The Economy’s Not a Rock, and Paper Isn’t Killing It

Matt Yglesias writes that paper money kills economies because it institutes an effective lower bound on interest rates, the primary instrument of monetary policy. People like Miles Kimball have long argued that the “zero lower bound” and, hence, liquidity trap is basically a “policy choice” – a consequence of our cash economy. That is to say, under an electronic money system, we can easily implement negative nominal interest rates, giving monetary policy infinite power at all times.

The best way to think about this is imagine we all had dollar bills whose purchasing power was proportional to the length of the note, and the government can change the rate at which the note evaporates at will. If the rate of paper evaporation is increased, money demand will fall as consumers and investors across the world will throw cash for goods, services, and assets propping up a rapid recovery. In fact, the government doesn’t even have to increase the rate of evaporation, as long as it merely announces a credible intention to do so in the future.

But central banks can’t credibly announce the coming of negative interest rates, not the least because it isn’t physically possible in our current paradigm. Does that mean paper money is killing the economy…? I think not, for several reasons. Primarily, paper electronic money would be a superior choice to current monetary policy (and I, personally, have no animus towards accepting the future. Note that I’ve always hated carrying around cash, and don’t even have a wallet, so I love my electronic money, also known as Visa. But a lot of people use cash, and this would distributionally hurt them the most). But what we might call “conventionally unconventional” policies of quantitative easing are not out of steam.

Even Paul Krugman, the high priest of “monetary policy probably can’t gain traction in a liquidity trap”, agrees this has nothing to do with economic constraints of monetary policy as much as the conservatism of the central banking profession. That is to say, no one believes the central bank is sufficiently radical. In which case, we ask, what exactly is the point of militating for the abolishment of paper money – which is a far more radical experiment altogether?

Kimball – and maybe Yglesias – might argue that bringing it to the front of economic dialogue will make it easier for future crises to be handled effectively. But that would suppose getting rid of paper money is somehow fundamentally better than other unconventional options – given central banks were the right level of radical. We must make this stipulation because it makes no sense comparing a world where we are too timid to follow the policies proposed by Scott Sumner or Paul Krugman, but crazy enough to burn away paper.

And this contention is questionable at best. For example, even with negative interest rates, the central bank would need to set some sort of policy target. A lot of bloggers and forward-thinking economists like the idea of a nominal income target. I think Paul Krugman prefers a 4% inflation target (I don’t really know). If the latter – a higher inflation target – was the “optimal” solution between the two, then electronic money is most likely superior. The only point of a higher inflation target is to vastly reduce the risk of future recessions driving the equilibrium interest rate to the point of liquidity trap (and maybe reducing the effect of wage rigidities, but nominal targeting would accomplish this as well), and there’s some evidence that this is not optimal. (Edit: though still far, far better than current policy).

For reasons noted here, I don’t think a higher inflation target is superior to nominal income level targeting. In this case, it’s worth wondering whether negative interest rates really add a whole lot to the monetary policy arsenal, again, provided, markets didn’t think the central bank was skittish about its policies. The answer, I expect, is a probable “no” for reasons listed below:

  • A nominal income target works as much through expectations of action as much as action. So once such a regime is credibly instituted, money velocity is unlikely to fall as much as it did even during a pretty serious crash. This doesn’t require lower interest rates.
  • proper quantitative easing plan can very easily provide above expectations with adequate firepower. What would such a plan look like? A symmetric Evans Rule. That is, for every month that the Federal Reserve misses its nominal income target, the scale of asset purchases are increased by some percent n. The exponential growth here would immediately convince investors that inflation is coming, stabilizing nominal income growth.

The only reason we would need negative interest rates under a nominal income target is if quantitative easing was somehow less welfare efficient than negative interest rates. This is likely to be the case if the central bank was forced to inject liquidity via the purchase of many private assets. However, with government debt levels where they are, this is not a significant concern, and can always be fixed with the issuance of higher maturity debt.

