Sweden and peak cash

The Swedes really don't like cash. First, consider that Sweden is the only country in the world that I'm aware of where reliance on paper money is in decline. Second, no country's central bank has produced a nominal deposit rate as negative as Sweden's, for as long. Yet even at -0.85% per year, Swedish banks who own those deposits haven't fled into 0% cash, providing some indication of the degree to which they hold banknotes in disdain.

ABBA won't accept paper

As the chart below shows, cash outstanding continues to grow in almost every country except Sweden. Japan and Denmark are the only countries that come close to pacing the Swedes, although both nations continue to show incremental growth in demand for banknotes. Even Kenya, where m-pesa has taken hold, shows strong cash demand.

Sweden reached "peak-cash" somewhere between 2007 and 2008. The reason for this change of heart is public preferences, not government diktat. The monetary authorities can only indirectly influence the demand for cash, say by introducing/removing various banknote denominations, or altering the quality of its note issue (say by making notes harder to counterfeit). By virtue of deposits being convertible into cash whenever the depositor desires (and vice versa), the allocation between cash and deposits is primarily up to the public, not the monetary authorities.

One theory is that Sweden become more law-abiding in 2008, thus reducing their demand for paper kronor. Cash is typically demanded by criminals and tax evaders to avoid creating a paper trail. That Sweden's underground element suddenly decided to go legit doesn't seem very plausible to me. Demographics is a more likely contributor to peak cash. As a nation's population growth slows, the demand for cash peters off with it. This can't be the entire explanation, however, since other countries that also suffer from poor population growth profiles (like Canada) show rising cash demand. This leaves technology as the most likely culprit. As electronic payment options improve, it makes little sense to endure the hassle of withdrawing and holding a small horde of dirty paper in one's wallet.

According to a MasterCard study, 89% of transactions in Sweden are cashless, compared to 80% in the U.S. Situation Stockholm, the street paper sold by homeless vendors in Sweden's capital, can be purchased with a card rather than cash, and while London's buses went cash-free earlier this year, bus fares disappeared several years ago in Stockholm. Unlike the U.S. and other laggards, Sweden has a near real-time person-to-person payments system called Bankgirot which has been active since 2011. Bank customers can download an app called Swish, which allows them to make immediate mobile payments over the Bankgirot network. In southern Sweden, Vicar Johan Tyrberg has installed a card reader to make it easier for worshipers to make offerings. And finally, despite having a hit song entitled Money, Money, Money, ABBA refuses refuses to accept cash at the ABBA Museum. Apparently ABBA member Bjorn Ulvaeus is leading a crusade against banknotes after his son's apartment was burgled twice.

No zero lower bound, at least not yet

As a second illustration of Swedish cash abhorrence, consider that no other central bank has maintained a negative deposit rate as low as Sweden's central bank, the Riksbank, for as long. The Riksbank reduced its deposit rate to -0.85% this month after having maintained it at -0.75% since October 2014. A few nations come close. The Swiss, for instance, reduced rates to -0.75% in January, as have the Danes—but both are behind the pace set by the Swedes.

The key point here is that with Riksbank deposits being penalized 0.85% per year, one would assume that that they'd be quickly converted into Swedish banknotes. Cash, after all, pays 0% a year, superior to -0.85%. But that hasn't happened. As the chart below shows, cash left on deposit at the Riksbank stands at around 150 million kr, roughly the same level it has been at for the last twelve months (and far above 2008-2012 levels).

Who keeps funds on deposit at the Riksbank? As the business day progresses and Swedes make payments among each other, banks who maintain settlement accounts at the Riksbank will find themselves in a surplus or deficit position. While those in surplus can elect to park their excess at the Riksbank's overnight deposit facility, they'll usually try to lend these positions to deficit banks in the interbank lending market or participate in Riksbank fine-tuning operations at the end of the day, both of which provide superior returns to the deposit rate. For whatever reason, Swedish banks typically leave a small portion of their surplus in the deposit facility, bearing the awful return on deposits for the sake of enjoying whatever conveniences the deposit facility offers.

That this 150 million kr in -0.85% yielding deposits hasn't been converted into cash is an indication of just how low Swedish opinion on cash has sunk. Consider the myriad number of costs a bank that wants to cash out its balance will have to incur. A Brinks truck must be hired in order to transport the cash to the bank's vaults. The cash must be counted, requiring a diversion of tellers' resources from other important activities. With the majority of Swedish bank branches having gone cashless, they may need to reinvest in handling infrastructure before they can take delivery of a truck full of banknotes. Next, that cash needs to be vaulted, which means displacing other valuables from being safeguarded (like a client's jewels), forcing the bank to forfeit a vaulting fee. Finally, the cash needs to be insured from theft. No wonder Swedish banks continue to use the Riksbank's deposit facility, even at a -0.85% rate; like the public, banks don't consider cash to be a convenient option.

Could Swedes one day re-embrace cash?

Swedes are proud of their move towards digital payments, but this trend could very rapidly come to an end. In an effort to hit its inflation target, the Riksbank may have to push interest rates even deeper into negative territory. At much lower levels, even the most cash-hating Swedes will have to re-consider their aversion to paper. The consequences could be significant. While only a small quantity of deposits are kept in the Riksbank's deposit facility, much larger amounts—around 30 billion krone—are invested at the Riksbank via overnight fine-tuning repos, which currently pay -0.2%. If the Riksbank reduced the fine-tuning rate much lower (say to around -1.5%), these repos would be rapidly converted into cash by banks. The public holds many hundreds of billions more worth of deposits at Swedish commercial banks. Should Riksbank rate reductions force banks to respond by ratcheting down their own deposit rates to -1 or -2%, how long before Swedes empty out their bank accounts, turning Sweden into a cash-only economy?

To avoid reverting to a cash-only economy at extreme negative rates, the Riksbank would do well to hitch itself to the cashless trend. One way to go about this without calling in all banknotes would be to reign in the number of paper products the central bank currently offers consumers, in particular high denominations of notes. Just stop allowing conversions into the 1000 krona note, and maybe the 500 krona note too, or consider canceling these large denominations outright. Not only would this reduce the central bank's printing costs, but it would provide more room for further rate cuts into negative territory—without the threat of a mad dash into Swedish cash.

As for the rest of us...

As in Sweden, I'm pretty sure that cash demand in places like Canada and the US will eventually peak as continued advances in payments technology and a more rapid adoption of those technologies lead consumers to demand less of the stuff. Central banks might consider adapting to this trend ahead of time by reducing the number of paper products they offer to the public. Do the Swiss really need a 1000 SFr note? Do Europeans need a €500 note, and Canadians $100 notes? Alternatively, why not do what Bill Woolsey advocates? Let's gradually privatize the issuance of paper currency. If anyone can make cash relevant again, it's innovators in the private sector. And if they can't, then maybe the banknote deserves to die a slow death.

Secondly, Sweden shows that the so-called zero-lower bound isn't actually at zero, but some distance below that. Cash is awfully burdensome, as evidenced by Swedish banks who are willing to hold deposits at -0.85% despite the option to earn 0%. Central bankers at the Federal Reserve, ECB, and elsewhere would do well to heed this Swedish data point. If they need to loosen monetary policy in order to hit their targets, they can go well below -0.5% before having to fear mass conversion into cash. The world's central bankers have much more interest rate ammunition than they let on.

