Friday, June 21, 2013

Does the zero lower bound exist thanks to the government's paper currency monopoly?

Many moons ago Matt Yglesias wrote that the "zero lower bound is a pure artifact of the existence of physical cash."  In this post I'll argue that the zero-lower bound, or ZLB, is an artifact of our modern central bank-managed monetary system, and not the existence of cash. In a free banking system in which private banks issue banknotes, competitive forces would force bankers to rapidly find ways to pierce below the ZLB, rendering the bound little more than a fleeting technicality.

What is the zero lower bound? When the economy's expected rate of return drops significantly below 0%, interest rates charged by banks should follow into negative territory. But if banks set sub-zero interest rates on deposits, everyone will quickly convert them into central bank-issued paper currency. After all, why hold -2% yielding deposits when you can own 0% yielding cash? The inability to set negative interest rates is the zero-lower bound problem.

As I'll illustrate, the threat of getting stuck at the zero-lower bound would impose such huge losses on private note-issuing banks that bank managers would quickly find creative ways to circumvent the problem. Central bankers, who aren't beholden to the same financial motivations as private bankers, needn't pursue these same zero-lower bound innovations with such zeal. This distinction has significant implications for the economy. Insofar as policies designed to remove the ZLB can prevent large macroeconomic distortions, central bankers are more likely to avoid such policies and destabilize the macroeconomy than private banker who, driven by bottom line concerns, will be quick to adopt ZLB-avoiding innovations.

Let's set up our free banking system. Say that the Fed ceases issuing paper currency and only creates deposits. Into this void, private banks begin issuing their own paper dollar banknotes which can be exchanged for bank deposits at a rate of 1:1. This isn't such a strange idea—for much of its history, Canada has enjoyed a privately-supplied paper currency. A few years later the economy nosedives and pessimism reigns. Private banks are desperate to decrease deposit rates into negative territory, say -4% or so. After all, banks earn income from the spread between the rate at which they borrow and the rate at which they invest. If, during bad times, a banker is investing at a -2% loss, he or she needs to be borrowing at -4% in order to earn spread income.

Unfortunately for our private banker, the intervening ZLB impedes rates from dropping into negative territory. Any attempt to cut to -4% and bank depositors will flock to convert negative yielding deposits into the bank's 0% yielding banknotes. Very quickly the bank's entire liability structure will be comprised of banknotes, a disastrous outcome since a bank that funds itself at 0% while investing at -2% will go broke very quick.

In a negative return world, profit-maximizing private banks would solve their ZLB problem using several strategies:

1. Remove Cash

If banks remove all of their already-issued cash from the economy in return for deposits, the deposits-to-cash escape route will be effectively erased, thereby clearing the way for banks to reduce deposit rates to -4%. One way to do this, courtesy of Bill Woolsey, would be for banks to issue cash with a call feature. Much like a convertible bond allows the bond issuer to force conversion upon investors, bank notes would carry a conversion clause permitting the issuing bank to call in all cash when it desires to reduce deposit rates below zero. [1]

2. Cease conversion into cash

Note-issuing banks might simply close the cash conversion window while allowing existing cash to remain in circulation. This would cut off any rush to convert deposits into cash upon a reduction of deposit rates to -4%. The price of existing cash would jump to a high enough level such that it would be expected to decline at a rate of 4% a year. Conversion stoppages are not without precedent. In 18th century Scotland, banks often issued notes with an option clause that allowed them to cease redemption should a bank run begin.

3. Penalize cash

By penalizing cash, a bank imposes a large enough cost on cash holders so that negative yielding deposits are no longer inferior to cash. There are plenty of ways for a bank to do this. One way is to impose a negative interest rate on cash by requiring cash holders to pay to "update" their bank notes lest they expire. This update fee, which would amount to around 4% a year, would forestall depositors from making a dash for cash when the bank sets deposit rates at -4%. In times past, locally-issued "scrip" like Worgl have had negative interest rates attached to them.

Another creative way for a banker to penalize cash is to impose a capital loss on cash holders. Rather than offering permanent 1:1 cash-to-deposit exchanges, banks might commit themselves to buying back cash (ie. redeeming it) in the future at an ever worsening rate to deposits. As long as the loss imposed on cash amounts to around 4% a year, depositors will not convert their deposits to cash en masse when deposit rates are cut to 4%.

In sum, a number of innovative routes are available for note-issuing banks to let their borrowing costs drop into negative territory. By necessity, private note-issuing banks will adopt these strategies in order to protect their shareholders from the painful effects of mass conversion of cheap deposit funding into relatively costly 0% cash.

That's all fine and dandy, but our note-issuing mechanism is run by a centralized monopoly, not competing private banks. Because the ZLB is no less binding for central banks than it is for free banks, over the last few years economists and pundits have come up with all sorts of draconian techniques for central banks to escape the ZLB. There have been calls to ban cash, penalize it, and destroy it. At first I was somewhat appalled by these ideas as they seemed to be gross infringements on people's ability to use cash. Over time I've realized that these authoritarian solutions are, somewhat paradoxically, the very same innovations that competing bankers would devise in a free banking world in order to free themselves of the ZLB problem. In other words, we can back out what a monopolist currency issuer *should* be doing  to combat the ZLB by imagining what a network of competing banks *would* do. [2]

For instance, in a negative rate world a central bank ban on paper currency would be the equivalent of competing note-issuing banks simultaneously calling in their entire issue of paper currency in order to protect their solvency. If free banks were to penalize cash by redeeming it at ever deteriorating rates, this would be exactly the same strategy that Miles Kimball advocates central banks adopt in order to escape the ZLB.

