I was in Frankfurt at the European Central Bank recently to meet people and give a presentation on negative nominal interest rates (the “zero lower bound problem”). For reasons I don’t understand, this topic generates almost as much heat and emotion as a critical piece on Obama. Some of the reactions to my previous post on the issue made me consider starting further posts on this issue with a health warning. Because the heat and emotion are based on heart-stopping ignorance and lack of elementary logic, I will have another go at explaining the basics.1
The purpose of the exercise is to eliminate a silly asymmetry in the monetary policy arsenal. Because of the existence of currency with a zero nominal interest rate, the interest nominal rate on all financial assets is constrained to be no lower than zero (actually, because of high carrying costs for currency, nominal interest rates on things like bank accounts could be slightly negative, but that’s a second-order issue). So when inflation threatens, our monetary masters can raise the official policy rate to any level they deem appropriate. When deflation and recession threaten, they can only cut the official policy rate to zero. After that, it’s quantitative easing, credit easing, and other unconventional monetary policy measures.
It helps not to confuse nominal and real interest rates in this discussion. Real interest rates (inflation-corrected interest rates), on nominal instruments have been negative (ex-post) on many occasions in our inflationary past. They will be so again in our inflationary future, especially if we live in the US.
It may also help that I am not advocating permanently negative nominal or real interest rates on currency or anything else. The purpose of the exercise is to describe three ways to eliminate an asymmetry in the ability of the monetary authority’s ability to set the short-term risk-free nominal interest rate. Adoption of any of these proposals makes negative nominal interest rates possible. Whether the pursuit of sensible monetary policy would ever drive the official policy rate into the negative range is an empirical issue. Some exercises by Federal Reserve Board staff with an econometric model of the US economy and a Taylor rule (a rule that causes the official policy rate to be raised when the output gap increases and raised more than one-for-one when the expected inflation rate increases) suggests that, but for the zero lower bound, the Federal Funds target rate would today be at negative 5%. I believe that, before this contraction is over, all leading monetary authorities (Fed, ECB, Bank of England and Bank of Japan) would have set their official policy rates at negative levels, if they had been able to.
Removing the zero lower bound
My earlier post described three ways of removing the zero lower bound on nominal interest rates:
- Abolish currency
- Tax currency holdings
- Decouple the numéraire/unit of account from the currency/medium of exchange/means of payment by introducing a new currency (the rallod) and abolishing the dollar currency. The dollar would remain the numéraire. The authorities would set the exchange rate between the dollar and the rallod. There would no longer be a zero lower bound on dollar nominal interest rates because there is no longer any dollar currency. There would be a zero lower bound on rallod nominal interest rates because of the existence of rallod currency. If the dollar interest rate set by the monetary authority has to be negative (say - 5%) to achieve the objectives of the monetary authority, the rallod interest rate could remain zero, provided the monetary authority announced a credible appreciation of the value of the dollar in terms of the rallod (by 5%).
As regards the first proposal, the abolition of government-issued currency, other private means of payment (cheques drawn on bank accounts, credit cards, debit cards, cash-on-a-chip and other forms of e-money) could perform most of the legitimate/legal transactions role of currency. The monetary authority could also offer every citizen an account with the central bank, which could be administered through existing commercial banks, savings banks, or post offices. These accounts, which would have to have non-negative balances, could pay positive or negative interest, as the situation demanded.
As regards proposal (2), taxing the holding of money balances, the key issue is, if the desired interest rate on currency is negative, to get the holder (bearer) to come forward to pay the interest due (the tax) to the central bank. If currency notes have an issue date on them, as most do, it would be very easy to announce an expiry date for currency as legal tender. The holder of the currency note would have to come forward to pay the interest due to the central bank before the expiry date. The currency would be stamped or marked in some way, to show it is current on interest due.
A particularly cute example of such an expiry model was described recently in a blog post by Greg Mankiw. He attributes it to a student of his. I was reminded at the ECB that Charles Goodhart has been offering this example for years. It works as follows:
- All currency notes have serial number ending in integer from 0 to 9.
- Currency notes also should have a year printed on them.
- Once a year, on a fixed date, the central bank randomly selects integer from 0 to 9.
- All currency notes ending in that integer, printed in that year or earlier, lose their legal tender status and are no longer redeemable/exchangeable at central bank for anything else.
- The expected nominal interest rate on currency is therefore -10%, enough to give even the most determined deflation-fighting monetary authority a lot of room for manoeuvre.
The proposal amounts to a negative interest rate version of the British Premium Bond, a government bond that bears no interest and earns no capital gains but enters the holder into lotteries.
There is one problem with this proposal, not recognised by Mankiw or Goodhart – taking away legal tender status from currency notes need not have any effect on their value. The value of fiat money is what people think it is. Taking away legal tender status may provide a nice focal point for the currency notes involved, on the value that Mankiw and Goodhart expect – zero. But legal tender status is not necessary for fiat currencies to have any particular value. The currency notes stripped of their legal tender status could continue to exchange at par with the equal denomination currency notes that were not stripped of legal tender status by the annual lottery.
It may therefore be necessary to reinforce the loss of legal tender status with the threat of confiscation, or some other fine or penalty. Taxing currency will, I am afraid, remain rather intrusive and administratively cumbersome. This may of course recommend it to some of our leaders.
What store of value would people hold?
The most uninformed comments on the earlier post were all variants on the statement that “if nominal interest rates were negative, people would all hold some other store of value instead”. One answer to this is “that is actually what we are trying to achieve – getting people to dump currency and other assets bearing a negative short nominal interest rate and inducing them to acquire other assets, preferably real assets and commodities instead.” That would be almost right, but not quite.
Under none of the proposals would people switch into currency if the nominal rate of interest were negative. Under proposal 1, there is no currency. Under proposal 2, currency has a negative nominal interest rate; under proposal 3, rallod currency has a zero interest rate but is not a better store of value than negative interest dollar bonds because the dollar appreciates vis-à-vis the rallod. There is no dollar currency.
Would they switch into commodities as a store of value? If the commodity is non-durable, consumption has been boosted. If the commodity is durable and, for simplicity, has a constant marginal real use value over time, a simple arbitrage argument shows that the money price of the commodity would fall by x% per period if the period nominal interest rate is -x %.
There would be nowhere to go that would dominate the bond with the negative nominal interest rate as a store of value. Banks could still make money – that depends not on the level of interest rates but on the spreads between their borrowing and lending rates. If a bank borrows from the central bank at -5% and lends at -2%, it will make the same amount of profit on a loan of a given size as it would if it borrowed at 5%and lent at 8%.
How would people living off their savings manage with negative nominal interest rates? First check what real interest rates are. If deflation were strong enough, savers could still be making out like bandits, even with negative nominal rates. If real rates are negative, you live by consuming your capital. If that means poverty for some and creates social problems, go to the Treasury or the Ministry of Social Affairs. Don’t bother the central bank.
To a better future, with negative nominal interest rates as part of the central bank’s asset menu.
Editors’ note: This column draws from a post at Willem Buiter’s Maverecon blog.
1 See also Robert Hall’s Vox column on the negative interest rates.