Gauti Eggertsson, Ragnar Juelsrud and Ella Getz Wold: Are Negative Nominal Interest Rates Expansionary?

It is great to see people doing formal modeling of negative interest rate policy. And it is especially good to see work of this type by a team including Gauti Eggertsson, whose research I wrote so highly of in my post "Pro Gauti Eggertsson." I wish I knew Gauti's coauthors, Ragnar Juelsrud and Ella Getz Wold better. Since this was originally posted, I have corresponded with them. Ragnar sent me this link to an ungated version of the paper

One of the most remarkable things about this paper is that instead of saying that the lower bound on interest rates is inevitable it explicitly bills itself as showing why the lower bound on interest rates needs to be removed. On pages 5 and 6, Gauti, Ragnar and Ella write this:

There is a older literature however, dating at least back to the work of Silvio Gesell more than a hundred years ago (Gesell, 1916), which contemplates more radical monetary policy regime changes than we do here. This literature has been rapidly growing in recent years. In our model, the storage cost of money, and hence the lower bound, is treated as fixed. However, policy reforms can potentially alter the lower bound or even remove it completely. An example of such policies is a direct tax on paper currency, as proposed first by Gesell and discussed in detail by Goodfriend (2000) and Buiter and Panigirtzoglou (2003). This scheme directly affects the storage cost of money, and thereby the lower bound on deposits which we derive in our model. Another possibility is abolishing paper currency altogether. This policy is discussed, among others, in Agarwal and Kimball (2015), Rogoff (2017c) and Rogoff (2017a), who also suggest more elaborate policy regimes to circumvent the ZLB. An example of such a regime is creating a system in which paper currency and electronic currency trade at different exchange rates. The results presented here should not be considered as rebuffing any of these ideas. Rather, we are simply pointing out that under the current institutional framework, empirical evidence and a stylized variation of the standard New Keynesian model do not seem to support the idea that a negative interest rate policy is an effective tool to stimulate aggregate demand. This should, in fact, be read as a motivation to study further more radical proposals such as those presented by Gesell over a century ago and more recently in the work of authors such as Goodfriend (2000), Buiter and Panigirtzoglou (2003), Rogoff (2017c) and Agarwal and Kimball (2015). In the discussion section we comment upon how our model can be extended to explore further some of these ideas, which we consider to be natural extensions.

Gauti, Ragnar and Ella return to this theme on page 33, near the end of the main body of the working paper:

In our model exercise, the storage cost of money was held fix. However, one could allow the storage cost of money - and therefore the lower bound on the deposit rate - to depend on policy. One way of making negative negative rates be expansionary, which is consistent with our account, is if the government takes actions to increase the cost of holding paper money. There are several ways in which this can be done. The oldest example is a tax on currency, as outlined by Gesell (1916). Gesell’s idea would show up as a direct reduction in the bound on the deposit rate in our model, thus giving the central bank more room to lower the interest rate on reserves - and the funding costs of banks. Another possibility is to ban higher denomination bills, a proposal discussed in among others Rogoff (2017c). To the extent that this would increase the storage cost of money, this too, should reduce the bound on the banks deposit rate. An even more radical idea, which would require some extensions to our model, is to let the reserve currency and the paper currency trade at different values. This proposal would imply an exchange rate between electronic money and paper money, and is discussed in Agarwal and Kimball (2015), Rogoff (2017a) and Rogoff (2017b). A key pillar of the proposal – but perhaps also a challenge to implementability – is that it is the reserve currency which is the economy wide unit of account by which taxes are paid, and accordingly what matters for firm price setting. If such an institutional arrangement is achieved, then there is nothing that prevents a negative interest rate on the reserve currency while cash in circulation would be traded at a different price, given by an arbitrage condition. We do not attempt to incorporate this extension to our model, but note that it seems relatively straightforward, and has the potential of solving the ZLB problem. Indeed, the take-away from the paper should not be that negative nominal rate are always non-expansionary, simply that they are predicted to be so under the current institutional arrangement. This gives all the more reason to contemplate departures from the current framework, such as those mentioned briefly here and discussed in detail by the given authors.

My post that most directly expresses this point is "If a Central Bank Cuts All of Its Interest Rates, Including the Paper Currency Interest Rate, Negative Interest Rates are a Much Fiercer Animal"

Putting their model in the context of my post "The Supply and Demand for Paper Currency When Interest Rates Are Negative," they are treating the case of a Rate of Effective Return on Cash (ROERC) curve that is flat after a certain point. I argue in my post that is not the only plausible case. There are several other ways in which their model simplifies away from issues I have stressed on my blog:

1. Gauti, Ragnar and Ella deemphasize transmission mechanisms that do not involve banks, which I argue in three key posts are quite important:

However, even though there are transmission mechanisms that go around banks, causing problems for the banking system could easily be seen as an unacceptable side effect. I make this point in "What is the Effective Lower Bound on Interest Rates Made Of?"

2. In a way Gauti, Ragnar and Ella are very clear about, their model leaves out the subsidies that central banks pursuing negative interest rates can provide to private banks. Here is a key passage from pages 36 and 37:

Our model exercise focuses exclusively on the impact of negative policy rates39. Other monetary policy measures which occurred over the same time period are not taken into account. This is perhaps especially important to note in the case of the ECB, which implemented its targeted longer-term refinancing operations (TLTROs) simultaneously with lowering the policy rate below zero. Under the TLTRO program, banks can borrow from the ECB at attractive conditions. Both the loan amount and the interest rate are tied to the banks’ loan provision to households and firms. The borrowing rate can potentially be as low as the interest rate on the deposit facility, which is currently -0.40 percent40. Such a subsidy to bank lending is likely to affect both bank interest rates and bank profits, and could potentially explain why lending rates in the Euro Area have fallen more than in other places once the policy rate turned negative.