Another contention might be that it is easier to implement a “rules based” rather than “discretionary” monetary policy with the ability to vary interest rates below zero. While there is a sense that quantitative easing is discretionary, that only has to do with the conservative nature of the Federal Reserve, and there’s no reason why following a Taylor Rule when rates exceed zero, and an “exponential growth of asset purchases” when rates fall below zero is any more discretionary. It’s just as algorithmic, but with one extra condition. Die hard monetarists even want to institute a “nominal income prediction market” which would remove the discretionary element of maintaining the rule entirely.

Michael Woodford or Paul Krugman’s preferred monetary policy – “credibly promising to be irresponsible” – might be better achieved under negative interest rates but, even then, that’s not a clear conclusion. If central banks can’t credibly commit to keep interest rates at zero for a long time due to institutional conservatism, I’m not sure how we could a) abolish paper money, and b) credibly convince the market that we’ll bring them below zero for long enough. That the Bank of Japan increased interest rates whenever the economy was just about to recover is an example of this difficulty.

Anyway, if Bernanke could somehow promise that interest rates will be zero on January 01, 2017 there’s a very good chance we’d hit escape velocity from the liquidity trap. And that’s a less radical promise than getting rid of paper money altogether. (Can you imagine what Austrians and their ilk who dominate America’s policy minds on both sides of the aisle would say about NEGATIVE interest rates?) By the time we reach a political consensus that paper money is archaic, we’ll have a far better monetary policy to begin with by virtue of the fact that it is less radical. (Not to mention the fact that in modern markets simply holding a foreign currency won’t be a bad choice, either).

I sometimes feel arguments for a negative interest rate are substituted in place of arguments for a better policy target. But the latter is the important debate, and the former is only a tool to achieve the latter. If an optimal target necessitated negative interest rates, I’d be writing about them every day. But I’ve yet to see an argument why a nominal income level target requires negative interest rates. Importantly, the central bank can technically levy a penalty on excess reserves which has the same benefits.

Paper money is killing the economy, but so is central bank conservatism. The former is just a symptom, the latter a disease.

  1. Benjamin Cole said:

    Excellent blogging. As Milton Friedman would say (in this context) “Print, baby, print.”

  2. Good stuff. Some comments:

    “Michael Woodford or Paul Krugman’s preferred monetary policy – “credibly promising to be irresponsible” – might be better achieved under negative interest rates but, even then, that’s not a clear conclusion. ”

    Actually, the whole point of being able to set negative interest rates is so you don’t have to credibly promise to be irresponsible. It allows a central banker to reduce the return on reserves in the present (to some negative amount) rather than having to promise a future reduction in returns. It’s just a continuation of the conventional policy of manipulating interest rates that we had during the Great Moderation, except with the possibility of going negative — Greenspan, for instance, never had to commit to being irresponsible, he just lowered the overnight rate.

    “what exactly is the point of militating for the abolishment of paper money – which is a far more radical experiment altogether?”

    Aren’t you focusing in on the wrong experiment? Remember, Miles’s plan isn’t necessarily about abolishing paper. It’s about introducing a variable conversion rate between paper and deposits. If you think about it, this strategy isn’t even an experiment, actually. It’s very similar in concept to policies adopted in the late 1800s to go off the bimetallic standard and onto a pure gold standard. Rather than enforce a fixed ratio between gold:silver, authorities let the ratio float. That way the economy needn’t revert between gold and silver every few decades. Doing the same with notes:deposits means that we won’t experience mass movements from deposits to notes when the ZLB becomes a problem.

    “and an “exponential growth of asset purchases” when rates fall below zero is any more discretionary.”

    But that’s the whole problem. Rates can’t get below 0 because of the existence of 0% cash. No amount of QE will ever be able to make rates fall below 0.