A lazy central banker's guide to escaping liquidity traps

For lazy central bankers, this post describes three lite strategies for getting interest rates below the zero lower bound. Rather than requiring drastic action, these methods can be quickly deployed without having to spend too much energy—leaving plenty of time for the afternoon squash game.

1) Let's start at the beginning. What is the zero lower bound? If a central bank reduces interest rates below 0% then banks will rapidly convert all their central bank deposits into cash. No point accepting a -2% return if you can get 0%, right?

2) The zero lower bound is a problem. From time to time, a central bank may need to venture into negative territory to hit its monetary policy targets. Cash impedes the smooth descent into negative territory.

3) We already have a few go-to plays for dealing with our inability to get below zero: quantitative easing, forward guidance, and fiscal policy, each with its own set of warts. While quantitative easing has become a popular tool over the last few years, theory tells us that purchases are irrelevant at the zero lower bound. Promising to keep rates at 0% for longer than is prudent has also been used by a few central banks, notably the Bank of Canada. Unfortunately the market finds forward guidance confusing and may see little credibility in it, given the fact that the central banker who initiates the promise may not be in office to carry it out. This problem is called time inconsistency. And lastly, while fiscal policy may be a good way to evade the zero lower bound problem, it hinges on flaky political processes and arduous negotiations.

4) A more direct way to get around the zero lower bound problem may be necessary. Our lazy central banker might have to make alterations to the very nature of cash itself.

5) A sure-fire way to remove the lower bound is an outright abolition of cash. It gets around the time inconsistency problem and the flakiness of politics. But abolishing cash is a drastic step. Banknotes serves a role in protecting privacy and are popular with the unbanked. Abolish cash and you hurt both. Given the degree of preparation and effort needed to remove cash, and the political wrangling this option would require, a lazy central banker may want to take a pass.

6) Rather than removing cash, just harm it. Silvio Gesell's stamp tax, for instance, attacks cash's pecuniary return. In this spirit, Miles Kimball's crawling peg between electronic currency and paper currency burdens those who own cash with a capital loss. The crawling peg banishes the zero lower bound—without requiring the drastic step of immediately removing all banknotes. It's an elegant solution, you can read the details here (pdf).

7) There are a few drawbacks to a crawling peg. Driving a wedge between paper and electronic currency creates two different sets of prices at the till, one for deposits and the other for cash. A chocolate bar, for instance, might have a sticker price of $1.00 in electronic money, but require a cash payment of $1.05. This will be confusing and inconvenient for shoppers, necessitating an expensive and costly education campaign by our central banker. According to Kimball, instituting a crawling peg requires that a nation enact a unit of account switch. Prices must be set in terms of electronic currency, not paper currency, otherwise the central bank will lose control over the price level. While a switch in standards is by no means impossible, it does require time and effort.

8) Which finally gets us to our lite strategies for lazy central bankers. These options don't suffer from time inconsistency or flaky politics. They get us below zero without requiring the abolition of cash, nor do we get two different sets of prices at the till, nor do we need a nation to switch to a new unit of account. In short, if enacted, they'd keep our system pretty close to the current system.

9) Laziness isn't without a cost. Unlike the abolition of cash and Miles Kimball's crawling peg, the lite methods don't free us entirely of the lower bound. They only soften it up a bit, re-situating the bound a few percentage points lower. This buys room for central banks to cut rates,  but not infinite amounts. If extremely negative rates are necessary, say -6%, then there is no lazy option: best get off the couch and go with a full-out crawling peg.

10) There are a number carrying costs on cash holdings, including storage fees, insurance, handling, and transportation costs. This means that a central bank can safely reduce interest rates a few dozen basis points below zero before flight into cash begins. The lower bound isn't a zero bound, but a -0.5% bound (or thereabouts).

11) The various lite strategies all exploit the fact that differences in carrying costs among the various note denominations mean that banknotes are not naturally fungible. Put differently, bills aren't perfect substitutes for each other. Large denomination notes, say $100 bills, incur lower storage and handling fees than small denomination notes like $10s. After all, a hundred-thousand $10 bills (worth $1,000,000) take up ten times more storage space than a ten-thousand $100s (also worth $1,000,000). However, a central bank renders the two types of notes equivalent by offering to convert pesky low denomination $10s into sleek large denomination $100s at no cost to the owner. This means that the public can avoid the nuisances of small denomination note storage, for free. So at any point in time the note-owning public is bearing the carrying cost of the highest denomination note, not the lowest ones.

12) To get a bite, the following three lazy techniques all boost the carrying cost of cash.

13) They do so by interfering with the traditional smooth switch out of small denomination notes and deposits into large denomination notes afforded by a central bank. The effect is to put an end to banknote fungibility. The public, previously sheltered from the hassles of holding pesky low denomination notes, must now bear those costs, while being barred from racing into sleek high denomination notes.

14) By implementing any one of these lite techniques, the additional carrying costs now imposed on cash remove any incentive to convert increasingly negative yielding deposits into banknotes. A central bank that had previously reduced its deposit rate to, say, -0.5% before finding itself snug against the lower bound, will now be able to reduce its deposit rate to a much lower level, say -2.5%, without fear of mass flight into cash.

15) The first method a lazy central banker should consider is the abolition of large denomination notes. A central bank issues a proclamation giving people one month to bring in all $100s for conversion into ten $10 bills. Any large denomination notes remaining in circulation after one month will be disavowed. Once all high-value denomination are demonetized, the market clearing carrying cost on cash holdings will no longer be the superior rate on $100s, but the much heftier one on $10s. The expected return on cash holdings having been diminished, a central banker who had previously found him or herself stuck against the lower bound now has room to go lower without fear of mass flight into cash.

16) Even with the $100 having been abolished, the remaining low denomination notes in circulation can continue to serve a role in protecting privacy and serving the unbanked.

17) The second method involves closing the high denomination "conversion window." Specifically, a central bank ceases converting both low denomination notes and deposits into high denomination notes. The only window the central bank will keep open is between deposits and low denomination notes. This means that anyone who converts deposits into cash can now only get pesky small notes, forcing them to bear the higher carrying costs of $10s rather than the minimal inconveniences of sleek $100s. A central bank can now cut its deposit rate much deeper into negative territory than before since depositors are far less likely to flee into bulky cash.

18) If we close the conversion window, won't those who hold negative-yielding deposits and low denomination notes simply trade them for zero-yielding high denomination notes on the secondary market? Sure, but the opportunity will be a fleeting one. The closing of the conversion window effectively freezes the quantity of high denomination notes in circulation. The price of $100s will immediately rise to a premium over bulky low denomination $10s and negative-yielding deposits. After all, $100s impose much lower carrying costs than the other two instruments. This premium removes any incentive to flee deposits and low denomination notes.

19) Won't the public suffer the inconveniences of having two different sets of prices? Not really. Rather than having an electronic currency price and a cash price (as in point 7), the closing of the high denomination conversion window will create a combined electronic/low denomination price and a high denomination price. The public, which almost never transacts in high denomination $100s anyways, can conveniently ignore the high denomination price level.

20) Nor does our lazy central banker need to worry about switching standards. Given that consumers only rarely pay with high denomination notes, it's highly unlikely that retailers currently set prices in terms of $100s. In fact, even now retailers often refuse to accept large value notes. It's likely that we probably already live in a world with a low denomination/electronic currency standard.