I have emphasized the importance of central bank subsidies to private banks in several posts:

3. In Gauti, Ragnar and Ella's model, if private banks tried to have negative rates on checking or savings accounts, all of their customers would turn to paper currency storage. But that is not the only possible interpretation of why they did not lower their checking and savings account rates below zero in negative interest rate companies. Thinking that even 5% of their customers would jump ship to another bank if they went first to negative checking and saving account rates would be enough to make these checking and saving account rates quite sticky at zero. But if the central bank took its target rate and interest on reserves into deeper negative territory, banks might lower their checking and saving account rates despite this fear. And if other banks followed suit, they might not lose as many customers as they feared.

In other words, isn't the first fear the fear of customers jumping to another bank if checking and saving account rates are reduced below zero, not paper currency storage? This would generate a stickiness that could be overcome in the way paper currency storage with a linear effective return of -.01 % annually cannot be overcome (without changing paper currency policy).

4. In line with much of the literature modeling monetary policy, Gauti, Ragnar and Ella do not have investment in the model. This makes their facsimile of the Great Recession in the model deficient. For what I consider a better model of the Great Recession, see "On the Great Recession."

Conclusion. I look forward to more articles doing formal models on negative interest rate policy. I wrote about paper that Gauti, Ragnar and Ella mention in "Markus Brunnermeier and Yann Koby's "Reversal Interest Rate." Matthew Rognlie has also written a nice paper in this genre: “What lower bound? Monetary policy with negative interest rates." 

I anticipate writing something in this genre myself at some point in the future. Right now my priorities in writing academic papers on negative interest rate policy are writing a second policy-focused paper with Ruchir Agarwal and a paper with Peter Conti-Brown on the law relevant to negative interest rate policies in the US. 


FocusEconomics: How Will the Fed Reduce Its Balance Sheet & How Will the ECB End QE? - 18 Economic Experts Weigh In

Link to the article above

I was one of the economists asked by FocusEconomics about where the Fed and European Central Bank are headed with QE. Here are the answers I contributed:

1. How do you think the Fed will unwind its multi-trillion dollar balance sheet resulting from its stimulus program without severely upsetting the bond and equity markets?

I expect the Fed to reduce reinvestment in mortgage-backed securities more, and possibly earlier, than they reduce reinvestment in long-term US Treasury bonds. The reduction in reinvestment will probably happen gradually, not all at once. There will be a pause in rate increases after the first announcement of reduction in reinvestment, both to compensate and for assessment.  

2. How will the ECB, which is still stuck in a quantitative easing cycle, be able to bring it to an end without plunging Eurozone countries into yet another financial crisis?

I think the ECB will move very slowly to cut back on its stimulus.

The key for avoiding another financial crisis is to keep raising effective capital requirements. If Trump appointees want to weaken or slow down the tightening of capital requirements, the key thing to watch is if European officials distance themselves from the US, saying they want tighter requirements than the US wants, or if they simply go along with a lean towards less strict capital requirements by the US. 


Lauren Razavi: India Just Flew Past Us in the Race to E-Cash

Link to Lauren Razavi’s post “India Just Flew Past Us in the Race to E-Cash”. Hat tip to and Joseph Kimball

What India’s government did in demonetizing the 1000-rupee and 500-rupee notes was a mess. But it did have the helpful effect of spurring mobile payments, both by the current inconvenience for paper currency and, as people look toward the future, reducing trust in paper currency. 

Two quotations from Lauren Razavi’s article linked above flesh out that story: 

1. All of this has created a newfound system that practically incentives mobile payment. With so many people queuing up at banks every day — and a lot of Indian bureaucracy to wade through in order to open a traditional bank account or line of credit —the appeal of more convenient digital alternatives is easy to understand. According to a report in the Hindu Business Line, as many as 233 million unbanked people in India are skipping plastic and moving straight to digital transactions.“Cash has lost its credibility and payments are no longer perceived in the same way,” says Upasana Taku, the cofounder of Indian mobile wallet company MobiKwik, which reported a 40 percent increase in downloads and a 7,000 percent increase in bank transfers since demonetization. “There’s chaos at the moment but also relief that India will now be an improved economy,” she says.

2. Before last month, Paytm, a mobile app that allows users to pay for everything from pizza to utility bills, saw steady business—it was processing between 2.5 and 3 million transactions a day. Now, usage of the app has close to doubled. 6 million transactions a day is common; 5 million is considered a bad day.

Reducing the Importance of Cash: Sweden and South Korea

Link to Bryan Harris and Kang Buseong’s article “South Korea to Kill the Coin in Path towards ‘Cashless Society’”

Although deep negative interest rates are straightforward to handle even when a currency region uses paper currency intensively, the needed changes in paper currency policy are likely to be seen as less upsetting to people when cash usage is low. Thus, even when the time has not yet come for more dramatic changes in paper currency policy, it is useful for public policy to encourage the replacement of cash by other means of transactions. 

Some countries are much further along in reducing cash usage than others. The article above points in particular to Scandinavian countries and South Korea. Two quotations:

  1. Globally, Scandinavian countries are leading the charge towards cashless societies. More than half of Sweden’s 1,600 bank branches neither hold cash nor take cash deposits.
  2. South Korea is already one of the least cash-dependent nations in the world. It has among the highest rates of credit card ownership — about 1.9 per citizen — and only about 20 per cent of Korean payments are made using paper money, according to the BoK.

