Saturday, January 25, 2014

An alternative to electronic money, negative interest rates and the lower zero bound.

Recently, I exchanged the following tweet with Miles Kimball, a professor of economics at the University of Michigan and a fellow economics blogger.

At issue is whether charging negative interest rates and demoting paper money are the right government policies for dealing with the limitations of the lower zero bound.  I've been thinking about this very question for some time, and I believe that a hybrid approach, which I discuss at length here, is a more effective strategy.  More importantly, such approach will not generate the political firestorm and popular backlash, should governments attempt to charge negative interest rates and restrict the use of paper money. 

The idea behind the hybrid approach is to shift control over fiscal deficits and surpluses to the Federal Reserve.  As a result, the Fed will have access to both fiscal and monetary policy tools.  More specifically, I call for a federal sales tax and federal investment credit both of which are to be set by the Federal Reserve.  In good times, the Federal Reserve can keep the tax at 0%.  During times of severe economic collapse when monetary policy is constrained by the lower zero bound, the Fed can lower the sales tax to let's say -5%, in effect creating a sales credit, which will immediately act to increase the cost of holding money without the Fed having to resort to inflation or negative interest rates.  Here is an excerpt from the post, which I referenced above:
The hybrid approach to government intervention creates a host of new possibilities and tools.  For example, in a recession the Federal Reserve will not have to rely on outsized moves in interest rates which act to inflate money balances held by the public that can later fuel an asset bubble.  Instead, the Fed can lower sales taxes and increase investment credits.  This will encourage real economic activity and expand the money supply through fiscal deficits rather than money balances stuffed in mattresses and bank accounts.  If the economy is overheating or demand for money is low, the Fed can raise taxes and drain excess money supplies through fiscal surpluses.  This is especially important today should the demand for money begin to decline in the aftermath of QE and trillions of excess reserves on the Fed's balance sheet. 
Also, turning the sales tax into a sales credit can eliminate the restrictions imposed on monetary policy by the lower zero bound.  Since the Fed cannot lower rates below zero, it can begin to pay people to spend which effectively raises the cost of holding money.  A side benefit to a negative sales tax during a severe recession is that it will deflect any political charges that the Fed bailed out Wallstreet but failed to help Main street! 
Europe could implement the hybrid approach through VAT Credit funded by the ECB.  Currently, all EU-member countries are subjected to one-fits-all monetary policy.  ECB could use the VAT Credit to customize policy to circumstances specific to each country.  For example, during the boom days prior to the crisis, the ECB could have raised rates to prevent overheating in the periphery while increasing the VAT Credit in Germany to spur domestic consumption.  Conversely, today the VAT Credit would go to Spain, Italy and Greece.  This will expand the supply of much needed euros and help these countries overcome the ravages of the Great Recession. [More on VAT Credit here]
Emerging economies can also benefit from this approach.  The biggest threat to their economic stability are unpredictable foreign capital flows, which often respond to monetary policy and conditions abroad rather than to domestic priorities.  By increasing sales taxes when foreign money is easy and abundant, an emerging economy can absorb excess money supply and mitigate both trade and fiscal deficits.  When those capital flows inevitably dry-up, sales taxes would be lowered to cushion the impact on domestic consumption.
Technically, Miles Kimball is correct.  The lower zero bound means that rates have to fall into negative territory in order to restore the equilibrium between savings and borrowing.  On the surface, charging negative interest rates and demoting paper money seems like an obvious solution.  The problem with such approach is that it will have many unintended consequences, not the least of which being the loss of government monopoly over money issuance. And I am not referring to Bitcoin here, but true digital currencies backed by credit-worthy non-governmental parties, which will surely proliferate should governments attempt to tinker with  paper money.  Furthermore, the US experience under the bi-metallic standard in the 19th century suggests that if there are two money standards (electronic and paper money), the cheaper money (the demoted dollar bills) will always displace the more expensive money (electronic dollar).  Such strategy, I am afraid, will lead to destruction of electronic money and untold strain to the financial system.

Currently, central banks target 2% inflation precisely for the lack of tools at the lower zero bound.  Since inflation reduces the effective rate, the inflation target acts as a cushion against the lower zero bound.  Proponents of electronic money believe that under a negative rates regime, central banks would no longer require such cushion and would be in a position to discontinue inflation targeting.  The thing they are forgetting is that inflation works through voluntary pricing mechanisms in the marketplace.  As a result, people accept low levels of inflation albeit begrudgingly.  Instead, if the Fed starts charging negative interest rates, it will no longer rely on voluntary transactions to achieve its goals.  As a result, the Fed will become the focal point of public outrage, which will exact high political price. 

The reason why equilibrium interest rates fall into negative territory during times of severe economic distress is simple.  People are afraid that they will be poorer in the future.  As a result, marginal utility of current spending is lower than the expected utility future spending.  This is the equivalent of saving for a rainy day.  The lower zero bound comes into play as people arbitrage their negative required returns by holding cash at 0%.  If you attempt to take away that option, people will find other ways to arbitrage.  Instead, by lowering the sales tax, governments can erase the shortfall in marginal utility of current spending and effectively eliminate the lower zero bound.  This is a clean and simple solution that will receive broad public support.  Furthermore, the Fed will now be perceived as the hero who helps Main Street rather than the money villain who protects Wall Street!

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