Friday, May 4, 2012

Escaping the zero-lower bound by only printing $20s

Scott Sumner had a good post on the difficulties of escaping the zero-lower bound when you speak in the language of interest rates. Here he is:
Krugman was way ahead of the profession in 1998 when he emphasized that monetary policy wasn’t about the current setting of the policy instrument, but rather the expected future path. But he didn’t take that far enough. That implies that the current instrument setting is primarily a signaling device. And that means you really need an instrument that doesn’t become mute when you most need it to speak loud and clear. In other words, nominal interest rates are the worst possible instrument. 
In the comments I proposed one way to escape the zero-lower bound:
The Fed simply has to set a negative federal funds rate or IOR, and to prevent everyone from holding their savings in 0% interest cash, impose a compensating burden on cash holders by issuing only $20 bills and lower. This will impose significant inconveniences on cash holders, mainly storage costs, and let the fed funds rate remain below 0.
One problem with this policy would be its negative effect on the $ brand. US $100 and $50 bills are prized all over the world. Cease issuing them, and people might permanently switch to Euros. This would cause the proportion the Fed's zero-interest liabilities to permanently shrink relative to its floating interest liabilities (reserves). That's fine when interest rates are negative or near zero. But when they start to rise, so will the Fed's interest costs, thereby shrinking the Fed's profits and the dividend it pays each year to the government. In other words, less seniorage. Zero-interest cash is a great funding source.

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