In Sweden, cash usage is low and declining–so much so that I could point out that it made no sense in Sweden to let the “tail wag the dog” by letting paper currency get in the way of otherwise optimal interest rate policy.  

There are three key factors in the decline in cash usage in Sweden. First, some time back, Sweden stopped subsidizing cash usage. There is only one place in Sweden for banks to get cash from the central bank: at a cash window near Arlanda airport near Stockholm. Carting cash to or from anywhere else in the country must be paid for by someone other than an arm of the government.

Second, Swedish kronor are not that useful for international crime. Finland provides an interesting natural experiment. Until it joined the euro zone, cash usage was declining in Finland, paralleling what was happening in Sweden. But since Finland joined the euro zone, cash withdrawals have increased greatly. Why? The Finnish markka was not very useful in international crime. The euro is. 

Third, electronic forms of payment are advancing quickly in Sweden. For example, the mobile app Swish now makes it very easy for people in Sweden to transfer funds to anyone else with the app on their phone. 

It is not necessary to eliminate paper currency entirely to make deep negative interest rates possible. But it makes things easier both politically and practically if cash usage is already seen of as something of only marginal importance.  

Update: JP Koning points out another big factor in the decline in cash usage in Sweden, which he lays out in his post “Thoughts on Rogoff’s ‘Curse of Cash'”:

As discussed in this excellent post by Martin Enlund, the Swedes implemented a tax deduction in 2007 for the purchase of household-related services such as the hiring of gardeners, nannies, cooks, and cleaners. This initial deduction, called RUT-avdrag, was extended in 2008 to include labour costs for repairing and expanding homes and apartments, this second deduction called ROT-avdrag.

Enlund’s chart shows how the decline in krona outstanding closely coincides with the timing of the introduction of RUT and ROT:

Prior to the enactment of the RUT and ROT deductions, a large share of Swedish home-related purchases would have been conducted in cash in order to avoid taxes, but with households anxious to claim their tax credits, many of these transactions would have been pulled into the open. Note the rise in RUT and ROT payments on Enlund’s chart, for instance. Calleman reports that  the number of customers using registered domestic service companies rose from 92,000 in 2008 to 537,600 in 2013. Since the implementation of RUT and ROT, Swedish opinions on paying for undeclared work have changed dramatically. In 2006, 17% said it was completely wrong to to hire undeclared labour. In 2012, 47% felt it was completely wrong.

In passing, let me say that giving some kind of tax break or at least tax exemption for services provided at a low wage rate is also good for helping those near the bottom of the income distribution. It accords with many people’s intuitive notions of fairness. And it is helpful for efficiency as well–helping to make sure that ad hoc opportunities for gains from trade are not missed. And given the option of evading taxes by using cash, trying to tax such low-wage services may not in fact provide enough tax revenue to make current policies of trying to tax such services worth the bad side effects.

India’s Assault on Cash

Link to Amy Kazmin’s article “India’s cash chaos sparks growing backlash” on (the Financial Times website)

Link to Wikipedia article “Indian 500 and 1000 rupee note demonetisation”

Link to Raymond Zhong’s Wall Street Journal article “India’s Money Launderers Soil Modi’s ‘Spring Cleaning’ of Cash”

India’s sudden declaration that its existing 500- and 1000-rupee notes were invalid and needed to be replaced by new notes, with severe restrictions on that conversion is so far afield from my proposals for taming paper currency that I have been slow to write about it. Nevertheless, there are some interesting lessons to be learned. In this post, I will assume you know the basics. For that, the Wikipedia article flagged above is actually much better than the news accounts. Here are some of the lessons to draw and theoretical insights sparked by thinking about this episode:

First, the details of any modification in paper currency policy matter a lot. Getting the details wrong can make a big mess. 

Second, central banks and governments do big unexpected things. With a bit of care, there is no reason they can’t do big things that are well-designed and have much smaller side-effects instead of big things that are badly designed and cause a great deal of trouble.

Third, a policy that doesn’t depend on surprising people is likely to be better implemented, since policies can be planned and executed better if the depth of secrecy required is less and therefore more people can be brought in on the planning.  

Fourth, keeping large cash hoards is inherently risky, since almost all of the reasons one might want to keep a large cash hoard are reasons the government is likely to frown upon. In practice, governments are unlikely to tolerate the equivalent of what in the US would be the trillions and trillions of dollars of hoarded cash needed to enforce a lower bound on interest rates. (See “How Negative Interest Rates Prevail in Market Equilibrium.”)

Fifth, reducing the expected rate of return on paper currency relative to the rate of return on bank money causes a flight away from paper currency, not a flight toward paper currency. People in India are not saying “If we can’t freely turn in paper currency without restrictions and without documentation at the bank, let’s just quit dealing with the banks and instead use the cash the government is trying to invalidate for transactions instead.”

Sixth, it is important to think through all of the ways that people might try to get around something. Approaches that leave no way around (such as a gradually changing effective exchange rate for paper currency that makes the return on paper currency equal to the return on safe, short-term electronic rates) have a real advantage. 

Next Generation Monetary Policy: The Video

Starting at the 20:30 mark in this Mercatus Center video is my presentation “Next Generation Monetary Policy.” Here is a link to the Powerpoint file for the slides I used.

This was at a September 7, 2016 Mercatus Center conference on “Monetary Rules in a Post-Crisis World.” You can see the other sessions here. (Note the 1/5 in the upper left corner of the video. Click on that to access session 1 of 5, 2 of 5, etc.) 