21) Which brings us to our third method: vary the conversion rate between low denomination notes/electronic currency and large denomination notes. Central banks currently allow free conversion between deposits, low value notes, and high value denominations. The idea here is to keep the conversion window open, but levy a fee, say three cents on the dollar, on anyone who wants to convert either deposits or low denomination notes into high denomination notes. Conversion between low value notes and deposits remains free of charge.

22) A central banker can now safely guide rates to a much more negative rate than before, say to -2.5% rather than just -0.5%. Prior to instituting a conversion charge, the public would have fled from deposits to cash at such low rates. Now, while people can still convert deposits at no cost into low denomination notes, this offers them no real advantages given the high carrying costs on such notes. And flight into high value notes is forestalled by the conversion fee.

23) As with the second lite method, the third creates two different sets of prices: one for low denomination notes/deposits and one for high denomination notes. But this doesn't matter, see point 19. Nor do we have to switch standards, see point 20.

24) The main difference between the second method and the third one is that the exchange rate between high denomination notes and low denomination notes/deposits is allowed to float in the former versus being fixed under the latter.

25) The third lite method is akin to Miles Kimball's crawling peg, except that the conversion penalty is set on high denomination notes only, not cash in general. But if we steadily widen the peg so that it includes mid-value denominations, and then add small denominations, then the third lite technique isn't so lite anymore. It has basically become Kimball's peg. At some point along that transition, we start to inherit the inconveniences of the crawling peg (see point 7). For instance, the dual price level becomes much more inconvenient, especially once $10s (and lower) are included. However, the advantage is that we can now push rates much deeper into negative territory.

26) Which means its possible to incrementally transition from a lite program to an all-out option like a crawling peg or total abolishment of cash. Lazy central bankers may prefer to stick their toes in the water before jumping all the way in.

27) By the way, I've mentioned the first lite technique here, here, here, and here. I mentioned the second lite technique here. I haven't mentioned the third before.

28) If I was a lazy central banker, of the three lite programs I'd be partial to the second one; the closing of the high denomination conversion window. Removing high denomination notes from circulation would probably have messy political implications and draw the public's wrath. Levying a fee is an assertive, some might say aggressive stance necessitating the creation of new processes and administration expenses. Simply closing the $100 window seems like it would take the least amount of effort. It doesn't require that any new infrastructure or the decommissioning of existing machinery. As for the pricing of high denomination notes, this gets outsourced to the market.

Slow greenbacks, fast loonies

Canada trails the U.S. is a common refrain, but not when it comes to payments. Courtesy of the Interac e-transfer service, Canadians have been able to make person-to-person (P2P) payments in real-time as early as 2002. By person-to-person, think email or mobile phone payments to friends, family, or your landlord, and by real-time, the receiver of a payment can immediately turn around and use those funds to buy something. By contrast, most Americans are still stuck in the nebula of three day delays when it comes to P2P. 

Why this incredible lag? I think it's for the same reason why the U.S. banking system is so much more unstable than the Canadian banking system. Whereas Canada has a small number of strong national banks, the U.S. has a large population of weak undiversified regional. This lack of size and strength renders U.S. banks prone to failure while simultaneously making it difficult for them to coordinate together in order to create shared-use systems. 

Part of the problem in providing a real time P2P solution to consumers is that U.S. banks can't use the Federal Reserve's existing small payment network, ACH, to do the job. ACH is a forty year old system that transfers funds with delays sometimes lasting as long as 3-4 days. That being said, the Canadian equivalent small payment system, the ACSS (run by the Canadian Payments Association) isn't much better, with settlement occurring the next business day. Yet somehow we Canadians enjoy real time P2P. 

Over a decade ago, Canadian banks decided to avoid ACSS altogether and set up their own proprietary network to provide real time P2P capability. Run by Interac, a bank-governed non-profit, the network processes P2P payments, nets them out across all banks, and provides instant communications among participants. At the end of the day, the banks settle balances owing and owed by trading Bank of Canada clearing deposits via the CPA's Large Value Transfer System (LVTS). Even before the banks settle among each other, Canadians will have instant access to funds they have received either via email or their smart phone (or, if they have been debited, lose access to these funds). Heck, Royal Bank even has real-time payments via Facebook. [1]

As anyone who has read the free banking literature knows, the U.S. has an awful history of bank regulation. Until recently, law makers forbade banks from setting up national branch systems, with unit banking being the norm. (Here is George Selgin on the topic). As a result, the U.S. is characterized by a patchwork quilt of banks, 6,891 in fact, with the top five banks accounting for only 56% of all deposits. Canadian law, on the other hand, never discouraged national branch banking. As a result, Canada has five dominant banks with broad exposure to all provinces and maybe two dozen smaller banks, the "big 5" accounting for at least 80% of Canadian deposits. 

You can understand now why it would be difficult for U.S banks to set up their own real-time payments system. In Canada, only a handful of bankers needed to be convinced that the time and effort to build a mutually beneficial system was worthwhile before the remaining minority followed. A much larger expense must be incurred in herding U.S. banks towards that same equilibrium. It's sort of like fax machine adoption. A single fax machine is useless, but the value of every fax machine increases as the installed base of fax machines grows, since the total number of people with whom each user can send/receive faxes rises. Ideally, everyone just agrees ahead of time to get a fax, or in the case of P2P, all bank decide to jointly build a shared network. Tough to do when you're a thousand squabbling voices. Enlightened cooperation among a few large banks, the Canadian solution, gets you there quicker.

The result is that in the U.S. most of the P2P solutions haven't been developed by banks, but by technology companies. Finance tech giants Fiserv and Fidelity National Information Services have developed their own networks; Popmoney and People Pay. Upstart Dwolla is trying to convince financial institutions to adopt its FiSync real-time service. This plethora of competing networks reminds me of what I've read about the early days of electrical utilities in the U.S., with multiple competing wire systems running down the streets. To avoid this sort of redundancy, some might say that the best option is to have a regulated monopoly like the Fed take the baton, say by upgrading ACH to real time. And with so many different competing systems, I can't help but wonder how they 'talk' to each other. If there were three or four brands of fax machines, and each brand could only receive its own faxes, how much less useful is the fax network?

So we Canadians have ubiquitous real time P2P and the Americans don't. However, the dark side to the Canadian system is that cooperation among the few needn't always be so enlightened. Just as the chiefs of the big 5 banks can get together in a back room and cobble together a mutually beneficial shared network, it's just as easy for them to set up a mutually beneficial pricing scheme—at the expense of consumers. It costs $1.50 to do an Interac e-transfer. Sounds suspiciously high to me. 


[1] My source for information on the Interac e-payments system is the CD Howe's Mati Dubrovinsky, who briefly describes how the system works here.  

The zero problem

The price of bitcoin is a capricious thing. Imagine that you've saved enough bitcoin to take your significant other out to a fancy restaurant. When the bill comes you discover to your horror that the price of bitcoin has crashed sometime between main course and desert. For the next few hours you're both stuck doing the restaurant's dishes. Far less embarrassing to choose dollars as your payment media at the outset given the unlikelihood of a dollar crash. This has always been one of bitcoin's main problems. The burden that a consumer must endure in absorbing bitcoin's incredible volatility until the time of payment outweighs any reduction in transaction fees that they might enjoy.

