I am delighted to have Dylan Matthew’s permission to mirror here in full his extremely skillful writeup on Wonkblog of his interview with me. The theme of the November 14, 2013 interview is eliminating the zero lower bound on nominal interest rates by making electronic money the unit of account and legal tender. Dylan’s piece provides the most accessible explanation of the nuts and bolts of my proposal for how to get the negative interest rates I have argued we desperately need in our monetary policy toolkit.
After the text of Dylan’s writeup, I give a direct answer to the question in Dylan’s title.
Miles Kimball is a professor of economics at the University of Michigan, focusing on business cycle theory (including monetary economics), the economics of uncertainty, cognitive economics and the economics of happiness. He writes the blog Confessions of a Supply-Side Liberal and on Twitter as @MilesKimball.
Recently, Kimball has developed a proposal to use electronic money to enable central banks to set negative nominal interest rates, which would have major implications for monetary policy and economic policymaking generally. See here and here for writings of his outlining the idea, and here for the PowerPoint he has delivered to a number of central banks, including the Bank of England, the Bank of Japan, the Danish Nationalbanken, and the Federal Reserve.
The idea has gained traction in response to a speech in which Larry Summers argued the inability of interest rates to go negative could cause secular stagnation like that Japan has suffered during the last two decades. Kimball and I spoke on the phone Thursday about his proposal; an edited transcript follows.
For readers who may not be familiar with monetary policy — what is the problem that electronic money solves? What’s the issue it helps us overcome?
If you ever have a situation where the interest rate needed, in order to get back to full employment, is less than zero, then you’re in trouble, because your path is blocked. We’ve blocked the economy’s ability to get itself in balance by not having negative interest rates.
People are shocked by negative interest rates, and you have to explain to people what those are. It basically means you’re paying a storage company — the bank — to store your money, and there are circumstances where that’s the way the economy should work
Many times, the economy desperately wants people saving, and interest rates will be positive and strong, but you get other periods of time when people are actually reluctant to borrow, because companies are scared of whether they can make a good profit by investing and buying new equipment or building a factory, and people are scared to buy automobiles or build a home.
There are situations where people are really scared to invest at an interest rate of zero. There’s some interest rate where they would invest, but it would have to be lower. You have situations where people are saving a lot because they’re scared, but they’re not spending a lot, and the way to correct that imbalance is for that interest rate to go down until things right themselves.
That way, you’re encouraging people to borrow and invest, and telling people that what we need is not for you to save — saving in general is a great thing, but right now that is not what the economy needs. You should be rewarding savers a lot, but there are these temporary periods of time where people are saving too much, and you want to give some encouragement to people to stimulate the economy. Every bit of a negative interest rate is making it so that savers get less and making things easier for borrowers. Like any change in prices, it helps some people and hurts others, but in a broader sense by getting employment back in gear, it helps everyone.
Just to be crystal clear — which interest rates are we talking about? Are we talking about credit card interest rates, car loans, mortgage loans, small business loans? All of the above?
There are a lot of different interest rates. What you want to have happen is for all the interest rates to go down in tandem. We’re talking about short term interest rates, because the virtue of short term interest rates is they’re a way to get stimulus right now, when we need it, as opposed to two or three years from now, when we don’t need it as much. When you operate on long term interest rates, the trouble you run into is that it’s very difficult to stimulate the economy now without also stimulating it later. You have to convince people that you’re willing to stimulate the economy later a bit more than would normally make sense.
By contrast, the short term interest rates can control the rate of the stimulus. You can have the stimulus go away when it would be excessive. If any of the many interest rates are blocked and can’t go down to their natural equilibrium level, you’ll have a problem. You need the whole range of interest rates freed up.
All right, so there are some times when you want one or more interest rates — on mortgages, small business loans, credit cards, whatever — to go below zero. We want people to be able to borrow $200,000 to buy a house and pay back only $190,000, if that’s what the market rate ought to be.
How does electronic money let us do that? How does it let us go negative?
More and more, we’re doing transactions electronically: credit cards, debit cards, etc. With bank money, it’s easy to have negative interest rates. It’ll take a little getting used to, since the account balance is gradually declining over time. Banks may call this “carry charges” or something like that. If you just let the money sit in the bank and there are negative rates, it will gradually decline. As long as something’s a number in an account, it’s very straightforward to have those numbers gradually decline, however shocking that feels.
With paper money, it takes a little more engineering. It’s not particularly hard, but it does take more than just having numbers in the account go down. If you’re a bank, and you can force the government to lend to you at a zero interest rate by having it give you paper money in exchange for electronic money, why would you ever lend to someone paying an interest rate less than zero? What’s causing the problem is that we’re forcing the government to accept that deal. We’ll take anybody’s electronic money and let them turn it into as much paper money as they want earning a zero percent interest rate. That’s what’s creating this inability to make interest rates negative.
