Breaking Through the Zero Lower Bound

1. Breaking Through the Zero Lower Bound Miles Kimball Presentation at the Federal Reserve Board November 1, 2013

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

3. Preface: Where the Zero Lower Bound Comes From • The zero lower bound arises when a government issues pieces of paper (or coins) • guaranteeing a zero nominal interest rate • over all horizons • that can be obtained in unlimited quantities in exchange for money in the bank. • This acts as an interest rate floor, making people unwilling to lend at significantly lower rates. • Cf. milk-price supports in the United States.

4. Preface: “Electronic Money” • Eliminating the zero lower bound involves distinguishing between paper currency and electronic money (which in the 1930’s, Robert Eisler called “bank money”). Electronic money would be “the real thing.” • The electronic dollar, euro, yen, pound, etc. would be the unit of account. • The central bank would define which accounts constituted electronic legal tender. This would be the only legal tender.

5. Preface: “Electronic Money” (cont.) • The government is a big enough market player that it should be able to establish the electronic dollar (e-$) as the unit of account if all its dealings were on that basis (taxes, accounting rules,..) • That the government can determine the equilibrium on daylight savings time suggests private firms and households would follow the government’s lead on this. • For public relations, the name “electronic money” for the policy has real advantages, because it can be described as a natural transition to a 21st century monetary system.

6. Preface: The Urgency of Understanding How to Eliminate the Zero Lower Bound If the zero lower bound were eliminated, Japan could retain a zero inflation rate and still get all the monetary stimulus it needs.

7. Preface: The Urgency of Understanding How to Eliminate the Zero Lower Bound Long in advance of the actual elimination of the zero lower bound, a speech by any member of the FOMC reassuring the public that eliminating the zero lower bound is a feasible policy choice that can be turned to if needed could reassure markets that whatever shocks hit the economy, economic recovery will not fail for lack of monetary policy firepower.

8. Preface: The Urgency of Understanding How to Eliminate the Zero Lower Bound In large measure because of the zero lower bound, other means of stimulus are being employed that may have bad side effects: • Running up the national debt with traditional fiscal policy • The unusual spreads generated by QE • The danger of reigniting a home-price bubble with QE • A possible sense in the future that past forward guidance has precluded what would otherwise seem appropriate policy.

9. Preface: History of Thought for Negative Rates and Electronic Money • Non-unit-of-account “bills of credit” in the early United States. “Continentals” lost value without causing rampant inflation (see Hall and Sargent 2013) • Silvio Gesell’s stamped currency (1906) • Robert Eisler’sdepreciating paper currency (1932) • Marvin Goodfriend’sadvocacy of a modern version of stamped money (2000) • Marvin Goodfriend’sdiscussion of suspension of payment in paper currency (2000)

10. Preface: History of Thought for Negative Rates and Electronic Money • Willem Buiter’sdiscussion of a wide range of mechanisms for avoiding massive paper currency storage (2004, 2007, 2009) • Abolish paper currency • Tax currency and stamp it (like Silvio Gesell) • Depreciating paper currency (like Robert Eisler) • Greg Mankiw’sdiscussion of random invalidation by serial number (2009) • Matthew Yglesias’s advocacy of abolishing paper currency (December, 2011)

11. Preface: History of Thought for Negative Rates and Electronic Money • My own advocacy of a crawling-peg exchange rate between paper currency and electronic money, as here (November 2012). • The Urbanization Project’s elucidation of a crawling peg as a way to elicit substantial seignorage without inflation (Miles Kimball, Paul Romer, etc. November 2012) • Focus on the details of policy tools to inhibit paper currency storage (Frances Coppola January 2013 and Miles Kimball January 2013 to date)

12. Outline • The Zero Lower Bound is a Problem • How to Eliminate the Zero Lower Bound • The Best Place to Act Against the Massive Paper Currency Storage that Would Enforce the Zero Lower Bound. • “A Minimalist Implementation of Electronic Money” • “How to Set the Exchange Rate Between Paper Currency and Electronic Money” • “The Path to Electronic Money as a Monetary System”/”Going Off the Paper Standard” • “The Costs and Benefits of Repealing the Zero Lower Bound … and Then Lowering the Long-Run Inflation Target” • Discussion and Conclusion

13. I. The Zero Lower Bound is a Problem • The zero lower bound is a key motivation for steady state inflation above zero. Ben Bernanke, March 20, 2013 press conference: So historically, the argument for having inflation greater than zero—we define price stability as 2 percent inflation as do most central banks around the world. And one might ask, “Well, price stability should be zero inflation. Why do you choose 2 percent instead of zero?” And the answer to the question you’re raising which is that if you have zero inflation, you’re very close to the deflation zone and nominal interest rates will be so low that it would be very difficult to respond fully to recessions.