Or maybe not. Marc Andreessen recently posted a number of thoughts on twitter. The most interesting ones are #9 to 17, namely that bitcoin's fabled volatility needn't deter regular folks from using it as a cheap and fast payments mechanism.

15/For example, payment applications of BItcoin don't require users/merchants to hold BTC for any period of time. All benefits still gained.
— Marc Andreessen (@pmarca) January 5, 2015

In effect, it's possible to enjoy all of bitcoin's benefits without having to hold an inventory of the schizophrenic stuff. Consider that when merchants currently receive bitcoin in exchange for their product, their payments processor (say Bitpay or Coinbase) will instantaneously convert those coins into US dollars, thus sparing the merchant the risk of holding volatile bitcoin. As for shoppers, a service that allows them to purchase bitcoin in the instant prior to paying for a good would preclude them from having to bear the risk of a bitcoin crash. (1)

It's the "never-hold" approach to bitcoin. As long as just-in-time bitcoin purchases and sales are possible, shoppers and merchants can avoid bitcoin's worst feature, its volatility, while enjoying all of its best features, low fees and speed. These just-in-time services aren't free. Bitpay and Coinbase extract a fee for providing merchants with protection from bitcoin hyper-volatility, and a provider of shopper volatility protection would also expect to be compensated. Now I'm not sure how large these two fees would come out to. However, as long as the total cost is less than the fees levied by competing mechanisms like credit card networks, then bitcoin provides a net benefit to society. (2)

Touché, Andreessen. En Garde!

I've been talking about the potential for bitcoin to be displaced by stable-value cryptocoins as media of exchange for a while now. But if Andreessen is right (and I'm inclined to think he is) then who really cares if bitcoin suffers from +/-50% daily price changes? Whether it's worth $100 or $100,000, either way it serves regular folks as a superior last-second value transfer mechanism (subject to the above cost condition). We may not need stable-value cryptocoins after all.

But Andreessen is missing one of the larger points of the volatility criticism, which I'll call the zero value problem. Granted, we needn't care whether bitcoin is worth $100 or $100,000, but we do care if it is worth $0. While no categorical difference exists between any two given positive bitcoin prices, a categorical difference *does* exist between a positive price and a price of zero. Bitcoin works smoothly at any positive price, but it breaks down as value-transfer mechanism when it's worth nothing.

A key pillar of the volatility critique is that bitcoin's price earthquakes arise because the only players in the market are speculators. A more fancy way to say this is that bitcoin has no non-monetary demand. By non-monetary demand, I'm referring to that portion of an asset's total demand that would remain if prospective owners were notified that they could never sell that asset after purchasing it. Given this imposition, I sincerely doubt anyone would be willing to buy bitcoin. By and large, people only want the stuff because it can be got rid of in the future.

By way of comparison, gold has both monetary and non-monetary demand. There are consumers who will purchase the yellow metal knowing that they can never sell it again, say as jewelry or ornamentation. Same with an IOU like a stock or banknote. Because an IOU offers dividends (or a promise of cancellation at an attractive price), investors will be content to hold that IOU knowing that they can never resell it. This is the Warren Buffett approach to holding an asset, whereby one's favorite holding period is forever.

With the only folks holding bitcoin being future sellers, i.e. speculators, enter the zero value problem. An object whose value is purely speculative has no equilibrium price. In economics-speak, its price level is indeterminate. A $10,000 price is as good as a $10 price, or a $0 price. And that last price will inevitably arrive—maybe in 2015, maybe in 2020, maybe not till 2025—when for some reason or other speculators all begin to get antsy at the same time. It could be something as innocuous as the belief that everyone else is about to sell (because they expect everyone else to sell, because they expect everyone to sell, etc). When a reflexive process like this begins, the only way for the bitcoin market to accommodate everyone's desire for an exit is for the price of bitcoin to hit zero.

For illustrative purposes, gold isn't subject to the zero value problem because if a speculative panic begins, consumption demand kicks in to anchor gold's price at some lower level. The same goes for central bank money.

At $1, bitcoin still works. But at zero, bitcoin breaks down as a payment mechanism. Since bitcoin no longer has a positive purchasing power, regular shoppers can no longer make just-in-time bitcoin purchases in order to consummate a transaction. Merchants will quickly pull bitcoin price quotes from their websites, unwilling to trade something (their wares) for nothing (bitcoin). Since the financial reward to mining will have disappeared, the process for verifying the blockchain may become tenuous. All the hard work put into building a payments mechanism will be gone in a few moments of speculative fervour. And what happens to all of the other "use cases" that Andreessen describes, like bitcoin apps and sidechains, when bitcoin hits zero?

Even if bitcoin hits $0 for an hour or two, won't the inevitable dead cat bounce fix the problem? Not necessarily. The best theory for how bitcoin rose above zero back in 2009 is the 'bootstrapping theory.' A small clique of insiders conspired to trade what was then an intrinsically-useless token among each other, generating a long enough history of positive prices so that bitcoin began to be accepted by naive outsiders at a non-zero price. From nothing, otherwise worthless tokens had pulled themselves up by their own bootstraps. Andreessen admit as much in his eleventh tweet.

11/Bitcoin was specifically designed to use speculation early on to overcome the normal chicken/egg boostrapping problem for new networks.
— Marc Andreessen (@pmarca) January 5, 2015

The point I'm trying to make here is that if bitcoin were to fall to zero, a dead cat bounce isn't the natural next step. Rather, as in 2009, an outlay of time and resources would be required to fabricate a positive price. In essence, bitcoin would need to be re-boostrapped. But how to go about this process? Who would be willing to join the front line and risk their capital trying to trick the market into valuing bitcoin at a positive price again? Surely not all the former bitcoin millionaires. Keep in mind that it might take multiple efforts to jump start the system. And with bitcoin being so much more widely known than before, the re-bootstrapping process might take significantly more resources than it did in 2009. Finally, even if the system is successfully kickstarted after a few days, what about the damage that is incurred in the interim thanks to a period of inactivity? Could it do irreparable damage to bitcoin's reputation as a payments mechanism, in the same way that Visa would suffer if it went down for a few days?

How to overcome the zero problem

Luckily, there's a pretty easy fix to the zero problem. Set bitcoin's minimum price at US$1 so that it never has to go through a re-bootstrapping process.

To set a minimum price, bitcoin believers like Andreessen should consider donating US$21 million to a bitcoin stabilization fund. The fund will have a standing bid to purchase all bitcoin at $1. Since there will never be more than 21 million bitcoin in existence, the fund will have the financial resources to credibly support this price. In an extreme scenario in which all speculators run to the exits, the stabilization fund will be left holding 21 million bitcoin and no dollars. The good thing is that no harm will be done to bitcoin as a just-in-time value transfer system. The fund will make a market in bitcoin at $1, providing shoppers with an avenue to acquire the requisite bitcoin from the fund (say at $1.01) just prior to consummating a purchase, and providing merchants with a right to sell bitcoin at $1 in the moment after a sale.

The core idea here is that if speculators are for the moment unwilling to set a positive value for bitcoin, then someone else needs to. At some point after hitting the fund's $1 floor, speculators will likely gain enough confidence to once again take up the baton and drive bitcoin's price above $1. The roller coaster ride begins anew. If so, the stabilization fund's job is done, for the time being at least. It can start selling its hoard of bitcoin into the rally, replenishing its dollar reserves so that it can once again enforce the $1 floor should that necessity arise.