18 Misconceptions about Eliminating the Zero Lower Bound (or Any Lower Bound on Interest Rates): The Video

My hosts at Chulalongkorn University in Bangkok were good enough to videotape my talk there and post the video on YouTube, as I encouraged them to do. In addition to being the only complete video so far of the presentation “18 Misconceptions about Eliminating the Zero Lower Bound,” (which is my main presentation at central banks on my Fall 2016 tour of European central banks as well), there is some excellent Q&A at the end of this video. 

How Negative Rates are Making the Swiss Want to Pay Their Taxes Earlier

Link to Ralph Atkins’s October 26, 2016 Financial Times article “Switzerland enjoys negative interest rates windfall: Taxpayers settle bills early and bond investors pay to lend money to government”

In “Swiss Pioneers! The Swiss as the Vanguard for Negative Interest Rates” I wrote:

there is no question that negative interest rates will require many detailed adjustments in how banks and other financial firms conduct their business. Like it or not, Swiss banks and the rest of the Swiss financial industry may be forced to lead the way in figuring out these adjustments, just as the Swiss National Bank is leading the way in figuring out how to conduct negative interest rate policy. The Swiss are eminently qualified for that pioneering role. The rest of the world would be well-advised to watch closely.

Some of the adjustments that need to be made in a negative rate environment are to the tax system. Recently, Swiss cantonal governments and the Swiss federal government have realized they can lower incentives for early tax payments, since low interest rates on other accounts provide an incentive to pay taxes early. Here are the two passages I found most interesting for the details reported:

Although Swiss retail banks have largely shielded ordinary bank customers from negative interest rates, companies face penalties for holding large amounts of cash. That has increased the appeal of incentives traditionally offered by Swiss cantons as well as the federal government for early tax payments.

Companies entitled to tax rebates had also waited to reclaim funds from the state, the finance ministry in Bern said. …

The federal government is not only enjoying a boost to its finances [from negative interest rates on its bonds up to a 20-year maturity]. It does not have to worry about paying charges on cash accounts either: it is specifically excluded from the negative interest rates imposed by the SNB, which acts as its banker.

All of these issues were quite predictable, but it is fascinating to see them actually playing out. This example is important because it indicates that some of the steps necessary to eliminate the zero lower bound that are not within the authority of central banks might be handled in a reactive way by other arms of government. 

Thanks to Ruchir Agarwal for pointing me to this article.

The Political Perils of Not Using Deep Negative Rates When Called For

Link to Jon Hilsenrath’s Wall Street Journal special report, updated August 26, 2016, “Years of Fed Missteps Fueled Disillusion With the Economy and Washington”

How well has what you have been doing been working for you?

People are quick to think that the political costs of deep negative rates to a central bank are substantial. But it is worth considering the political costs of not doing deep negative rates when the economic situation calls for it. Take as a case in point the failure of the Fed to do deep negative rates in 2009. Regardless of the reason for the Fed’s not doing deep negative rates in 2009, it is possible to see the consequences for the Fed’s popularity of the depth of the Great Recession and the slowness of the recovery. 

In his Wall Street Journal special report “Years of Fed Missteps Fueled Disillusion With the Economy and Washington,” Jon Hilsenrath tells the story of the Fed’s decline in popularity, and presents the following graphic: 

How Americans rate federal agencies

Share of respondents who said each agency was doing either a ‘good’ or ‘excellent’ job, for the eight agencies for which consistent numbers were available

The Alternative

There is no question that the Fed’s failure to foresee the financial crisis and its role in the bailouts contributed to its decline in popularity. But consider the popularity of the Fed by 2014 in two alternative scenarios: 

Scenario 1: The actual path of history in which the economy was anemic, leading to a zero rate policy through the end of 2014.

Scenario 2: An alternate history in which a vigorous negative interest rate policy met a firestorm of protest in 2009, but in which the economy recovered quickly and was on a strong footing by early 2010, allowing rates to rise back to 1% by the end of 2010 and to 2% in 2011.   

In Scenario 2, the deep negative rates in 2009 would have seemed like old news even by the time of the presidential election in 2012, let alone in 2014. In the actual history, Scenario 1, low rates are still an issue during the 2016 presidential campaign, because the recovery has been so slow. 

It Looks Good to Get the Job Done

At the end of my paper “Negative Interest Rate Policy as Conventional Monetary Policy” (ungated pdf download) published in the National Institute Economic Review, I discuss the politics of deep negative interest rates–not just for the United States, but also for other currency regions that needed them. My eighth and final point there is this:

Finally, the benefits of economic stabilisation should be emphasised. The Great Recession was no picnic. Deep negative interest rates throughout 2009 – somewhere in the –4 per cent to –7 per cent range – could have brought robust recovery by early to mid 2010. The output gaps the world suffered in later years were all part of the cost of the zero lower bound. These output gaps not only had large direct costs, they also distracted policymakers from attending to other important issues. For example, the later part of the Great Recession that could have been avoided by negative interest rate policy led to a relatively sterile debate in Europe between fiscal stimulus and austerity, with supply-side reform getting relatively little attention. And the later part of the Great Recession that could have been avoided by negative interest rate policy brought down many governments for whom thepolitical benefits of negative interest rate policy would have been immense. And for central banks, it looks good to get the job done.

Dan Bobkoff and Akin Oyedele: Economists Never Imagined Negative Interest Rates Would Reach the Real World--Now They’re Rewriting Textbooks

Link to Dan Bobkoff’s and Akin Oyedele’s October 23, 2016 Business Insider article “Economists never imagined negative interest rates — now they’re rewriting textbooks”

An October 23, 2016 Business Insider article emphasizes just how far negative interest rate policy has come in the last four years since I published “How Subordinating Paper Currency to Electronic Money Can End Recessions and End Inflation” (originally titled “How paper currency is holding the US recovery back”) and started following negative interest rate discussions closely. 