So what the government needs to do is make it possible for paper money to have an interest rate that’s less than zero. Let’s say you needed a negative 5 percent interest rate. You’d say, “Today a paper dollar is worth the same as an electronic dollar, but in a year it’ll be worth 95 electronic cents.” That means that if you went to your bank, and withdrew 95 cents from your account, you’d get a paper dollar. If you deposited a paper dollar, you would have 95 cents added to your account. In all respects the paper dollar would be worth 95 cents.
This wouldn’t go on forever, because at some point the higher interest rate would be appropriate, and you could have paper currency gradually gain in value until a paper dollar is equal to an electronic dollar again. A lot of the time it would be exactly like it is now in terms of the relative value of paper and electronic dollars. The paper dollar would gradually depreciate in value, and then come back up to normal. The Fed would be choosing a paper currency interest rate. It could be negative, it could be positive, it could be zero.
What do we need to do to transition to this kind of system, with an exchange rate between electronic and paper dollars?
I think everybody agrees that the political realities are that it’s unlikely we’ll do this tomorrow, but I think it’s extremely important to work toward this. Who knows when the next crisis will happen? We need to be prepared. If the politics of this are such that it’s not in the politically feasible toolkit now, we’ll work to get it in the toolkit in the future. We need to be getting people used to the idea.
We can do a lot to make this easier by encouraging a lot of transactions to go through electronic money. It ought to be the policy of all the governments in the world to do all they can to speed the transition to doing the vast majority of transactions electronically. The other thing is to firm up the status of electronic money as legal tender. Debt repayment should be done in electronic terms, and we should make sure commercial law is supportive of that. You want to do a lot of things to establish that the normal way a lot of transactions go, and the way that legal contracts are drawn up, is on the basis of electronic money as the real thing.
You don’t have to do anything to actively discourage people from using paper money but you do want to smooth the road to electronic money being a real thing, and the government working in terms of electronic money, and legal terms being in terms of electronic money. A lot of that is easy when you get it done when everything’s at par. It clarifies how things would happen when you went off par, and that if you ever did go off par, electronic money would be the real thing. Anything you can do to firm up the legal status of electronic money as the real thing makes it easier to do what it takes to go to negative interest rates. There are a large number of preparations we can do to make this feasible.
What’s the Fed’s role here? If I’m Janet Yellen, what can I do to set a system like this up?
There’s plenty you can do. There are electronic wallet companies who need to get regulatory approval for things, and there are going to be issues with them. The Fed needs to see companies introducing and making a better electronic wallet as being on the side of the angels for economic policy.
But I think that a lot of this can be done by law professors. There are law professors who put together commercial codes, and they ought to be talking about these issues, and encouraging people to write debt contracts that are explicit about paying in electronic terms. It’s not all government action. Much of it is businesses and lawyers thinking through how to make the world work when a lot of things are done electronically, and making it clear that the electronic money is the real thing, and being clear that there could be a moment in the future where a macroeconomic emergency makes it so that a paper dollar is not worth the same amount as an electronic dollar.
Lawyers try to be aware of a lot of things that are relatively unlikely. If they realized how serious the discussions are about this kind of thing at central banks, they’d be doing more to get prepared.
How serious are the discussions? What’s the typical central banker’s view on this, would you say?
Nobody I’ve talked to disputes that it will work, technically. Nobody’s had a serious dispute about that. It’s something that people at central banks are very interested in. Nobody thinks this can be done tomorrow in any politically feasible sense, so it’s not like there’s any news emanating from central banks on that front, but from a technical and intellectual point of view, everyone I talk to at every central bank takes it seriously.
How do the nuts and bolts of this work, practically? How do you make it such that a paper dollar is worth 95 cents?
Let me start by talking about where the zero lower bound comes from. Where does the inability of the central banks to lower interest rates below zero come from? It comes from this possibility of massive paper currency storage, where instead of having money in the bank you store cash in a storage locker or something where it earns a 0 percent return. Doing that has three steps: (1) taking it out of the bank (2) storing it and (3) putting it back into the bank and turning it into bank money again. You can attack any of those three steps.
You could attack the withdrawal stage, and say you can’t take it out, or have a fee on withdrawal, or say you’re not printing any more paper money, but there are several disadvantages to that. One of them is that you actually want people to take paper money out of the bank if you want stimulus for the economy. But also people would be really freaked out, People like the idea that they can always just take their $5,000 out of the bank if they really want to. There’s also a legal problem. It sounds a lot like a taking. You had this money in the bank, and they’re taking it away from you. I just think that looks really bad. If you stop the printing of paper money entirely, it makes cash into an exotic financial security, and its value would go up and down in a jagged way, like the stock market. That seems like a minor disaster to me.