Think of the provisioning of a bitcoin stability fund as a public service. If bitcoin's promise is as enormous as folks like Andreessen believe, then the fund's $21 million price tag is a small cost to ensure that said promise isn't destroyed in a zero-value bitcoin scenario.

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(1) I was going to point out that I don't think anyone is offering this service, but now I see that one is: Cryptosigma.
(2) If the combined cost of merchant protection and shopper protection +  bitcoin transfer fees are higher than the costs that banks and the card networks earn on transactions, then bitcoin may not be the panacea that everyone makes it out to be. 

Grexit: An Escape to More of the Same

The upcoming Greek election has renewed interest in the idea of Grexit. This option is often presented to the Greek public as desirable given that it would restore an independent monetary policy to the nation.

Beware, this is dangerous advice. The euro isn't a glove that you can take on and off, it's a Chinese finger trap; once in, it's tricky to get out. Even if Greece were to formally leave the euro, odds are that it would remain unofficially euroized, leaving it just as bereft of an independent monetary policy as before. The real trade off in a Grexit-or-not scenario is between formal membership in the euro with some say in monetary policy, no matter how small, or informal membership without any say whatsoever.

The optimists, say someone like Hans-Werner Sinn, advise the Greeks to leave the euro and adopt a new currency. The value of this new drachma would immediately collapse. As long as prices in Greece are somewhat sticky, Greek goods & services will become incredibly competitive on world markets, spawning an export/tourism-led recovery. By staying on the euro, however, Greece forfeits the exchange rate route to recovery. Instead, Greece's competitiveness can only be restored via a painful internal devaluation as wages and prices adjust downwards.

While the optimists tell a good story, they blithely assume a smooth switch from the euro to the drachma. Let's run through the many difficult steps involved in de-euroization on the way to an independent monetary policy. All euro bank deposits held at Greek banks must be forcibly converted into drachma deposits, and speedily enough that a bank run is preempted as Greeks desperately try to evade the corral by moving euros to Germany. At the same time, the Bank of Greece, the nation's central bank, needs to issue new drachma bank notes, the public being induced to use these drachmas as a medium of exchange.

Now even if Greece somehow pulls these two stunts off (I'm not convinced that it can), it still hasn't guaranteed itself an independent monetary policy. To do so, the drachma ₯ must also be adopted as the unit of account by the Greek public. Not only must financial markets like the Athens Stock Exchange begin to publish stock prices in drachmas, but supermarkets must be cajoled into expressing drachma sticker prices, employees and employers need to set labour contracts in terms of drachmas, and car dealership & real estate prices need to undergo drachma-fication.

Consider what happens if drachmas begin to ciruclate as a medium of exchange but the euro remains the Greek economy's preferred accounting unit. No matter how low the drachma exchange rate goes, there can be no drachma-induced improvement in competitiveness. After all, if olive oil producers accept payment in drachmas but continue to price their goods in euros, then a lower drachma will have no effect on Greek olive oil prices, the competitiveness of Greek oil vis-à-vis , say, Turkish oil, remaining unchanged. If a Greek computer programmer continues to price their services in euros, the number of drachmas required to hire him or her will have skyrocketed, but the programmer's euro price will have remained on par with a Finnish programmer's wage.

As long as a significant portion of Greek prices are expressed in euros, Greece's monetary policy will continue to be decided in Frankfurt, not Athens. Should the ECB decide to tighten by lowering interest rates, then Greek prices will endure a painful internal deflation, despite the fact that Greece itself has formally exited the Euro and floated a new drachma.

We know that a unit of account switch (not to mention successful introduction of drachma banknotes) will be hard for Greece to pull off by looking at dollarized countries in Latin America. To cope with high inflation in the 1960s and 70s, the Latin American public informally adopted the U.S. dollar as an alternative store of value, medium of exchange, and unit of account. Even after these nations' central banks had succeeded in stabilizing their own currencies, however, dollarization proved oddly persistent. This is referred to as hysteresis in the economics literature. Economists studying dollarization suggest that network externalities are the main reason for hysteresis. When a large number of people have adopted a certain standard there are significant costs involved in switching over to a competing standard. The presence of strong memories of past inflation may also explain dollar persistence.

In trying to de-euroize, Greece would find itself in the exact same shoes as Latin American countries trying to de-dollarize. Greeks have been using the euro for 15 years now to price goods; how likely are they to rapidly switch to drachmas, especially in light of the terrible performance of the drachma relative to other currencies through most of its history? Those few Latin American countries that have successfully overcome hysteresis required years, not weeks. If Greece leaves the euro now, it could take decades for it to gain its own monetary policy.

As an alternative illustration of the power of network externalities, consider the multi-year plans made by Slovakia (pdf, fig 2) prior to switching over to the euro, or the Czech Republic's timeline when it makes the changeover. Each step must be broadly communicated and telegraphed long ahead of time so as to ensure that all members of a nation are properly coordinated, thus ensuring the network effects engendered by the incumbent currency can be overcome. These euro changeover plans weren't adopted a few days before the switch, but often as much as a decade before.

In sum, I fail to understand how Greece can ever expect to enjoy the effects of a drachma-induced recovery if the odds of drachma-fication or so low, especially given the sudden nature of a Grexit. At least if it stays part of the euro, Greece has a say in how the ECB functions thanks to the Bank of Greece's position in the ECB Governing Council. And at least Greece's inflation rate and unemployment rate will be entered into the record as official data worth considering by ECB monetary policy makers. For just as the Federal Reserve doesn't consider Panamanian data when it sets monetary policy (Panama being a fully dollarized nation), neither would the ECB care about Greek data if Greece were to leave the euro, though still be euroized.

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Basil Halperin responds.

No, Swiss National Bank shareholders are not pulling the strings

Swiss National Bank share certificates

Gavyn Davies blames the Swiss National Bank's corporate structure for the floating of the Swiss franc. Paul Krugman intimates the same, as does Cullen Roche. Here is Davies:

But the SNB is 45 per cent owned by private shareholders, many of whom are individuals, who receive dividends from the SNB. The rest is owned by the cantons, which have been complaining recently about insufficient cash transfers from the SNB.

Davies goes on to say that the influence of shareholders, combined with the peg, means that the SNB is particularly concerned about balance sheet losses. The idea seems to be that currency pegs often result in large balance sheet fluctuations, forcing a suspension of shareholder dividends.

I disagree, as a quick peek at the details shows:

1) The dividend to which Davies attributes so much importance is minuscule. In aggregate it comes out to just CHF 1.5 million per year, or US$1.7 million. Private shareholders, who own just 40.3% of the SNB's shares, are entitled to around 700,000 CHF per year in total. And these crumbs are shared among 2,219 private shareholders, most of whom hold ten shares or less. Are we to assume that these private interests care so much about the possible forfeiture of this trickle of cash (and just for a year or two) that they'd bother marshaling the significant effort required to influence Tommy Jordan, Chairman of the SNB, to drop the fixed exchange rate? Not a chance. These are nickles and dimes we're talking about.