14. I. The Zero Lower Bound is a Problem(continued) • The zero lower bound is a key motivation for steady state inflation above zero. • Ben Bernanke, March 20, 2013 press conference: There is research, for example, which asks the question how often do you tend to hit the zero lower bound? And our belief few years ago was that it was a very rare event and now it has become more common. • Larry Ball “The Case for 4% Inflation”: A 4% target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. Voxhttp://www.voxeu.org/article/case-4-inflation

15. I. The Zero Lower Bound is a Problem(continued) • Many central banks are up against the zero lower bound in macroeconomic situations indicating output less than the natural level • In particular, in the absence of the zero lower bound, the world economy’s Great Recession might have been much shorter. • To keep certain spreads from being too thin, many central banks are unwilling to go as low possible given storage costs of cash.

18. Swiss Interest Rates

19. Negative Interest Rates in Switzerland • There is only a limited history of the use of negative interest rates. Many decades ago, Switzerland discouraged incoming Swiss-franc deposits by imposing a negative interest rate on balances placed with Swiss banks. In other words, a person deposited money in the bank, and the bank charged the depositor for the privilege of keeping it there. http://www.ritholtz.com/blog/2013/05/negative-interest-rates/

20. Negative Interest Rates in Sweden • In July 2009 Sweden's Riksbank was the first central bank to use a negative interest rate, lowering its deposit rate to −0.25%, a policy advocated by deputy governor Lars E. O. Svensson.[5][6] to counter economic slowdown due to the financial crises of 2008. The deposit rate is the interest (or in this case, "penalty") commercial banks get for depositing capital at the Riksbank overnight. The lending rate, i.e. the interest commercial banks have to pay for borrowing money, was still positive, at 0.75 percent.

24. I. The Zero Lower Bound is a Problem (continued) • The Bank of Japan has been up against the zero lower bound for a long time. This could be an important factor behind the relatively poor macroeconomic performance of the Japanese economy in the last 20 years or so.

25. Japanese Treasury Bill Rates

26. Real GDP Per Capita in Japan

27. Log of Real GDP Per Capita in Japan

28. Japanese Price Level (Log of GDP Deflator for Japan)

29. Assessing Japanese Monetary Policy: Has NGDP(the Velocity-Adjusted Money Supply) Been Smooth? • Quartz 21—>Optimal Monetary Policy: Could the Next Big Idea Come from the Blogosphere? • http://blog.supplysideliberal.com/post/50646128943/quartz-21-optimal-monetary-policy-could-the-next-big • Influenced by Market Monetarism. • Focuses on the behavior of NGDP, the velocity adjusted money supply (MV=PY)

30. Why NGDP (the Velocity-Adjusted Money Supply) Should be Smooth • To a first approximation, optimal monetary policy is to keep the economy at the natural level of output. • Inflation data only gradually reveal where the natural level of output is. • Therefore, a good approach in absence of ZLB is: • Very-short-run interest rate target • Medium-run NGDP target with steady growth at a rate that factors in estimates of of what tech progress, pop, capital stock, etc. mean for growth in natural output. (Choice of the estimated growth rate for natural output is a key task of the central bank.) • Long-run inflation target at zero.

31. Log of Nominal GDP for Japan

32. Nominal GDP for Japan Since 1994

33. I. The Zero Lower Bound is a Problem (continued) • “The Great Moderation”: when not facing the zero lower bound, central banks of advanced countries have done well in short-run stabilization in recent decades, freeing up fiscal policy to focus on long-run issues.

34. “The Great Moderation”

35. I. The Zero Lower Bound is a Problem (continued) • The zero lower bound makes it hard to get the time path of monetary stimulus right. • The short-term interest rate is the intertemporal relative price between spending now and spending a little while (say a year or two) in the future. • To get considerably more stimulus now than a year or two in the future, it is important to have a low short-term interest rate that makes goods now look inexpensive compared to goods a year or two from now.

36. The Constraint the Zero Lower Bound Puts on the Time Path of Stimulus The zero lower bound creates a constraint between amount of stimulus now and amount of stimulus later. Typically, when below the natural rate, with a binding ZLB, • To get enough stimulus now, there would have to be too much stimulus later. • To get the right amount of stimulus later, there would have to be too little stimulus now. • This creates two problems: • Too little now or too much later • Credibility problems for enough now.

37. Removing the Constraint and Restoring Credibility • If the zero lower bound is eliminated, the constraint between stimulus now and stimulus later is also removed. • This means it is possible to stimulate the economy now without convincing people the central bank will overstimulate the economy in the future. • As Krugman says about fiscal policy, low enough negative short-term interest rates will work, regardless of what people believe about the future. • If beliefs about the future reduce the stimulus from monetary policy, in the absence of the zero lower bound, the short-term interest rate can simply be lowered further to compensate.