One of the big advances in fostering understanding of negative interest rate policy is the publication of Ken Rogoff’s book The Curse of Cash, which has a thorough discussion of the full-bore negative interest rate policy I distinguished from current negative interest rate policy 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.” (See my post “Ana Swanson Interviews Ken Rogoff about The Curse of Cash for more about the book.) Ken has been on the hustings promoting his book, and in the process greatly raising journalists’ and their readers’ understanding of negative interest rate policy. This article has some audio of Ken explaining negative interest rates. 

Here is what Dan Bobkoff and Akin Oyedele write about the remarkable progress of negative interest rate practice:

The policy has evolved from radical idea to mainstream policy of postrecession governments in Europe and Asia. And in the US, Federal Reserve Board Chair Janet Yellen has said the US will not rule out using them if it needs to. …

In textbooks like Mishkin’s, a 0% interest rate was known as the “zero lower bound.” It just didn’t seem to make sense to go below that.

Now economists have to rename it. …

Today, countries with negative policy rates make up almost a quarter of global gross domestic product, according to the World Bank.

One element of Dan’s and Akin’s article deserves further discussion. They touch on the difficulty of passing through negative rates to household depositors:

“It’s very hard to obviously get depositors to accept negative interest rates for putting their money in there,” said Marc Bushallow, managing director of fixed income at Manning and Napier, which manages $35 billion in assets.

What’s much more likely is that only big banks will be forced to pay to lend money to one another. That would exempt small depositors from paying, but still have some of the stimulus effects that the central banks intend to have.

Something I emphasize in my talks to central banks is that a central bank is better off letting private banks handle much of the pass-through because the negative in regular people’s deposit and savings accounts that are likely to be a political problem a central bank represent a customer-relations problem for private banks that the private banks are likely to handle relatively carefully.

I think of negative deposit rates for small household checking and savings accounts as a big enough political problem for central banks that I have been strongly recommending to central banks that they use a tiered interest-on- reserves formula that actively subsidizes zero rates for small household checking and savings accounts. If a central bank can announce that it is trying to avoid having regular people with modest balances face negative rates in their checking or savings account, it should dramatically mitigate the political costs to a central bank of a vigorous negative interest rate policy. 

I have written about subsidizing zero rates for small household accounts in a number of posts:

Courage on the part of central bankers plus smart efforts to mitigate the political costs of a vigorous negative rate policy can do a great deal to advance negative interest rate policy as an element of the monetary policy toolkit. Nations that have such courageous and shrewd central bankers can then return to the Great Moderation, while maintaining low inflation targets. 

Why Central Banks Can Afford to Subsidize the Provision of Zero Rates to Small Household Checking and Savings Accounts

The Bank of Thailand, which currently has a policy rate of only 1.5%, and so might need negative rates if there is a big shock to the Thai economy.  Image source.

The Bank of Thailand, which currently has a policy rate of only 1.5%, and so might need negative rates if there is a big shock to the Thai economy. Image source.

One of my key recommendations to central banks to reduce the political costs of a vigorous negative rate policy is to use the interest on reserves formula to subsidize the provision of zero interest rates to small household checking and savings accounts, as you can see in my posts “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies” and “Ben Bernanke: Negative Interest Rates are Better than a Higher Inflation Target” and “The Bank of Japan Renews Its Commitment to Do Whatever it Takes.” (Also see “How Negative Interest Rates Prevail in Market Equilibrium” for a discussion of how the marginal rates that matter most for market equilibrium can be negative even if many inframarginal rates are zero.) 

If rates become quite negative, this subsidy could become a significant cost to the central bank, since funds from private banks put into one tier of reserves would be getting a zero rate from the central bank, but after putting those funds into T-bills, the central bank could be earning a deep negative rate on those funds, say -4%. Nevertheless, I think central banks can handle the expense. This post explains why. (Talking to other economists at the Minneapolis Fed’s Monetary Policy Implementation in the Long Run Conference yesterday helped a lot in figuring this out.)

First, the transition to negative rates will create a large capital gain for the assets on the central bank’s balance sheet, while most of the central bank’s liabilities are shorter term or floating-rate liabilities and so do not go up as much in price. This includes paper currency as a liability, since in an electronic money policy that allows deep negative rates, the paper currency interest rate is a policy variable set equal to a rate close to the target rate. (See “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”)

Second, the fact that the central bank can create money means that it cannot face a liquidity constraint as long as it is ultimately solvent. And the ultimate solvency of a central bank must be judged in the light of all future seignorage the central bank is likely to earn, ever, even if that ability to earn future seignorage is not represented by any asset that can be immediately sold.

As long as the central bank is trying to stimulate the economy, there is no problem with it creating additional money to pay all of its bills, including to pay its losses on its holdings of negative-rate Treasury bills. When it is time to tighten, any central bank that can pay interest on reserves doesn’t have to have an asset to sell in order to tighten monetary policy. Interest on reserves can be paid by newly created reserves using a central bank’s fundamental authority to create money. As long as there will be seignorage someday sufficient to mop up those extra reserves, this is a perfectly good way to tighten monetary policy.

Third, what matters for the sustainability of paying positive interest on reserves once it is time to tighten is the amount of seignorage the central bank could earn if it needed to. In an emergency, an electronic money policy allows for the possibility of seignorage from paper currency interest rates below the target rate, say by as much as 5% below.

Fourth, the markets will expect that the central bank is ultimately backed by the fiscal authority. Note that because it faces no liquidity constraints, the central bank can always wait and wait and wait for a very propitious time to beg the fiscal authority for an infusion of funds. And the markets know this. So the solvency of the central bank depends on the willingness of an exceptionally favorable fiscal authority at some future date to give it an infusion of funds. (To that exceptionally favorable fiscal authority, the central bank can argue that the deep negative rates that cost it a lot in subsidies saved the fiscal authority a lot of interest expense.)

