Breaking Through the Zero Lower Bound

1. Breaking Through the Zero Lower Bound Miles Kimball Center on Finance Law and Policy Presentation, Oct, 2013

2. The Zero Lower Bound • The zero lower bound arises when a government issues pieces of paper (or coins) guaranteeing a zero nominal interest rate over all horizons. • This acts as an interest rate floor, making people unwilling to lend at significantly lower rates. • An analogy is milk-price supports in the United States.

3. The Great Moderation • Although the Fed made serious mistakes in financial regulation during the Greenspan era (1987—2006), that was a halcyon time for monetary policy proper, not only in the US, but around the world. Economists talked of “The Great Moderation.” • During that time, monetary policy worked by using the creation or extinction of central bank reserves to lower or raise short-term interest rates such as the overnight “federal funds rate” and the closely linked 3-month Treasury-bill rate.

4. The Great Recession • After the financial crisis, the ZLB contributed to a prolonged the economic slump.

5. A Starker Picture: The Employment to Population Ratio

6. The Zero Lower Bound in Action • The following graphs show that a rule that short-term interest rates could not go negative posed a relevant constraint for many major economies from 2009 to the present--and mattered much earlier for Japan.

9. Japanese Treasury Bill Rates

11. The Inability to Lower Short-Term Rates Below Zero Has Led to Other Expedients to Get Stimulus • 2% inflation instead of zero inflation • “Quantitative easing”: large-scale purchases of long-term government bonds and mortgage-backed securities) • “Forward guidance”: quasi-promises to keep short-term rates at zero far into the future • Large budget deficits

12. Central Point The zero lower bound is a policy choice, not a law of nature.

13. How to Eliminate the Zero Lower Bound: “Electronic Money” • Eliminating the zero lower bound involves distinguishing between paper currency and electronic money (which in 1930’s, Robert Eisler called “bank money”). Electronic money would be “the real thing.” • The electronic yen, dollar, euro, pound, etc. would be the unit of account. It would also be legal tender. • Paper currency could continue in existence, but would be subordinated to electronic money.

14. Establishing Electronic Money as the Unit of Account • Tax returns done in terms of electronic $ • Accounting standards require that accounting be done in e-$ • Make sure accounting in government agencies is done in e-$ • Like Daylight Savings Time • If necessary, require retailers to post a price in e-$ (possibly in addition to a paper currency price).

15. Three Possible Places to Attack the Massive Paper Currency Storage that Would Enforce the Zero Lower Bound • WITHDRAWALS? --Restrictions or fees on paper currency withdrawals have the disadvantage of preventing withdrawals for spending as well as withdrawals for storage. Also the ability to withdraw has great option-value for people. • STORAGE? --Storage of paper currency can be done in a very low-tech way by anyone. Also, criminals already have experience in secret storage of paper currency. • DEPOSIT (OR REDEPOSIT) OF PAPER CURRENCY! --A temporary, time-varying fee on the deposit or re-deposit of paper currency can effectively stop massive paper currency storage. See below on the time-variation (including why it can be temporary).

16. The Time Varying Deposit Fee • If the deposit fee is gradually increased over time, then the longer paper currency is stored, the higher the fee that has to be paid to turn it (back?) into bank money. • Thus, paper currency will earn a negative return during that time, that can be thought of as a negative interest rate. • The central bank would control the “paper currency interest rate” just as it now controls the fed funds rate, the discount rate and the interest rate on reserves kept with the central bank. • If all of these interest rates are reduced in tandem, including the paper currency interest rate, the spreads important to financial firms could be kept in the normal range.

17. The Deposit Fee Creates an Effective Exchange Rate Between Paper Currency and Electronic Money • To avoid the deposit fee, banks would offer paper currency to customers at a discount. Hence, if banks were making any deposits with the central bank, the deposit fee would establish an exchange rate between paper currency and electronic money. • (1-deposit fee) = exchange rate at which paper currency trades for electronic money. (Ignoring transactions costs.) • Ideally, to encourage this, the central bank would charge the deposit fee on net deposits, thereby effectively allowing withdrawals of paper currency at a discount. • While this exchange rate would probably hold for all dealings with banks, it need not hold at retail shops. For a while, shops would accept money at par (a) to avoid credit & debit card fees, and (b) to be nice to customers.

18. If, Given Recovery, the Average Nominal Rate Over Time is Positive, the Exchange Rate Can Return to Par.

19. Leaks that Need to Be Plugged • Discounting vault cash applied to reserve requirements by the same percentage as the deposit charge. • Establishing a legal right for any individual, business, government agency, or creditor to refuse payment in paper currency at par.

20. Key Legal Questions • Does the central bank (the Federal Reserve, in the US case) have the authority to levy a proportional fee when banks deposit paper currency in their account with the central bank? • Does the central bank have the authority to have vault cash held banks count less toward reserve requirements than reserves in the account the bank has with the central bank? • Is it legal for retailers to charge more when a customer pays in paper currency than when a customer pays by credit card, debit card or check?

21. Key Legal Questions (cont.) • Is a loan contract provision enforceable that stipulates that a borrower must pay a surcharge if the borrower makes interest or principal payments in paper currency? • In typical existing loan contracts, could lender refuse to accept repayment made with large amounts of paper currency? • If, in principal, typical existing loan contracts allow a borrower to repay with large amounts of paper currency, how difficult would it be to get a judgment to that effect?

22. Key Legal Questions (cont.) • Does Congress or Parliament have the authority to stipulate that “dollar” or other currency in existing loan contracts means the amount that a dollar in a bank account would be worth, if the value of a dollar worth of paper currency diverged from the value of a dollar in a bank account? • Under current law, can the IRS disallow payment in paper currency? • In the Eurozone, does the European Central Bank have the authority to require national central banks to impose a proportional fee on the deposit by banks of paper currency with the national central bank? • Alternatively, could the European Central Bank centralize all reserve accounts of banks in Frankfurt?

23. Conclusion • The zero lower bound is a policy choice. • The zero lower bound is costly. • ZLB interferes with stabilization policy • The ZLB forces stabilization policy to rely on large deficits, QE and forward guidance • ZLB is a big enough problem it motivates higher inflation than would otherwise be optimal • The zero lower bound can be eliminated through • A time-varying charge for depositing paper currency at the central bank • A discount for vault-cash as applied to reserve requirements • A legal right to refuse payment in paper currency (or coin) at par. • Electronic money would be “the real thing”: the unit of account and legal tender.