requirement that firms (whether they have a paper price or not) affirmatively post prices in electronic dollars, I have every confidence that the electronic dollar can be made the unit of account.

Of course, it helps if a large fraction of transactions is done in electronic dollar terms before the transition.  

JP: Miles, when you get the chance can you critique my recent post? I’m trying to work out some “lite” techniques for breaking below the the zero lower bound. I believe they would work, but the devil’s in the details.

A lazy central banker’s guide to escaping liquidity traps.

Miles: Ken Rogoff suggests getting rid of the highest denomination notes first as the path toward eliminating paper currency entirely.

Ruchir Agarwal (my coauthor on the nascent academic paper on eliminating the zero lower bound) and I think that eliminating high denomination notes is a nice way to lower the fraction of transactions in paper currency in order to ease the transition into a crawling peg.

I think even the hardest-core version of eliminating high denomination notes (say $100s and above, then $50s–ordinary people mostly use $20s and below) of saying people have to turn them in is not all that radical. But if something less radical is needed, I like the idea of just not printing more.  

One important thing in favor of the “not printing more” option that you might mention is that it just might be within the legal authority of the Fed + Executive branch (without new legislation) even if the crawling peg is not. But I need Greg Shill’s upcoming series of guest posts before I know things like that.

I had some responses to your paragraph here:

7) There are a few drawbacks to a crawling peg. Driving a wedge between paper and electronic currency creates two different sets of prices at the till, one for deposits and the other for cash. A chocolate bar, for instance, might have a sticker price of $1.00 in electronic money, but require a cash payment of $1.05. This will be confusing and inconvenient for shoppers, necessitating an expensive and costly education campaign by our central banker. According to Kimball, instituting a crawling peg requires that a nation enact a unit of account switch. Prices must be set in terms of electronic currency, not paper currency, otherwise the central bank will lose control over the price level. While a switch in standards is by no means impossible, it does require time and effort.

1. First of all, we may well be on an e-dollar standard already. It is not easy to tell when paper dollars are at par. So I don’t count this as necessarily a switch in the unit of account. Rather it is resolving an ambiguity in what the unit of account will be in favor of the e-dollar. That, I think is much easier than a switch in the unit of account.

2. I routinely argue (as you can see in my Powerpoint file and in my interview with Alexander Trentin

SNB should introduce a fee on paper currency

that up to something like a 4% paper currency deposit fee (which could easily be all that is ever needed, since -4% rates for 1 year are powerful enough to get a robust recovery in many countries), paper currency would probably be accepted at par at most retailers that deal in cash, since those retailers are now only getting about 96 cents on the dollar when people pay with American Express cards. Paper that yielded 96 cents on the dollar would look just as good.

But also, it really isn’t that big a deal if, say, paper is running at a 7% discount so that retailers no longer accept it at par at the cash register. That is no more complicated than a 7% sales tax at the cash register, which people don’t blink an eye at. 

Notice that the front end of the crawling peg (a discount of, say, 0 to 4 or 5%) is most important for initial acceptance of the program. In the region where lite programs could go, the crawling peg is also very light, since cash would almost surely be at par at retailers. So I would argue that where a lite program will work, the crawling peg is also easy, and because it has the potential to go further, will have the advantage of creating stimulative expectations to a much greater degree than an approach that is limited to the lite region.   

Miles: On further thought, although it is great for crime-fighting, making everyone turn in their $100 and $50 bills by a given date may be seen as somewhat draconian. Saying that after a certain date the Fed will accept them only at a discount, that will gradually increase, then pick up speed is a nice way to both (a) do the elimination of high-denomination bills in a less draconian way and (b) get people used to the idea of exchange rates for paper currency. 

JP: Miles, here’s the first bit of my response, the rest later this week!

1. First of all, we may well be on an e-dollar standard already. It is not easy to tell when paper dollars are at par. So I don’t count this as necessarily a switch in the unit of account. Rather it is resolving an ambiguity in what the unit of account will be in favor of the e-dollar. That, I think is much easier than a switch in the unit of account.

While I agree that e-dollars are important, I think that we are probably on some sort of odd mixed e-standard/cash standard. I see it as being very similar to bimetallism; one unit, two different definitions that vary be retailer. I’ve written before about a Visa/MasterCard standard (see these two posts [1][2]).

Things get even more complicated if we factor in debit transactions: they are more expensive than cash from the perspective of a retailer, but less expensive than credit card transactions, and may provide a third potential definition for the unit of account. 

It will be interesting to see if new rules allowing US retailers to put surcharges on credit card payments will result in a shift back to using paper dollars as the unit of account. 

Merchant Surcharging – Understanding Payment Card Changes

One of the reasons I touched on the unit of account switch in my post is because of Scott Sumner. He recently wrote:

Nonetheless, it is probably impossible to pay negative interest rate on currency. Nor do I think it is feasible to make it so that currency is no longer a medium of account (as Miles Kimball proposed.) 

Central banking in a negative seignorage world

I don’t know how common Sumner’s criticism is, but for those like him who don’t think that removing currency as the “medium of account” is feasible, then lite alternatives may be an alternative that convinces them. Personally, I think a switch (or a resolution of ambiguity as you call it) would probably be easy to execute and not cost too much.

JP:  …Miles, here are the remainder of my thoughts.

On further thought, although it is great for crime-fighting, making everyone turn in their $100 and $50 bills by a given date may be seen as somewhat draconian. Saying that after a certain date the Fed will accept them only at a discount, that will gradually increase, then pick up speed is a nice way to both (a) do the elimination of high-denomination bills in a less draconian way and (b) get people used to the idea of exchange rates for paper currency.

I agree.

I routinely argue that up to something like a 4% paper currency deposit fee (which could easily be all that is ever needed, since -4% rates for 1 year are powerful enough to get a robust recovery in many countries), paper currency would probably be accepted at par at most retailers that deal in cash, since those retailers are now only getting about 96 cents on the dollar when people pay with American Express cards. Paper that yielded 96 cents on the dollar would look just as good.

That’s a good point. Are fees on Amex really that high? Wow! Since Mastercard and Visa are so much more ubiquitous than American Express – many won’t accept Amex – shouldn’t we be using MasterCard/Visa as the standard? Interestingly, Australia imposes maximum credit card fees that are quite low. They also allow retailers to apply surcharges, which looks something like this:

There is rumbling up in Canada that we might do the same. In any case, depending on its laws concerning credit card interchange fees, each nation could have its own peculiar negative interest rate trigger point at which paper currency prices will start to diverge from electronic prices.

There’s also the production, distribution, and wholesale side of the economy to consider, which doesn’t transact using credit cards. They use things like cheques or wire transfers, with very low handling fees relative to the size of the transaction. The e-money price and cash price could diverge quite quickly as a crawling peg is implemented.

But also, it really isn’t that big a deal if, say, paper is running at a 7% discount so that retailers no longer accept it at par at the cash register. That is no more complicated than a 7% sales tax at the cash register, which people don’t blink an eye at.

At 7% the lite programs wouldn’t work anymore. And if a -7% rate is what it takes to ensure the central bank is hitting its targets, then two different prices is the least of our concerns! In any case, from a purely tactical perspective, if you run into someone who disagrees with the crawling peg idea because it creates dual prices, and you can change their mind, that’s great – but if you can’t change their mind no matter how hard you try, the lite options provide a fall back.