[Cash] is a redundant, indeed dominated medium of exchange and means of payment for legitimate transactions.
Or at least so says Willem Buiter, former BoE MPC member, and Maverick economist blogger in one of his recent negative-interest rate postings.
Accordingly, it’s about time we looked at the issue of negative interest rates. Are they even possible? Do they imply a cashless society? Can markets function in a negative interest environment? How do they even apply to the current crisis?
Buiter has been busy addressing those very questions as he leads what appears increasingly to be a campaign for the introduction of negative rates.
In a nutshell — and what you really need to know — is that negative interest rates do imply the end of cash.
Buiter says as much in this post (from earlier this month) in which he explains exactly how negative rates would even be possible.
On Wednesday he follows up with this post, where he explains to critics exactly why negative interest rates are now needed.
As he previously stated:
There is no theoretical or practical reason for not having the Federal Funds target rate and market rates at, say, minus five percent, if that is what your Taylor rule, or whatever heuristic guides your official policy rate, suggests.
The Taylor rule, by the way, is a formula for rate-setting based on the outlook for inflation and growth. It too has become somewhat of a talking point ever since John Taylor, the former Treasury official who devised it, stated “we may not have as much time before the Fed has to remove excess reserves and raise the rate.”
But back to the issue of negative interest rates. As Buiter explains, there is no problem in central banks charging a negative interest rate on reserves held with them. The only potential problem is currency itself, due to its bearer security status. Hence the problem is getting the bearer to turn up at all to take the payment away from him. As Buiter explains:
Currency is the only problem. Paying positive interest on currency is difficult because you don’t know the identity of the owner. The same note could be presented repeatedly to earn the interest due for a single period. To get around this problem, the instrument itself must be clearly identified as current or non-current on interest. Once interest has been paid, it is marked, traditionally by stamping it or by clipping a coupon off it.
With negative interest, the problem is not the owner turning up too often to claim his interest. It is getting him to turn up at all. Since the authorities don’t know I am the owner of the currency I own, why should I volunteer to pay the government money for the privilege?
Accordingly there are three direct ways to go about achieving a negative interest rate, says Buiter:
1) Abolish currency.
2) Tax currency and ‘stamp’ it to show it is ‘current on interest due’.
3) Unbundle currency from the unit of account.
On issue 1) Buiter says:
This is easy and would have many other benefits. The main drawbacks would be the loss of seigniorage income to the central bank. There may be a ‘millennium bug’ type transitional problem, if a lot of bad programmers have written code that blows up when the nominal interest rate hits zero (taking the logarithm of zero or of a negative number has interesting consequences), but all that means is a couple of wasted weekends at the office re-writing the relevant code.
Advanced industrial countries can move to electronic and bank-account-based means of payment and media of exchange without like problem. Negative interest rates on bank accounts and on balances outstanding on ‘centralised or networked electronic media’ like credit cards are as easy as positive interest rates. Debit cards simply transfer money between two accounts, both of which could pay negative interest rates and don’t pose a problem. You could even retain a measure of anonymity and have ‘cash-on-a-chip cards’, which, whenever the balance on the card is replenished by drawing funds from some account, calculate the average balance held on the cash card since the last replenishment and arrange for the appropriate interest rate (positive or negative) to be applied.
What that would achieve of course is “a pass the hot potato” type environment. Why would you save your money, if it just got eroded with interest payments you had to make? The spending incentive, however, would radically increase. Of course, that does imply the need for a cash-less society — something presumably not so digestible to a fair portion of society. Buiter’s opinion on cash-less society objectors however is:
The only domestic beneficiaries from the existence of anonymity-providing currency are the criminal fraternity: those engaged in tax evasion and money laundering, and those wishing to store the proceeds from crime and the means to commit further crimes.
In which case, perhaps there’s even an incentive for the world’s anti-fraud authorities to pitch for the concept. Although perhaps it would not go down too well in Spain, if the following is to be believed:
Large denomination bank notes are an especially scandalous subsidy to criminal activity and to the grey and black economies. There is no economic justification for $50 and $100 bank notes, let alone for the €200 and €500 bank notes issued by the ECB. When asked why the ECB subsidises and encourages crime by issuing these large-denomination notes, the answer comes back that Spaniards like to make large transactions in cash, and that the ECB does not want to be responsible for an increased incidence or herniated discs, caused by people having to schlep large suitcases filled with small bills to make their next home purchase. There is an answer to that answer: kvatsch!
Accordingly, Buiter concludes you might not have to abolish all cash to achieve a negative-interest environment after all — the elimination of just large notes might be enough to do the trick (wheelbarrows at the ready in Spain then):
Instead of abolishing currency altogether, we could only issue low denominations, say nothing larger than $5 or €5. The carry costs (safe-keeping, insurance and storage) for large amounts of cash are likely to become prohibitive if you have to do it all in fivers. The zero lower bound would be likely to shift to a significantly negative lower bound.