Fifth, given whatever large present value of subsidies to support zero rates to small household borrowers a central bank has the resources for, the central bank can afford to front-load the subsidies. Deep negative rates will probably be needed only for a short time, and if necessary, an announcement that without help from the fiscal authority the cap on the amount subsidized for a zero rate in checking and savings accounts will have to be gradually reduced will probably get some help from the fiscal authority, and if not can actually be carried out.

The bottom line is that a central bank is unlikely to get into serious budget trouble from subsidizing zero rates for small household accounts even if it takes rates to a quite deep negative level.

Judy Shelton Off-the-Mark on Monetary Policy

Link to Judy Shelton’s October 11, 2016 Wall Street Journal op-ed “A Trans-Atlantic Revolt Against Central BankersConservative leaders in the U.S. and Britain are standing up for those left behind by ultralow rates.”

In an October 11, 2016 Wall Street Journal op-ed, Judy Shelton manages to be wrong on many counts about monetary policy, but wrong in an instructive way. Let me answer her points. 

First, Judy does helpfully quote Maury Obstfeld and Christine Lagarde–both of whom are exactly right. Maury points out the political consequences insufficiently stimulative monetary policy among other economic problems: 

… as IMF chief economist Maurice Obstfeld recently told the press, the problem has to do with the political consequences of sluggish economic performance. “In short, growth has been too low for too long,” he said, “and in many countries its benefits have reached too few, with political repercussions that are likely to depress global growth further.”

Christine Lagarde is exactly right in pointing out the monetary policy can do more. In particular, negative interest rate policy is still in its infancy, and could go a lot further

In a Sept. 28 speech at Northwestern University, IMF Managing Director Christine Lagarde dismissed as “pessimists” those who think central banks are not stimulating economic growth. “In my view, there is more policy space—more room to act—than is commonly believed,” she declared. “Monetary policy in advanced economies needs to remain expansive at this stage.”

Having just returned from visiting the Bank of Japan (where I communicated the message of my advice in “The Bank of Japan Renews Its Commitment to Do Whatever it Takes” with this Powerpoint file–pdf download), the Bank of Thailand, Bank Indonesia and the Bank of Korea in the past two weeks, I am headed at the beginning of next month on a tour of European central banks to try to expand the set of options European central banks are actively thinking about. Copying over from the cumulative itinerary I keep updating in my post “Electronic Money: The Powerpoint File”

  • Sveriges Riksbank (Stockholm), October 31-November 1, 2016
  • Austrian National Bank November 2-4, 2016
  • Bank of Israel, November 7-8, 2016
  • Brussels Conference on “What is the impact of negative interest rates on Europe’s financial system? How do we get back?” sponsored by the European Capital Markets and Institute (ECMI), the Centre for European Policy Studies (CEPS) and the Brevan Howard Centre for Financial Analysis, November 9, 2016
  • Czech National Bank, November 10-11, 2016
  • European Central Bank, November 14-16, 2016
  • Bank of International Settlements, November 17, 2016
  • Swiss National Bank, November 18

1. Besides rejecting Maury’s and Christine’s sage words, Judy’s first mistake is to assume, that low interest rates exacerbate inequality. Judy writes: 

The monetary policies enacted by the world’s leading central banks are a predominant mechanism for doling out differential financial rewards—exacerbating income inequality in the process. The Federal Reserve’s ultralow interest rates, intended to stimulate economic growth, have flooded wealthy investors and corporate borrowers with cheap money, while savers with ordinary bank accounts have been obliged to accept next-to-nothing returns.

Judy does have company in this mistake:

British Prime Minister Theresa May took on her own nation’s central bank in an Oct. 5 speech at her Conservative Party’s annual conference. “People with assets have got richer,” she said. “People without them have suffered. People with mortgages have found their debts cheaper. People with savings have found themselves poorer.”

The problem with this view is that there is strong, mechanical tendency for those who are lending to have a higher net worth than those who are borrowing. Thus, if low interest rates hurt lenders and help borrowers, it seems much more likely that this reduces inequality. And many of those who are wealthy and yet are borrowing in a big way are the entrepreneurs and firms investing in factories, software and R&D that are so important to the progress of an economy. And many firms borrow with long-term corporate bonds that commit to levels of coupon payments that don’t immediately change with fluctuations in short-term interest rates. It is true that lucky homeowners contribute a great deal to inequality, but leaving aside the travesty of the Great Inflation of the 1970′s, this has had at least as much to do with capital gains in markets where construction is overly restricted as to interest rate fluctuations. 

2. Donald Trump is a little more on target in identifying those hurt by low rates–not those who are especially poor, but those who have been big savers who don’t like risk:

Mr. Trump readily admits that, as a developer, he likes low interest rates; at the same time, he recognizes that others have been penalized by the Fed’s monetary-policy decisions. As he said in a Sept. 12 CNBC interview: “The people that were hurt the worst are people that saved their money all their lives and thought they would live off their interest, and those people are getting just absolutely creamed.”

But this statement is still wrong, because it overestimates the power of the Fed and other central banks. In particular, the idea that central banks can initiate higher rates and keep them permanently higher is a myth exaggerating the power of central banks. In “Mark Carney: Central Banks are Being Forced Into Low Interest Rates by the Supply Side Situation” I talk about Bank of England chief Mark Carney’s eloquent explanation of how central banks must take as given what the natural rate of interest is. If they keep interest rates higher than that natural rate, it will hurt an economy badly, which will probably require lower rates to fix. Mario Draghi said something similar and similarly true, as I lay out in “Mario Draghi Reminds Everyone that Central Banks Do Not Determine the Medium-Run Natural Interest Rate.”