2) Even if the shareholders organized themselves and tried to pressure Jordan, why would Jordan care? Jordan is Chairman of the three member Governing Board, which calls the SNB's monetary policy shots. He is appointed by the Federal Council, Switzerland's federal government, not by shareholders. Nor can the shareholders get him fired, as a quick reading of the National Bank Act reveals. Jordan can only be removed from office by the Bank Council. And while shareholders can elect five members to the Bank Council, the Federal Council, Switzerland's federal government, chooses the other six members, thus monopolizing the process. The upshot is that SNB shareholders have been neutered and exercise no control whatsoever over Tommy Jordan's thought process.

3) As for the interests of the Cantons, Tony Yates deals with them here.

I'm not sure why everyone is making such a big fuss of the SNB's corporate structure—it's hardly unique among central banks. The Federal Reserve, for instance, is 100% owned by private banks. We never worry about U.S. banks having an undue influence of U.S. monetary policy for the same reason we shouldn't worry about SNB shareholders having an influence on SNB policy—their power has been legislatively usurped by the government, as a quick reading of the Federal Reserve Act will show.

The deeper question is this: should the SNB (or any other central bank for that matter) take into account potential losses on its asset portfolio? In general, I think that the quality of a central bank's assets *should* be a factor that every central banker considers. If a central bank's assets have permanently ceased to yield enough income to cover the bank's salaries and expenses, then the central bank will have to cover this operating deficit by printing new money. Inflation will rise above target, forcing the central bank to sell assets in order to tighten the money supply. While this momentarily solves the inflation problem, it only further crimps the bank's supply of income-yielding assets and its ability to cover operating costs. A progressively slippier slope of ever more inflationary money printing to cover bills ensues.

This won't be a problem as long as the nation's government promises to recapitalize the central bank once problems emerge, thus topping it up with the resources to pay salaries and restore its inflation targets. Slippery slope avoided. But as I learnt a few years ago when reading a classic paper by Peter Stella, governments have been known to leave their central banks stranded. The Philippines' Bankgo Sentral is the best example of a central bank, the recapitalization it was promised by the government having been perpetually delayed. And as Stella points out, the central bank of Costa Rica has made losses for close to two decades consecutively, impeding the central bank’s ability to achieve low inflation. Prudence dictates a central banker be aware of the risk of being stranded.

All that being said, the SNB is really not at the point of having to be concerned about its operating position. The Bank's recent (and potential) losses are paper losses, not real ones. Bank expenses--including banknote printing, personnel, and overhead--still come out to just several hundred million francs a year, while its investments are providing billions worth of francs in interest and dividends. With Tommy Jordan's CHF 865,000 salary and all other expenses easily being covered, there's no slippery slope here. In sum, it is highly unlikely that the unhitching of the euro was motivated either by shareholder concerns or SNB worries about the effect of losses on its portfolio.

Links: 
Central Banks That Trade on the Stock Market
Does the Swiss National Bank need equity? - Speech by Thomas Jordan, 2011 (HT Vaidas Urba)

The ZLB and the impending race into Swiss CHF1000 bank notes

Two things worth noting:

1. As many of you know by now, the Swiss National Bank (SNB), Switzerland's central bank, just reduced the rate that banks earn on deposits held at the SNB by half a percentage point to -0.75% (from -0.25%). The SNB had only recently instituted a negative deposit rate, having reduced it to -0.25% from 0% this December. The SNB will also be targeting a 3-month LIBOR rate of -1.25% to -0.25%, down from the previous range of -0.75% to +0.25%


2. The SNB issues the world's largest paper bearer note denomination, the hefty CHF 1000 note (pictured above). It's worth around US$1143.

The first is significant because as yet, no central bank has ever brought rates this deep into negative territory. The ECB's current deposit rate is set at -0.2% while Denmark's central bank, the Danmarks Nationalbank (DNB), applied a negative deposit rate of -0.2% on deposits that banks placed with the DNB in 2012. Neither of these top the SNB's ultra-low -0.75% rate.

The second point is significant because neither the ECB nor the DNB issue a note that approaches the real value of the CHF 1000.

Why is the conjunction of these two observations important? In short, we get to observe in real time how tightly the so-called zero-lower bound (ZLB) binds. When a central bank reduces the rate it pays on central bank deposits below 0%, arbitrage dictates that all other short term interest rates will follow along, including rates on government t-bills and insured bank deposits. However, one asset interferes with this adjustment: cash. Cash carries an implicit yield of 0%. If deposits or t-bills are being penalized at a rate of 0.25% per year, there are significant incentives for everyone to convert these assets into zero-yielding paper equivalents in order to avoid the 0.25% penalty. Not only will commercial banks all convert their deposits at the central bank to cash, but the public will clear out their bank accounts in order to hold paper. The upshot is that interest rates can't fall below 0% lest the  entire country turn into a 100% cash economy.

In practice, the 0% bound isn't a tight one since paper currency incurs storage and transportation costs whereas electronic deposits don't. What this means is that a depositor will grudgingly accept a slightly negative deposit rate in order to avoid having to bear the inconveniences of ungainly cash. So the zero lower bound actually lies a bit lower than 0%, let's say -0.4%. However, reduce rates far enough below that and the dash to cash beings.

This is where the CHF 1,000 note comes into the picture. The larger the denomination of paper currency issued by a central bank, the lower the storage and transportation costs. Take CHF 1,000,000 worth of CHF 20 notes. That's 50,000 paper notes. The costs incurred in counting, double counting, checking for counterfeits, packaging, loading into an armoured car, unloading into a vault, paying storage costs on that vault, and finally insuring the hoard will be quite high. Now imagine CHF 1,000,000 worth of CHF 1000 notes. That amount to just 1,000 slim paper notes, a fiftieth of the amount. Handling and storage costs come out to much less. The point being that thanks to the CHF 1,000 note, the zero lower bound binds a bit more tightly in Switzerland than anywhere else in the world.

What I'd expect over the next few months is a mad dash out of deposits into these colourful bits of paper. Luckily, the SNB provides data on its note denominations, which I've charted below going back to 1990.

The value of CHF 1000 denomination notes in circulation. Source: SNB

You can see that in general, the value of CHF 1,000 notes outstanding has grown quite quickly since 1990 and now comprises around 61% of the entire value of the Swiss note circulation. While that tally retreated a bit in 2014, it should start to grow at an above-trend rate in 2015 now that negative rates are in effect. The actual process will go something like this; the Swiss public will ask to convert their bank deposits into CHF 1000 notes, the banks being obliged to provide these notes by going to the SNB and converting their SNB deposits into cash.

If this process doesn't occur, the implication is that the costs of holding 1000 notes are even higher than 0.75% a year, thus giving the SNB even more breathing room to reduce rates.

I'd expect ongoing conversion into 1000 notes to impose a significant burden on the SNB, threatening both the banking system's deposit base and the effectiveness of monetary policy. There are a number of fixes that the Swiss might consider to offset this burden. First, the SNB can bump interest rates back up in order to stem the mania for 1000 notes, hardly an alternative if it is trying to get inflation back up to  its target. Alternatively, the Bank may decide to call in and demonetize the CHF 1000 notes, forcing everyone to accept five CHF 200 notes in its place (an idea discussed here). Since the 200 incurs more carrying costs than the 1000, the conversion into cash will be forestalled and the lower bound will have effectively been loosened downwards. Lastly, the Swiss might consider adopting a crawling peg between cash and deposits, as advocated by Miles Kimball.

The next and last option is the most interesting. When the public asks the banks for CHF 1000s, and the banks ask the SNB for 1000s, the SNB can just say no. In doing so, the SNB will have frozen the quantity of 1000s in circulation.