Of course, another way is following option two; marking cash as interest payments were collected — presumably a model that would create more of a “ticket-inspector” type society than a cashless one. As Buiter explains:
To get the bearer to come forward to pay the negative interest we can either rely on honesty and a sense of patriotic duty, or we can impose sanctions for non-compliance. I am afraid penalties for non-compliance (fines, a day in the stocks) would be required to make negative interest on currency work. This would require random checks etc. It would be administratively costly and unpleasantly intrusive. This may well endear the notion to our governments.
As for option three ‘unbundling the currency from the unit of account’ — introducing a whole new currency unit could – it seems – also do the trick. In a nutshell, Buiter sums it up as follows (although it’s worth taking a proper look at his full explanation to understand the mechanisms):
Now abolish the dollar currency and introduce a new currency, the rallod. The exchange rate between the rallod and the dollar is not constant. It can either be determined by the government or let by the market. In the first case, the government (central bank) supplies rallod on demand at the government-determined exchange rate; in the second case, the stock of rallod currency is exogenous (determined by the government but not available from the government in whatever quantity demanded at a given exchange rate. Since the rallod is the currency, there is a zero lower bound on the rallod interest rate on rallod-denominated securities (I am ignoring carry costs and assume that solution 2 is not applied to the rallod). However, since there no longer is dollar currency, the nominal interest rate on dollar securities can be negative as easily as it can be positive.
In conclusion, Buiter believes there’s no reason at all why central banks should not pursue the negative interest path: “Taxing currency may be awkward and intrusive, but abolishing currency is not just easy (just do it) but also has considerable advantages as a blow against criminality and terrorism.”
On Tuesday, it turned out his idea was even doing the rounds at the ECB. As Buiter blogged:
I spent yesterday in Frankfurt at the European Central Bank 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.
What’s more, Buiter appears to have been struck with a somewhat Vulcan-like bewilderment as to why anyone might find the idea controversial. He states:
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.
Buiter retorts that it’s simply about empowering central banks in their quest to achieve monetary targets – nothing more. Why not have a system in place that can when needed turn to negative interest rates to help stave off deflation and recession?
Adoption of any of these proposals makes negative nominal interest rates possible.
That is all. Here, by the way, is Buiter’s presentation to the ECB where he makes his case. According to the slides, the problem with QE and other unconventional policies is that they can still lead to a liquidity trap – eg. no matter how much money you throw at the system and how long interest rates stay at zero, the economy fails to be stimulated.
So are there any signals out there that we might be approaching a liquidity trap? Well, according to Marc Chandler, global head of currency strategy at Brown Brothers Harriman — as quoted here on Bloomberg (H/T The Pragmatic Capitalist) — the sudden dramatic fall in the LIBOR-OIS rate might indeed be indicating that very thing (our emphasis).
“There may be more to the decline than meets the eye,” Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co. in New York, said in a note. “It is widely acknowledged and documented that American savings are rising. There seems to be some other complications whereby the decline in Libor, which is driving the narrowing of the Libor- OIS spread, is a function of the crisis itself, perhaps even signs of a liquidity trap.”
While that is obviously debatable, Barcap noted earlier this month that the market is already beginning to price in negative interest rates in Treasury repos, although this is largley due to the introduction of the 300bp fails fee on May 1st.
As they explain:
The primary effect of the 300bp fails fee that went into effect last Friday has been the introduction of negative interest rates for specials in the Treasury repo market. Since May 1, a total of $30bn has traded at sub-zero interest rates — with the bulk of the activity occurring yesterday. On some days, however, nothing trades on the broker screens at under 0%. On Thursday, negative repo rate trading seemed to have fully taken hold — not only were several issues (particularly the old 3s and 10s) bid well below zero, but the daily volume (of $22.3bn) accounted for almost 18% of the total amount of general collateral traded.
And although the old 3s were well bid at a steep -1%, the volume-weighted average sub-zero rate was much higher, at -0.28%. This reflects the fact that once the securities came out of the SOMA’s daily lending program, the market cheapened significantly — pushing the volume-weighted average rate higher. More important that the level of negative rates has been the return of specials volume. Specials activity had fallen to about 10% of last spring’s level.
Participants had stepped away from the market, as rates were too low relative to the 0% pre-fails fee boundary to entice traders looking for spread. As this artificial limit has been removed and the opportunity to earn a wider spread between general collateral and (negative) specials rates has opened up, specials volumes have recovered — returning to about 20% of the overall Treasury collateral market.
More on how the 300bp could be a hindrance to liquidity in the short-term repo market can be read here on ZeroHedge.
If negative rates are what the introduction of a 300bp fails fee has achieved it does perhaps show that central banks are at least willing to experiment on this front.
Meanwhile, you might ask — as others apparently have also asked Buiter — wouldn’t a negative interest rate environment simply encourage people to hold some other store of value instead? Well that’s the very point, responds Buiter:
“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.
A shortage of short paper – Zerohedge
Libor Has Biggest Drop in Eight Weeks as Credit Thaws – Bloomberg
A squeeze defreeze – FT Alphaville
A commodity anchor, or oil as money – FT Alphaville