    That isn’t to say that huge QE can’t have some effect on the price level. By promising to keep huge amounts of reserves outstanding in the future, a central bank can lower today’s return on reserves and inspire movements today out of reserves into other goods and assets. Near term bills will fall to 0%, and eventually mid-term bonds will hit 0%, and finally long term bonds will fall towards 0%. The problem here, as Miles points out, is that we lose any sort of term structure of interest rates. Reducing rates below 0%, on the other hand, preserves the existing term structure of interest rates. Insofar as the term structure provides important information to economic actors, we may desire to preserve it rather than distort it.

    • Thanks for the comment.

      That’s a fair point about negative interest rates removing the need to credibly promise anything. But if we can credibly promise to be irresponsible, and that would work, why don’t we just do that instead? Why institute a system that’s not necessary and more radical? Speaking of which, I like the comparison with bimetallism, but that surely does not make this any less “radical”, so to speak? When I say radical I mean how “big a policy shift” is it. And I see “irresponsible” central banks or mass QE as a far smaller shift.

      You say QE can’t bring rates below zero. But QE can certainly signal a lot of inflation and real rates are what matter.

  3. Lawrence Bagshaw said:

    Surely the point of an economy is to create wealth by the free exchange of good and services. The key point within this is that money has to be a store of wealth. If you create negative interest rates simply in order to induce people to spend more discretionary income, you will find that people spend less of their discretionary income in order to compensate for reduced purchasing power arising as a consequence of rate manipulation.

    By way of example, if I spend $100,000 per year but realise that my savings of, say, $200,000 are losing value at the rate of say, 5% pa, I will reduce my annual expenditure to $90,000in order to save an additional $10,000.

    You would force me to do this to protect my savings.

    The big question which needs answering is how far we take currency debasement in the interests of full employment versus preserving the value of money as a store of wealth.

    It’s a difficult question but the answer lies in the question itself: debasement is manipulation and therefore is an act of economic dishonesty. If preserving money as a store of wealth were to be prioritised then clearly unemployment would be far higher but we would be managing our economy with clarity and integrity.

  4. It seems to me you are thinking in a bubble. if the US implemented such radical negative interest rates so would china, japan, the EU. Gosh! I wonder where that would end…?

  5. Removing paper money is just another step on our Perilous Quest for Perfect Money. Throughout time we have sought to change the money supply to something that can be spent faster and further with more distant strangers. the key word is ‘trust’. How do you trade with a stranger you might not trust? We’ve gone from commodity money, to commodity backed money, to gold and silver, to paper claim, and now electronic numbers. Guess what? We still have recessions. Recessions are not caused by a problem with the money supply, but by people who cannot settle their debts.

    There’s a reason for that: because the energy dividend released by complexity must always be smaller than the energy needed to create it, there will always be more consumers than producers. In a world where the money supply has gone from 100% savings-based specie, i.e. gold, silver and copper coins, to 97% interest-bearing credit there will always be people who can’t repay their debts. the continual robbing of savers to ameliorate this circumstance will merely propagate the mother of all meltdowns.

    it’s not economics, not even scamonomics, it’s thermodynamics.

    Best to let bad debt fail and be written off. small crashes make a system more stable than once in a lifetime big ones.

  6. cig said:

    Bernanke can easily promise interest rates at 0 (or wherever he wishes) in January 2017: he just needs to place a limit order at that price for the corresponding January 2017 dollar interest rate future, with an infinite quantity, funded by the Fed’s infinite liquidity.

  7. So everyone sells their over-priced treasuries and mortgages to the Fed, then what? The savings market has electronic cash and needs to do something with it. There’s no point buying any debt it’s losing money. So, in the first instance everyone sends their savings abroad destroying the US banking system. If capital controls were enforced (so much for the land of the free!) then Americans would buy gold, silver and classic cars. If you wanted to borrow money you would enter into a private repo deal at positive rates. But because the security demanded would be so high, lending would probably crash. Now the Fed has to buy all the gold, silver and classic cars in the world. Imagine seeing Ferrari GTOs and Austin Somersets on the Fed’s balance sheet!

