Ken Rogoff: Paper Money is Unfit for a World of High Crime and Low Inflation

The day when the zero lower bound is finally eliminated continues to inch closer. Ken Rogoff–who is not only a deep-thinking economist, but continues to be a policy heavyweight despite the weak hand he and Carmen Reinhart made the mistake of playing in relation to national debt and economic growth–has come out in favor of eliminating the zero lower bound.  He followed up a new NBER Macroeconomics Annual Chapter “Costs and Benefits to Phasing Out Paper Currency” with a May 28, 2014 article in the Financial Times: “Paper money is unfit for a world of high crime and low inflation.” Ken’s argument is straightforward:

Has the time come to consider phasing out anonymous paper currency, starting with large-denomination notes? Getting rid of physical currency and replacing it with electronic money would kill two birds with one stone.

First, it would eliminate the zero bound on policy interest rates that has handcuffed central banks since the financial crisis. At present, if central banks try setting rates too far below zero, people will start bailing out into cash. Second, phasing out currency would address the concern that a significant fraction, particularly of large-denomination notes, appears to be used to facilitate tax evasion and illegal activity.

As disadvantages of eliminating paper currency, Ken lists loss of seignorage and loss of anonymity where anonymity might be socially valuable in allowing personal experimentation that does not harm others. On both of those counts, keeping paper money in a subsidiary role can avoid these disadvantages. In particular, if paper currency is allowed to depreciate in relation to electronic money, it is possible to have seignorage without inflation, since if there is no inflation relative to the electronic money that serves as the unit of account, inflation relative to paper money is not really inflation at all.

Ken gives appropriate credit to Willem Buiter for working out theoretically the basic options of eliminating the zero lower bound:

The idea of finding creative ways to get around the zero bound on interest rates has been championed for more than a decade by Willem Buiter, a former UK Monetary Policy Committee member. Phasing out paper currency is by far the simplest. With electronic payments mechanisms becoming increasingly prevalent even in small transactions, and with the supply of paper currency overwhelmingly top-heavy with large-denomination notes, the case for keeping the currency status quo has weakened.

In my own recognition of Willem’s contributions, Willem appears as “Willem the Wise Warlock” in “The Story of Ben the Money Master.” (See also “Henrik Jensen: Willem and the Negative Nominal Interest Rate”

Ken argues that, of the options Willem lays out “Phasing out paper currency is by far the simplest.” Simplest is not necessarily best in this case. Although phasing out of paper currency may well be the ultimate destination for our monetary system, I continue to believe that at least as a transitional phase, it is attractive to start with monetary system that is as close as possible to the current system, consistent with eliminating the zero lower bound: the system I have written about repeatedly, in some detail, and have been explaining at central banks around the world.

Once the zero lower bound has been eliminated with a system as much like the current monetary system as possible, it is easy, if desired, to make a transition toward less use of paper currency by allowing paper currency to depreciate without ever appreciating it back to par. The quicker the depreciation of paper currency, the bigger the tax on activities that depend on then anonymity of paper currency–many of which (like criminal activity) do indeed deserve to be taxed. The higher the tax on paper currency (that is, the quicker the depreciation), the closer the monetary system would approximate the abolition of paper currency.

Note: Negative interest rates themselves are not a tax. When interest rates are negative, the money paid by the lender as a “carry charge” goes to the borrower, not the government. But setting a paper currency interest rate below the central bank’s target interest rate is a tax. In the system I have been advocating, the tax on paper currency is actually less than under the current system, since (a) inflation would be lower and (b) there would only be negative interest rates on paper currency when the central banks’ target rate was also negative, and the paper currency interest rate would be kept very close to the target interest rate during that period of negative rates.)