The second thing you could go after is storage. That’s a low tech thing, but criminal syndicates are very experienced in obtaining whatever economies of scale there are to be had in storing paper money. So it’s not really feasible to discourage storage by having some kind of tax on it, or making it illegal
The way to go after massive currency storage is to go after the deposit of paper currency into the bank. To get cash’s zero percent interest rate, you have to take the cash out when it’s at par with electronic money and put it back in at par, but if you put it back in and it’s worth less than electronic money, then you don’t get a zero interest rate.
Let’s say that the interest rate for both bank and paper money is negative 5 percent. If you have 100 dollars in the bank, it’ll become 95 dollars. That’s shocking, but it’s needed by the economy to encourage people to invest and spend instead of people just having piles of money sitting there doing nothing.
So what about paper currency? Well, the money in the bank is going to turn from $100 to $95, so you take out $100 and keep it for a year, and then you put it in the bank again and it becomes $95. In no way is the paper currency being disadvantaged; it’s treated exactly the same as bank money. It’s earning a negative five percent interest rate just like money in the bank. You’re making it fair between people keeping money in the bank and people who need paper currency. There’s no way to hide from the negative interest rate, so to earn a decent return they’d need to go out and invest in real stuff in the economy.
But let’s say I take all my cash out and just live off cash for as long as the interest rate is negative, and only deposit it when paper and electronic money are back at par. Isn’t that a way around this?
That’s actually something I emphasize. It’s great if people just want to save the paper money until the crisis is over. There is no problem with that. The problem is not the zero interest rate, it’s that you can earn a zero interest rate in unlimited amounts, over any horizon. The short term interest rates really matter. The paper money is likely to come back to par with electronic money, so you could save that way, but it’s important that temporarily the interest rates are able to be negative.
But what if I’m not just saving, and I’m buying groceries and whatever with the cash. Doesn’t that cause a problem?
Well, retailers might not apply the same exchange rate between paper and bank money as the banks, but they need to deposit their earnings too, which means it won’t be in their interest to treat cash exactly the same as electronic money. So in effect you’ll be subject to changing interest rates when you buy goods and services. You can’t escape that by doing everything in cash.
So, in theory at least, this could eliminate recessions if central banks are able to use negative rates to spur enough investment and spending to get the economy back to normal quickly. But you argue it could eliminate inflation too. How would that work?
Why do we have a 2 percent inflation target? Well, Bernanke says it’s because of the zero lower bound. We may need to get interest rates to be 2 percent below inflation, and if inflation is 2 percent, then you can get interest rates below inflation, but if it’s 0, you can’t get interest rates below inflation. The Fed is very clear about the fact that it chooses to do 2 percent inflation because it’s worried about the zero lower bound.
In practice, we’d choose zero inflation. In my presentation to central banks, I go through the costs and benefits of inflation, and other than steering away from the zero lower bound, there aren’t many benefits to it. There are people who quite seriously argue that we need inflation so companies can cut real wages when necessary, but other than that, steering clear of the zero lower bound is the big reason we have inflation. And there are a lot of reasons to not like inflation.
There are some quite serious proposals to raise our level of inflation. 2 percent isn’t enough, because we still run into the ZLB. Larry Ball, Brad DeLong, Paul Krugman, Ken Rogoff — they’ve all proposed this. There are quite serious voices calling for four percent rather than two; that’s the number they hit on.
With electronic money, you get the benefit of inflation, of steering clear from the zero lower bound, without the destructive aspects. With inflation, you’re constantly changing your economic yardstick. Using Greg Mankiw’s example, suppose we said a yard is 36 inches today, but next year it’s 35 inches. That’s a big miss. The thing you’re measuring in is the electronic dollar, and if there’s zero inflation there, you have a constant yardstick.
My answer to the question in Wonkblog’s title, “Can We Get Rid of Inflation and Recessions Forever?” is
- Yes, by changing the way we deal with paper currency, we can safely have inflation hover around zero, instead of hovering around 2% per year.
- No, we can’t prevent all recessions, but we can make them short if we are prepared to use negative interest rates. If we repeal the zero lower bound, we should be able to do at least as well as we did during what macroeconomists called The Great Moderation: the period from the mid-1980s to the first intimations of the Financial Crisis that culminated in 2008.
- Indeed, with sound policy we should be able to stabilize the economy somewhat better than during The Great Moderation, both because we keep learning more about the best way to conduct monetary policy and because eliminating the zero lower bound makes it safe to strengthen financial regulation and thereby prevent some of the shocks that might cause recessions.