    What worries me about this cashless negative rates idea is that it presumes borrowing behaviour would change, i.e. people would stop borrowing to speculate and suddenly start becoming productive entrepreneurs investing in industry. Why, the competitor is now the FED.

    The bottom line is that there is a limit to how much you can abuse savers. They got to have savings because they were smarter than everyone else.

  8. RebelEconomist said:

    Only insular Americans could come up with such a silly idea as zero interest rates on money. As in untrustworthy regimes everywhere from Argentina to Zimbabwe, people would simply switch to using someone else’s currency. The dollar was already beginning to be affected by this in 2006 – remember Gisele Bundchen and JayZ?

    • “people would simply switch to using someone else’s currency”

      Isn’t that the whole point? People aren’t buying enough, and there are nominal rigidities (and marginal buyers who are net debtors and will therefore buy less if prices go down and thereby increase their real liabilities), so you can’t easily fix the situation by getting prices down. So you make your currency cheaper, so that foreigners will buy stuff from you, and the problem is fixed. Of course if every country does it, you’ve got a new problem (or rather, you’ve got the old problem that most of this discussion has been about, since it’s essentially been an argument about the closed economy case)

      • Andy, I think you’re right about this. But my point here, albeit not very clear, was that it’s not a generalizable solution. At least not in the same way QE or forward guidance is (all monetary policies have a bit of zero sum in them, I suppose, but the value of depreciation isn’t always so much the export benefit as much as the increased price of imports sparking domestic inflation).

  9. Ashok, I’m not sure your symmetrical Evans rule does the trick. It would certainly work if there were no limits on what the central bank could buy, because the endgame would essentially be fiscal policy done by the central bank: after it had bought up every asset in the world, it would have to start buying newly produced output, and everyone agrees (and would anticipate many steps earlier) that this could get you out of a liquidity trap. But in practice, central banks are quite limited in what they’re allowed to buy. Generally they can’t even buy equity, let alone hard assets, and even most forms of debt are off limits. So the endgame is that the central bank buys every asset that it can legally hold, and it’s not clear that this (or, by extension, its hypothetical anticipation) would necessarily be enough to get you out of a liquidity trap.

    • I was actually planning a post on the innate fiscalism of Bernanke-style monetary policy. At a much more basic level, beyond restrictions on what assets the bank may purchase, the fact that it can buy debt requires there to be a sufficient supply of debt, which is predicated on fiscal policy.

      But I prefer to ignore the legality of it all in thinking about the economics. There probably are welfare losses associated with the central bank engaging in purely fiscal policy via the purchase of private assets. But the more important loss is the subversion of democracy. Hence the preferred option would be expansionary fiscal policy supported by the monetization of debt.

      The conservative vs. liberal debate can be whether that comes from broad tax cuts or investments in infrastructure etcetera.

  10. Nathanael said:

    Large negative interest rates are impossible. They aren’t a result of paper money.

    If you tried to institute negative interest rates, everyone would just repudiate the currency and buy other currencies, or warehouses of commodities, or stuff like that. At zero interest, we’re *already* dealing with a problem of commodity hoarding; we don’t want to make it worse.

    People will tolerate small negative interest rates — the fees for custody of their gold bars, the cost of security at their warehouses — but they won’t tolerate large negative interest rates. There’s ALWAYS a lower bound — it’s not an artifact of paper money.

    The key fact is that you can’t manage an economy strictly with borrowing and lending (interest rates). You have to manage it using spending and taxing (so-called fiscal policy).

    The zero lower bound is only one of several reasons why this is the case. A more important reason is that you can’t get blood from a stone — if inequality is too high, if the 99% are too poor, then the 99% *will not borrow* (interest rates are ineffective for the economy) but they *will* spend money which is *given* or *paid* to them (fiscal policy is effective for the economy).

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