What will happen next will amount to an instance of Gresham's law. Since a CHF 1000 note is better than five CHF 200 notes due to its lower carrying costs, and 200s can no longer be converted on demand into 1000s thanks to the SNB's freeze, the 1000 should trade in the market at a premium to its face value, say CHF 1012 or 1013. However, legal tender laws typically stipulate that a note cannot discharge debts at more than its face value, thereby resulting in the forced undervalution of the 1000 note in trade. As a result, the Swiss public and its banks will hoard their 1000s rather than spending them, preferring instead make payments and settle debts with lower denominations notes. Thus we get a modern version of Gresham's law, whereby 'good' CHF 1000 notes are driven out of circulation 'bad' lower-denomination CHF notes. Think of it as an unofficial demonetization of the 1000.

Ultimately, I think that this last solution is the easiest and lowest cost alternative for the Swiss to fix their impending problem of mass paper storage at the negative interest rates. It's a temporary fix, however. A permanent solution will require outright demonetization of large denomination notes, or something like Miles Kimball's plan.

Cracks in the zero-lower bound

Shibboleth, by Doris Scalcedo

John Cochrane writes an interesting post that makes the case that removing or penalizing cash would not remove an economy's 0% lower bound. Briefly, the zero lower bound problem arises when a central bank tries to reduce the interest rate on central bank deposits below zero. Because cash always yields a superior 0% yield, everyone will race to convert their deposits into cash, thus preventing a negative interest rate from ever emerging. By removing cash, this escape route is plugged and a central bank can safely guide rates to -4 or -5%.

Cochrane's point is that even if cash is removed, there are a number of alternative 0% yielding 'exits' to which people will flee, the effect being that rates will be inhibited from falling much below 0%. The examples he provides includes prepayment of taxes, bills, and mortgage payments, and the hoarding of gift cars or stored value cards like subway passes. In a follow-up post, he mentions a strategy of rolling over cheques.

There are two points I want to make:

1. Even with alternatives, a central bank can still create inflation

Scott Sumner points out that even in a cashless world at the zero lower bound, the existence of these alternatives cannot impede a central bank from driving up inflation. This is because the other alternative assets that Cochrane discusses are not media of account. To be a medium of account is to be that good which defines the $ unit that appears on a retailer's website and their aisles. What this means is that the the sorts of dollars that a retailer has in mind when setting sticker prices are those issued by the nation's central bank (in a cashless world, this would be central bank deposits). Retailers aren't using gift card dollars or stored value card dollars as the 'reference dollar' for their sticker prices.

Keep in mind that the use of central bank deposits as the medium of account does not preclude retailers from accepting gift cards in payment at the till. However, if they accept them, they'll probably apply some sort of reduction/addition to a good's advertised sticker price. If we assume that gift cards have become quite liquid in the absence of cash, I think it's conceivable that retailers would offer a reduction (ie. take gift cards at a premium) since gift cards would be a better asset than a deposit; in addition to being useful as media of exchange, they yield 0% rather than negative yielding deposits. We could imagine a range of different gift card premia developing based on their perceived quality, with cashiers consulting some sort of electronic guide to calculate the final bill.

In any case, Sumner's point is that as the central bank reduces rates into negative territory, sticker prices will all rise, despite the fact that alternative media exist that can be used to make payments. I think he's dead right.

2. Alternative escape routes will be resolved by simple product alterations, not a legal revolution

Cochrane's posts emphasize that in a negative rate world, all sorts of odd financial loop holes will be exploited in order to earn superior 0% returns. I think he's right on this. However, Cochrane seems to believe that that the government will have to upend 'centuries of law' in order to plug these alternative 0% instruments. I am more sanguine than him. If someone is exploiting a loophole in order to earn a superior 0% return, someone else is bearing that negative return. Institutions forced to bear the negative impacts of these loopholes will have an incentive to quickly evolve simple strategies to plug them, thus precluding any need for either Cochrane's rather dramatic 'legal revolution' or the heavy hand of the government.

Take Cochrane's first 'escape', gift cards. Consider a retailer that issues 0% gift cards in various denominations like $50s and $100s. Assume that in a world without cash, these cards have become relatively liquid. The central bank suddenly pushes rates to -5%. People who own negative yielding bank deposits will flock to buy the retailer's gift cards (assume that both instruments are equally risky) with the goal of immediately improving their expected return from -5% to 0%. The retailer, however, is left holding a -5% asset while owing a 0% liability, an awful position to be in. To remove the burden of this negative spread, our retailer need only reduce the return on newly-issued gift cards to -5%, say be introducing a redemption fee of 5%. A gift card worth $100, when redeemed, now only buys you $95 worth of stuff. Either that or just stop issuing the things. The loophole is closed and the problem solved.

The same goes for Cochrane's other 0% exit, prepayment if bills. A firm that allows for prepayments is accepting a 0% liability on itself; it effectively owes x dollars worth of some service or item. So we are back to our gift card example above, since gift cards are basically prepayments. Impose an appropriately sized fee on those who want to prepay and the problem is solved. Banks have always charged prepayment penalties on mortgages, car loans, and business loans, so this is nothing revolutionary in turning to this solution.

The next of Cochrane's 0% exits is a string of constantly renewed personal cheques. Rather than cashing a personal check, a cheque holder waits for that cheque to go 'stale', usually after 6-months, and then asks the issuer to issue a new one, rinsing and repeating as often as necessary. As physical bearer instruments, cheques (much like cash) cannot be made to pay negative interest, which allows the holder of a cheque to earn a perpetual 0% return. The unfortunate issuer of the cheque is left bearing a 0% liability in a world where their assets are yielding just -5%. This problem will quickly be resolved by people no longer writing checks. There is a less extreme alternative. Banks, unwilling to lose revenues from their cheques businesses, will simply increase cheque cancellation fees. Before a stale check is re-issued, it must be canceled, which traditionally incurs a cancellation fee. If the person running the scheme is required to pay an appropriately sized fee to carry over the cheque, the scheme can be rendered no more profitable than owning a -5% deposit.

Cochrane also points to Kenneth Garbade and Jamie McAndrews's scheme whereby depositors can purchase certified cheques from banks and thereby evade negative rates. According to Garbade and McAndrews, commercial banks "might find their liabilities shifting from deposits (on which they charge interest) to certified cheques outstanding," with this shift imposing significant costs on banks since certified cheques are less stable than deposits. If such a shift were to occur, banks would find themselves bearing a negative spread (liabilities yielding 0% while assets yielding -5%), a position they would be quick to remedy. One option would be to cease the issuance of certified cheques altogether. Alternatively, banks have always charged a fee for certified cheques. They could simply increase this fee to the point that the cost of holding a certified cheque is brought in line with the negative deposit rate. Once again, problem solved.

This fee strategy shouldn't be unfamiliar. It is the mirror image of the strategy adopted by U.S. commercial banks when interest rates were capped during the inflationary 1960s and 70s. Unable to reward depositors with sufficiently high interest rates, banks evaded the ceilings by offering implicit interest in the form of under-priced banking services, say by reducing fees on certified cheques. In our modern era in which deflation is pushing rates towards an equally artificial 0% barrier (in this case arising from the circulation of personal and certified cheques rather than a government imposed cap), all those services that a bank had been underpricing or pricing at market will now be adjusted upwards so that they are overpriced.