Central bankers are just making false excuses if they ever say they can’t stimulate more. But in the current environment, it is the truth when they say that the natural rate is low enough that they can’t stimulate effectively without having shockingly low rates

Somewhat paradoxically, the only time central banks are to blame for persistently low rates is if they have previously failed to make rates low enough. Because the Fed did not have a -6% rate back in 2009 as the Taylor rule would have recommended, the Great Recession dragged on, and zero rates persisted for seven years, 2009–2015, with very low rates in 2016 as well. Moreover, because no central bank in modern times has yet demonstrated a willingness to use deep negative rates, or to have even a small nonzero paper currency interest rate, the markets factor in the chance of a continuing slump up against a lower bound on interest rates. Demonstrating clearly that central banks have and are potentially willing to use much, much more ammunition if needed would do a lot to allay this fear and thereby possibly bring up long-term rates. 

3. It is interesting judging Judy’s statement that 

… unconventional monetary policy has failed to deliver the anticipated boost to growth. 

I suspect that, whatever the brave face they put on in public in order to maximize positive expectations, central bankers were always quite uncertain about how big the effect of quantitative easing would be. Since the simplest optimizing theories say that quantitative easing has no stimulative effect at all, the actual effect of quantitative easing was always going to depend on mechanisms that were not well understood. So anyone sensible would have had a large standard error on their estimate of the likely effective of quantitative easing. And similarly, there is reason for a large standard error on any estimate of the undesirable side effects of quantitative easing–particularly at dosages that higher than those that have been used so far. 

By contrast, simple theories say that negative real rates should have essentially the same effect regardless of whether they come from high rates of inflation or from nominal rates. So “anticipated boost to growth” is a much more tightly defined phrase in relation to negative interest rates. But we know that responding to a recession historically requires something like a 5 or 6 percentage point reduction in short-term interest rates to get historical norms of recovery speed. And presumably a major financial crisis like that toward the end of 2008, after having been allowed to fester, could easily require a bigger reduction in rates to offset by monetary policy. 

Given the moderate negative rates so far, relatively well-established numbers for the effect of interest rate cuts would not suggest any bigger an impact than we have seen from negative rates. And as I point out 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,” historical norms of the effect of interest rate cuts apply, strictly speaking, only when the paper currency interest rate is kept in line or below other interest rates.

4. Judy’s assertion     

… the Fed’s large-scale interventions in credit and investment markets have created significant distortions that threaten financial stability. We can’t expect Main Street to passively absorb the costs of a future Wall Street bailout; there is a limit to public patience with monetary policy that not only smacks of favoritism but might also be causing more harm than good.

understates the power of high capital requirements and low leverage limits to stabilize the financial markets once negative interest rate policy frees one from worrying about insufficient aggregate demand. Let me reproduce here my diagram from “Why Financial Stability Concerns Are Not a Reason to Shy Away from a Robust Negative Interest Rate Policy,” which is explained more there: 

5. Finally, Judy is one-third right in saying

Money should function as a reliable measuring tool and dependable store of value—not as an instrument of government policy.

Money should indeed function as a reliable measuring tool. Negative rate policy makes it possible to do short-run stabilization while maintaining a zero inflation target that preserves money as a reliable measuring tool. 

On the other hand, dependable stores of value should be more closely linked with the real side of the economy than money is. The zero lower bound problem that made the Great Recession and its sad aftermath drag on for so long comes from making money too good a store of value relative to the real investments in the economy that we need people to be making. 

Finally, I think money is needed as an instrument of short-run economic policy. The alternative of short-run variation in government spending and taxing to stabilize the economy is much, much more troublesome. Short-run fiscal policy distracts greatly from long-run fiscal issues. Also, because short-run fiscal policy takes legislative time, it distracts from supply-side reform in a way that monetary policy does not. 

It is one thing to say that government policy about money ought to be something simple like stabilizing the growth rate of nominal GDP as Milton Friedman recommended. It is quite another to say that money shouldn’t be an instrument of government policy at all. The only “neutral” monetary policy I know of is a monetary policy that is actually quite sophisticated: something like “conduct monetary policy so that the economy stays at the natural level of output” or “stabilize the growth rate of nominal GDP.” The idea that a neutral monetary policy that will get good results can be something simpler than that is a will-o’-the-wisp that will forever elude the grasp of those searching for it.  

Conclusion: No one should be allowed to get away with the kind of claims that Judy Shelton makes in her op-ed without directly answering the kinds of objections I just made to those claims. The sheer repetition of claims like the ones Judy makes does not make them true. They need to be defended.

More on Original Sin and the Aggregate Demand Effects of Interest Rate Cuts: Olivier Wang and Miles Kimball

Link to Wikimedia Commons page for “Girl with a Pomegranate” by William Bouguereau . The pomegranate connects to the classical Greek myth of  Persephone  as well as not being excluded by the Bible as a possibility for the forbidden fruit whose consumption constituted original sin.

Link to Wikimedia Commons page for “Girl with a Pomegranate” by William Bouguereau. The pomegranate connects to the classical Greek myth of Persephone as well as not being excluded by the Bible as a possibility for the forbidden fruit whose consumption constituted original sin.

