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Saturday, January 3, 2015

Negative Interest Rates And Abolishing Cash

There have been discussion of proposals to replace paper currencies with electronic money in order to allow governments to implement negative interest rates. Ken Rogoff recently published a working paper giving such a proposal, which helped kick off this discussion once again. Tony Yates discusses the latest round, along with links, in "John Cochrane, Ken Rogoff, cash-bans and the zero bound." (Although my economic viewpoint is quite different than John Cochrane's, once again I think his analysis is generally quite sensible in this instance.) I would argue that the desire to abolish cash is a sign that many economists are unable to learn from real world experience; if you find yourself in a hole, stop digging.

Negligible Negative Rates - Possible,  But Who Cares?



One used to read in various fixed income manuals that interest rates could not go negative. But as people who hard-coded this rule into pricers discovered the hard way, interest rates can go slightly negative. The theory was that people have the choice of holding currency, which has an embedded interest rate of zero, instead of bonds, and so nobody would buy bonds with a negative yield.

This is yet another example of the weakness of household-centric analysis used in mainstream economics. Fixed income trading is dominated by institutions, and they face various constraints on their behaviour. Other than banks that deal with vault cash, none are capable of storing cash safely. (And even banks would face capacity limits.) Additionally, large investors may not wish to hold money on deposit at private banks, since they will be beyond deposit insurance limits. Therefore, investors could be forced to hold government bonds with negative interest rates.

(In one of the earlier episodes of negative interest rates in Japan, my understanding was that foreign banks holding yen hit their counter party risk limits with Japanese banks. Since they did not bank directly with the Bank of Japan, they were forced into Treasury Bills. The Treasury Bill traders at the Japanese Banks saw this coming, and they bid up Treasury Bills so that they were at slightly negative interest rates. In this instance, the negative Treasury Bill rate was not intended by the Bank of Japan, which held the policy rate at zero.)

The "lower limit" on interest rates only binds if the interest rate on Treasury Bills is sufficiently negative that the banking system sees that it makes sense to start taking delivery of massive amounts of cash.

Therefore, under the current institutional framework, the true "lower bound" for interest rates is not 0%, but it is probably between -0.25% and -1%. Although it is possible to drive the risk free rate slightly below zero, this is unlikely to have much an effect on the economy. The reason why some economists want to abolish cash is that it would eliminate the ability of banks to store it in vaults, eliminating the constraint.


Situation In The Euro Area


The situation in the Euro Area is slightly more complicated by the reality that the currency area does not coincide with a viable political entity. Buying German bonds is a good way to position for the demise of the currency if you are forced to hold euros for some reason (such as living in the euro area, or an investor with currency constraints).

  • If the euro does not dissolve, your only cost is the lower carry on German bonds. This lower carry is the cost of your "euro catastrophe" insurance.
  • If the euro area loses a few weaker peripheral nations (such as Greece, Italy or France), the "euro rejects" will probably create new currencies that would be much weaker, and banking systems would be under severe pressure. German bonds would gain a lot of value in external purchasing power terms versus those alternative euro stores of value, even if there are limited gains when denominated in euro terms.
  • If the euro blows up completely, it seems unlikely that the Germans will repudiate their debt. You would likely be paid in the German successor currency, which would be stronger than the euro.

As a result, I would not gauge success of euro area policy by how negative a value German yields reach.

Forces A Shift To Electronic Money


If all money is electronic, administering a negative interest rate is easy to implement. Doing so with paper money is difficult, and would generate considerable costs for the private sector. (An example method would be to stamp an expiry date on currency, which would force retail establishments and households to scour their money to see if it is still valid.)

However, this would entail that all transactions would be tracked electronically. For those who are worried about government debt, this closes a lot of potential abilities to avoid taxes. However, this would mean that we would end up with a government that has even more capacity to monitor citizens than the government of Oceania in Orwell's 1984. (The rebellion of the protagonist - Winston Smith - was the purchase of a diary for "two dollars fifty" at a shop. Although the means of purchase was not given, it would have been even more dangerous to buy the book if all transactions were electronic and monitored by the state.)

An additional problem is the techno-optimism such a proposal entails. Electronic payment systems have been regularly hacked, and it seems like a bad idea to offer to transfer to make electronic transfers to every small business that you run into. Additionally, the assumption that the payments network will be continuously operating could run into difficulties as we transition into a future where more and more of our electricity will be sourced from intermittent sources. All commerce could grind to a halt upon any power failure.

The Costs Of Avoidance


Such a proposal would also predictably outrage a good number of people. This would create a large incentive to avoid currency that is being devalued by the central government. As a result, considerable efforts will be expended to find means to avoid holding money. Given the flexibility of contract law, this will not be too difficult.

As John Cochrane noted, commercial law enshrines the right to pay bills early. One method of avoiding holding money is pre-paying tax and other bills. Another method would be to create private currencies that do not depreciate, or to use a foreign currency. Normally, there is little incentive for most people in developed countries to avoid using their home currency, but a significant negative interest rate might do it.

Creating conditions to lose control of the currency used within your nation could be a spectacular policy error.

Why Do It?


The real mystery to me is why anyone would think such a radical step would help matters. In the United States and most other developed countries, real interest rates are quite negative. There was only a mild deflation in Japan, and currently in the Euro Area. To what extent neoclassical models work, the real rate of time preference cannot be negative, and so risk free interest rates are below households' time preference. Even so, there was little sign of an acceleration in economic growth. If the current policy of reducing interest rates has not worked so far, why will doing more matter?

If we drop the assumption that lower real rates are always stimulative, we can see why such a policy would make stagnation worse.
  • Negative interest rates are a tax. Increasing taxes is usually thought of as being a damper on growth.
  • People save for retirement. Lowering the interest rate forces increasing savings, which will lower growth rates. (See my discussion of stock-flow norms and "Secular Stagnation".)
  • It would drive investors to lend more money to even more dubious borrowers, which would increase the amount of capital that is destroyed by foolish investment decisions.
If growth is unacceptably slow, all you need to do is loosen fiscal policy. If you are a conservative, cut taxes. If you are a progressive, increase government spending. Only a fanatic believer in Ricardian Equivalence would dispute that such a step would not increase nominal GDP growth rates (at the minimum by raising the rate of inflation). And it is a lot easier to adjust tax rates than it is to build unneeded infrastructure for electronic payments.

(c) Brian Romanchuk 2015

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