In sum, no revolutions here, just markets adaptation via boring old fee changes.

In closing, Cochrane has much more legitimate worries about two other problems: Big Brother and the disproportionate effect on the poor if cash is removed. Agreed, these are big issues. Now it could be that the emergence of cryptocurrencies such as bitcoin solves the Big Brother problem so that there is no role left for cash in preserving anonymity. Let's put bitcoin aside though. The simple answer to both of Cochrane's concerns is that we don't need an outright ban on cash to remove the 0% lower bound. Just adopt Miles Kimball's proposal for a crawling peg between cash and deposits. Kimball's peg is designed in a way that it would impose the same penalty on cash as that incurred by deposits. This would allow central banks to push rates to zero without mass flight into cash, all the while preserving the institution of cash for the poor and those requiring anonymity. (I've written in support of Kimball's plan here and here)

There is also my lazy man's route toward getting below the lower bound (here, here, here). I call it lazy since it's not nearly as complete as Kimball's solution, nor as complicated. Simply withdraw high denominations of bills like $100s, $50s, and $20s. When a central bank sends rates to -3% or -4%, people will balk at fleeing from deposits into $1s, $5s, and $10s since low denominations are very inconvenient to store. That way the poor still get to use cash and the zero lower bound can be breached.

Cashing up the system

David Beckworth had a very interesting pair of posts outlining how QE would only have had a meaningful effect on the economy if the associated monetary base growth was permanent.

One addendum I'd add on the topic is that even permanent expansions of the monetary base can have no effect on the economy. The best example of this is the "cashing up" of the Reserve Bank of New Zealand (RBNZ) in 2006, an event that doesn't get the attention that it deserves in monetary lore.

Banks typically hold deposit balances at their central bank in order clear payments with other banks. Because New Zealand's clearing and settlement system was suffering signs of stress in the mid-2000s including delayed payments, hoarding of collateral, and increased use of the RBNZ standing lending facilities, the RBNZ decided to 'flood' the system with balances to make things more fluid. This involved conducting open market purchases that bloated the monetary base (comprised of currency plus deposits) from around NZ$6 billion in mid-2006 to just under NZ$14 billion by December of that year. See chart below.

 (Note that the RBNZ's problems began far before the credit crisis and were due entirely to the peculiar structure of the clearing system, not New Zealand's economy.)

This 'cashing up' of New Zealand's monetary system was fast, large, and permanent, so New Zealand should have experienced extremely high inflation, right? Actually, New Zealand's inflation rate was very reasonable and even declined a bit that year.

Why is that? As long as central banks are allowed to provide interest payments to depositors, permanent increases in the monetary base needn't have much of an effect on the economy. Like most modern central banks, the RBNZ pays interest to commercial banks that keep balances on deposit at the central bank. So even if a central banker permanently amps up the supply of balances, banks will not all simultaneously try to offload this excess supply and hyperinflation does not follow. This is because the deposit rate 'carrot' that is dangled in front of banks helps offset their urge to get rid of the excess. In fact, even as it was cashing-up the system the RBNZ increased its deposit rate by 5 basis points five times between July and October 2006 for a total increase of 25 basis points, a slight tightening of monetary policy. This brought the return on central bank balances to a level competitive with other assets like government treasury bills. Instead of panicking as the monetary base permanently exploded by 150%, New Zealand's banks shrugged and calmly accepted the new balances.

When central banks don't pay interest on deposits then a permanent increase in the base will typically have a large effect on the economy. Without an interest rate carrot to make deposits competitive with other assets, banks that are faced with large excess balances will race to get rid of them, causing a large spike in the price level. With the U.S. Federal Reserve only earning the legal right to pay interest in 2008, there are now no major central banks (to my knowledge) that lack their own deposit rate carrot. And all of them set that rate to be roughly competitive with the rate on other short term assets like treasury bills, specifically a few basis points below the rate on competing assets.

Just to make sure I've made my point, with the deposit rate on central bank balances being (almost) competitive with other assets, a permanent doubling in the supply of money will only cause significant inflation when combined with a large cut to the deposit rate. Keep that rate unchanged and the same doubling will only have a marginal effect on the economy. A doubling in the supply of money would actually be deflationary if combined with a large enough rise in the central bank's deposit rate. In short, central bank decisions about the deposit rate can override whatever permanent changes are made to the money supply.

Beckworth makes the case that the Federal Reserve's quantitative easing was never more than a temporary measure, and therefore had no meaningful effects on the economy. I agree with him that QE didn't have much of an effect, but not necessarily because it was temporary. Let's say that QE was not a temporary phenomenon but rather more akin to a permanent New Zealand-style 'cashing up' of the system. If so, would QE's effects on the economy have been more marked? Given the precedent set by New Zealand in 2006, I don't think so. Throughout the Fed's three QEs, the rate offered on Fed balances (generally referred to as interest on reserves, or IOR) was very competitive with the rate on other government-issued short term assets, and therefore banks would have been unlikely to feel any need to rid themselves of their rapidly growing pool of balances. So while I agree with Beckworth that the Fed's 'dirty little secret' is that QE was muted from the start, I don't think that this powerlessness necessarily hinges on QE being temporary—after all, permanent increases can fall on deaf ears, depending on the level at which the central bank's deposit rate is set. New Zealand is living proof of this.


PS. This isn't a gotcha post. Beckworth has mentioned this stuff before.

PPS. I'm not sure whether he'll agree with the following, though. Take the RBNZ again. It's 2006  and the Bank is paying a competitive rate on central bank balances. When it cashes up the system, the RBNZ simultaneously announces a regime change; it will now target 4-6% inflation rather than 1-3% inflation. It also says that the permanent increase in the supply of balances (and subsequent increases if necessary) will be sufficient to ensure this target is reached. The threat of a lower deposit rate will not be used to enforce the target, the rate being left unchanged. Will the RBNZ manage to hit its new target? I say no. Despite a regime change and a commitment to permanent open market operations, the Bank won't succeed in doubling inflation. This is because the unchanged deposit rate will be set too high, interfering with the RBNZ's ability to carry out its promise. 

References:
Review of the Reserve Bank of New Zealand's Liquidity Management Operations - A consultation paper, March 2006 [link]
Doubling Your Base and Surviving. Anderson, Gascon, Liu [link]
RBNZ 2007 Annual Report [Link]

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...and on a totally unrelated note, Happy New Year!

These were my top five visited posts in 2014, as measured by Google.

1. Fedcoin
2. Draghi's fake zero-lower bound and those pesky €500 notes
3. Is the value premium a liquidity premium?
4. Gilded Cage
5. Gresham's law and credit cards

Fedcoin, which I think the internet overrated, got picked up by Ycombinator, while Draghi's fake zero-lower bound and Is the value premium a liquidity premium (both much better than Fedcoin) were tweeted by Joe Weisenthal, spreader of ideas extraordinaire. Gilded Cage demonstrates the fact that people tend to prefer posts that attack individuals or groups of people and, finally, Gresham's law and credit cards is just plain awesome  ;)

Two of my favorite posts that went pretty much under the radar screen were Fear of Liquidity and Liquidity Everywhere. Ignoring the fact that these titles sound like adverts for diapers, do give them a read.

Thanks to all you who comment on this blog. It's always fun to read your thoughts, they get me thinking about the next post.

JP