38. II. How to Eliminate the Zero Lower Bound • The Best Place to Act Against the Massive Paper Currency Storage that Would Enforce the Zero Lower Bound. • “A Minimalist Implementation of Electronic Money” http://blog.supplysideliberal.com/post/50888412664/a-minimalist-implementation-of-electronic-money • “How to Set the [Effective] Exchange Rate Between Paper Currency and Electronic Money [in Banks]” http://blog.supplysideliberal.com/post/51048739791/how-to-set-the-exchange-rate-between-paper-currency-and • “The Path to Electronic Money as a Monetary System”/”Going Off the Paper Standard”

39. A. The Best Place to Act Against the Massive Paper Currency Storage that Would Enforce the Zero Lower Bound • 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 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. • 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).

40. B. The 3 Elements of a Minimalist Implementation of Electronic Money • Levying a deposit charge when banks deposit paper currency with the central bank. For example, with a 5% deposit charge, a deposit by a bank of ¥10,000 of paper currency would yield ¥9,500 in additional electronic reserves. • 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. (That is, paper currency would no longer be legal tender.)

41. 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.

42. How to Make Electronic Money De Facto Legal Tender: Gold Clauses as a Precedent for Electronic Payment Clauses in Debt Contracts From Wikipedia “Gold clause”: Gold clauses specified within business contracts allow the creditor the option to receive payment in gold or gold equivalent. A gold clause may prove valuable to the creditor in long term contracts, wherein questions may arise as to whether a currency in use at the time the contract was entered into would still have the same value when payment is due. Creditor concerns in respect to inflation, war, changes in government, and any other uncertainty about the future value of currency would be common reasons for adopting a gold clause within a contract. (Continued on next slide)

43. How to Make Electronic Money De Facto Legal Tender: Gold Clauses as a Precedent for Electronic Payment Clauses in Debt Contracts (cont.) • These clauses were common at the beginning of the 20th century. However, their use in the United States was invalidated by the Gold Reserve Act of 1934. Congress later reinstated their use for obligations (new contracts) issued after October 1977 in accordance with 31 U.S.C.§ 5118(d)(2).[1] • On August 27, 2008, the United States Court of Appeals for the Sixth Circuit affirmed the enforceability of such clauses in the decision Jamaica Avenue, LLC vs S&R Playhouse Realty Co..[2]

44. C. The Log Exchange Rate Between Paper Currency and Electronic Money is the Integral of the MPC’s Chosen Interest Rate for Paper Currency

45. What Having a Non-Zero Interest Rate on Paper Currency Means • Whatever the interest path chosen for paper currency implies that, say, ¥10,000 should cumulate has to be the exchange rate for paper currency vis a viselectronic money at that point times ¥10,000. • Thus, starting from par at the inception of an electronic money system, the principles of compound interest (with some combination of positive and negative interest rates) determine what the exchange rate between paper currency and electronic money must be.

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

47. Three Options for the Time Path of the Effective Interest Rate on Paper Currency • Return to par as quickly as possible, consistent with keeping the zero lower bound non-binding at all times: • Paper currency interest rate = monetary policy target interest rate (or maybe a little lower) during times of economic emergency. • Implement the Friedman rule: • Paper currency interest rate = target rate all the time • Constantly depreciate paper currency to earn seignorage without inflation. (e-yen=unit of account) • Attractive if it is otherwise hard to tax the shadow economy.

48. The Spread Between the Monetary Policy Target Rate and the Paper Currency Interest Rate • The Central Bank should move the target rate (e.g., fed funds rate in the US) in tandem with the interest on reserves (when negative not just excess reserves), the discount rate and the paper currency interest rate. • The spread between other rates and the paper currency interest rate will matter to financial firms. This can be a separate policy choice with electronic money. • Currently, negative nominal interest rates yield a very low (negative) spread of other rates over the paper currency rate of zero. An electronic money system can avoid the resultant side-effects of negative rates that occur under current paper currency policies, since the paper currency interest rate would be a policy variable.

49. D. “The Transition to Electronic Money as a Monetary System”/ “Going Off the Paper Standard” • Announce technical feasibility of eliminating the ZLB. • Strengthen macro-prudential regulation by raising equity requirements substantially above Basel III. • Ask banks and other financial firms to make contingency plans for negative interest rates.

50. D. “The Transition to Electronic Money as a Monetary System”/ “Going Off the Paper Standard” 4. Develop accounting standards for negative interest rates that take electronic money as the unit of account, and give to paper money then value it is worth in the market relative to electronic money. 5. Ask government agencies to prepare contingency plans for negative interest rates and non-par valuation of paper money.