In response to my post “How the Original Sin of Borrowing in a Foreign Currency Can Reduce the Effectiveness of Monetary Policy for Both the Borrowing and Lending Country” I received an interesting email from MIT graduate student Olivier Wang that led to the exchange below. (You will need to read “How the Original Sin of Borrowing in a Foreign Currency Can Reduce the Effectiveness of Monetary Policy for Both the Borrowing and Lending Country” first in order to understand this exchange. I am grateful to Olivier for permission to share this with you:

Olivier: I am a graduate student at MIT and I’ve been enjoying your blog a lot, so thank you! I’ve worked on some of the issues in your post on foreign currency borrowing. Whether a “depreciation makes debts look larger” depends on the pass-through of exchange rate to import prices. In the extreme but most studied case where prices are sticky in the foreign exporters’ currency and the depreciation is fully passed through (an assumption known as PCP), the real external debt burden stays invariant and original sin does not prevent monetary policy from stimulating the economy.

Another popular way to model contractionary depreciations has been to add a financial accelerator. If firms’ investments is constrained by their net worth, the depreciation will hurt the net worth of the currency mismatched firms and this effect might dominate the boost to net worth induced by the expenditure switching of consumers towards domestic goods.

Miles: Thanks for letting me know about this. I confess I don’t understand this:

One detail I emphasize there is that whether a “depreciation makes debts look larger” depends on the pass-through of exchange rate to import prices. In the extreme but most studied case where prices are sticky in the foreign exporters’ currency and the depreciation is fully passed through (an assumption known as PCP), the real external debt burden stays invariant and original sin does not prevent monetary policy from stimulating the economy.

If the thing I (the debtor-in-foreign-currency country) am exporting has a world price, then I effectively have another asset that goes up in value relative to my own currency when my currency depreciates. But if it isn’t that, I don’t understand the paragraph above at all. Could you help me out by trying to explain this to me a little more?I do understand the financial accelerator better. I should mention that sometimes wealth is not just wealth but also collateral.

Olivier: Apologies for being too cryptic. Suppose that as a consequence of an interest rate decrease, the Chilean exchange rate depreciates from 1 to 1.1 pesos per dollar. If I am a Chilean firm or household owing $100 abroad, my debt will indeed jump to 110 pesos, making me cut back on investment or consumption. But if the price of the foreign goods that I import (such imports being why I have this dollar debt in the first place) are set in dollars and don’t move much in the short run, their peso price also jumps by 10%, which makes me substitute towards domestic varieties of the same goods or simply buy different domestic goods (whose peso prices are also fixed in the short-run).

As everybody in the country does so, my own peso income also increases, and under these extreme pricing assumptions, the general equilibrium feedback and the reevaluation of the foreign currency debt net out, and the interest rate cut remains expansionary. Still, the economy is less stimulated than if the debt were denominated in pesos, as in this case an unexpected depreciation would directly transfer wealth from foreign creditors to domestic debtors.

If however the sticky price of half of my imported goods is set in pesos, the depreciation will only raise the price of the basket of imports by 5%, and the debt reevaluation will dominate. Taking this into account, the Chilean central bank might decide not to cut rates so much in response to domestic shocks.

All this is on top of the increased peso revenue from my exports that you mention, and which would be the most relevant effect in the case of Chile.

Miles: Thanks, Olivier! So a substitution effect toward domestic goods raises aggregate demand. I missed that.

Ana Swanson Interviews Ken Rogoff about “The Curse of Cash”

I highly recommend Ken Rogoff’s new book, The Curse of Cash. It has several chapters that touch on my proposal to engineer a nonzero rate of return on paper currency by taking paper currency off par. The other main part of the book is about the crime-control benefits of eliminating high-denomination bills–and perhaps having physically large, but low-value coins as the only form of hand-to-hand currency. 

I was an official reviewer of the book, and in that capacity strongly urged the publisher to get the book in print as soon as possible. Here is my blurb that is included in the book: 

The Curse of Cash is brilliant and insightful. In addition to giving a vivid picture of the cash-crime nexus, The Curse of Cash is the book everyone should read about negative interest rates. –Miles Kimball

Ana Swanson of Wonkblog interviewed Ken Rogoff about The Curse of Cash. Here are some interesting quotations from Ken Rogoff in that interview that focus on monetary policy:

1. … the fact that monetary policy has been paralyzed because of the zero lower bound has hurt, and it will hurt in the next recession. The European Central Bank, the Nordic central banks, the Bank of Japan, they have tiptoed into negative rate territory, but they haven’t been able to do much, because they’re worried about the run into cash.

If you look at what’s happened in Europe and Japan, Japan has done quantitative easing on a scale that’s already triple what the U.S. has done. Europe is on track to buy up 20 percent of all corporate bonds within the time frame of their new quantitative-easing policy, and it’s not working very effectively. I think negative interest rates would be vastly more effective. Central bankers can’t come out and say that, but I think they all wish they had that tool. Not so they could use it today, but if something really bad happens.

2. There are other ways to do it. You can basically tax currency, by charging people when they turn currency in at the bank, which is an idea that I trace back to Kublai Khan.

3. … if you can go to a negative interest-rate policy, it’s going to depreciate the exchange rate. That said, if you wait a year or two after the policy, the negative interest rate will be gone, the U.S. economy will have strengthened, and the dollar might be higher than where it started. It’s certainly going to be controversial, but it might not be as bad as what we have now. Now no one really knows what central banks are going to do, because they’re flailing away at the zero bound trying to find something that works, and it creates an enormous amount of uncertainty.

So negative interest rates are going to come. Central bankers need them in the current environment. In 10 to 15 years, certainly in 20 years, if it’s needed, they’ll have figured out how to do it. And when they finally find a way, I think it will be regarded as leading to a better and healthier financial system.

The second quotation is referring elliptically to my proposal, which Ken discusses in detail, quite approvingly, in the book.