That central banks have been so slow to evolve strategies for escaping from the ZLB could be due to any number of factors. Central banks aren't privately owned nor are they disciplined by competition, and central bankers don't have a mandate to turn a profit. Free banks, burdened by all of these checks, would be forced to rapidly adopt ZLB-escaping strategies or perish.

Further hampering efforts to get central banks like the Fed to innovate solutions to the ZLB is that these efforts might conflict with other goals. Withdrawing cash, penalizing it, or limiting conversion will put an end to, or at least diminish, the circulation of US paper dollars overseas. It might even result in the circulation of some other nation's 0% yielding currency in the US. But the universal circulation of greenbacks is one of the most potent symbols of US hegemony, real or perceived. In the interests of protecting this symbol, innovations for escaping the ZLB may get short shrift. In a free banking system, these sorts of non-pecuniary motives are unlikely to outweigh the profit and loss calculation that dictates the necessity of adopting such innovations.

So the zero lower bound problem isn't a problem with cash per se, it's just a function of monopolistic intransigence. If you really want to short circuit the ZLB, better to devolve the provision of notes to profit-seeking private banks. Until then, hopefully evangelists like Miles Kimball succeed in getting central banks to adopt  free banking-style contingency plans in preparation for the next time we experience a crisis that necessitates sub-zero interest rates.

[1] I confess that much of this post was inspired by ideas in two Bill Woolsey posts that I thought deserved wider circulation.

[2] The idea that harsh central bank policies like banning cash or penalizing currency might mimic free banking responses is a recurring theme on this blog. Here, I hypothesized that in a world characterized by free banking, legal tender laws might evolve naturally as the result of market choice. It's a strange world.


  1. "Withdrawing cash, penalizing it, or limiting conversion will put an end to, or at least diminish, the circulation of US paper dollars overseas."

    Maybe not. Suppose that a crawling-peg paper currency is introduced that pays positive rates of interest as well as negative, i.e. a consistent small interest spread (just enough to cover costs). That could make U.S. currency more popular overseas, since the carrying cost would almost always be lower than any competing currency. Plus, overseas users could use the paper currency as their unit of account rather than U.S. electronic money, eliminating point of sale conversion math.

    1. That's a good point. Most of the discussion about the crawling peg concerns what happens when returns go below zero, but if they are above zero, which they usually are, then any currency which offers a small return on top will out-compete the field.

    2. "Suppose that a crawling-peg paper currency is introduced that pays positive rates of interest as well as negative,"

      Ok, Konig clearly knows what you are talking about, so I assume you're making sense, but you do realize that for most of us, the idea of something paying both positive and negative rates of return is a little puzzling, don't you?

    3. Gene, I think what Max meant to say is that crawling-peg paper currency might yield a positive return at some point in time, and at another point in time yield a negative return. But not simultaneously.

      If the banker needs to encourage depositors to continue holding deposits when the deposit rate falls below zero, they'll set the crawling peg so that cash is penalized. When the deposit rate rises back above zero, they may set the crawling peg such that cash earns a positive return. Setting a positive return might be a good policy insofar as it allows the bank to steal note share from competitors who only pay 0% on notes.

  2. JP,
    Cash convertibility is like a put option. It allows a holder to "sell" deposits for cash at par. The question is, would a free banking regime operate without that put?

    On the liability side, if my free bank offered that put and competitors didn't, I would attract all deposits and become the monopoly issuer. Or I could charge a premium for the put and earn economic rent.

    On the asset side, its more complicated. The existence of the put would mean that I could not match lending rates when other banks took them below zero. This is like a call on borrowers to buy their loans in exchange for a zero-rate one. Since they know I own that call, borrowers may want a discount on the loan. This would prevent my monopoly position.

    We have a put and a call. Is there a market inefficiency that makes one more likely than the other? This is the same as asking whether cash exists out of some previous technological constraint, or whether a system gravitates towards the put and not the call for some other reason. I'm not sure of the answer. Judging from the behavior of depositors and borrowers in regimes that allow penalization of safely-stored wealth, I would venture to guess that the cash put is a feature that emerges from a complex system.

    1. Diego, I'm not quite following you on your 3rd para on the asset side.

      In general though I think it can't hurt to use the language of options. We know that Scottish banks circa 1750, which were freer than most, offered a conditional put option on notes, the famous option clause. Notes could be "put" back to the bank for specie, until the put was temporarily suspended by the bank. So notes and deposits with various sorts of exotic options attached to them have existed in the past, which means we needn't be constrained by the present status of notes/deposits when we try to imagine how banks might react to a plunge below 0.

  3. BTW, one "inefficiency" might be behavioral. That is, it may have to do with an "irrational" fear of falling below par, even though the put that prevents that from happening is costly.

  4. My latest blog post: "The Employment To Population Ratio (EMRATIO) is NOT a good indicator"

  5. "Over time I've realized that these authoritarian solutions are, somewhat paradoxically, the very same innovations that competing bankers would devise in a free banking world"

    I don't think it's that paradoxical as the "free banking" world you describe sounds a lot like an authoritarian world run by banks. In this world banks apparently still have direct access to state money via central bank deposits, but no one else does. They are all forced to use bank money exclusively because the state has apparently turned into an organization that operates only to benefit bankers.

    I think if you tried to deny the population its current right to own money issued by its own government, whilst preserving that as an exclusive privilege to be enjoyed only by bankers, there would be blood on the streets in no time.

    1. The scenario you describe doesn't sound much like a 'free market' in money, it sounds more like a form of banker fascism. That is, a state money system in which only banks are allowed to own state money, thus forcing everyone else to use only bank money.

      Or are you suggesting your 'free banking' system could be based on something other than state money, such as gold bullion, perhaps? If so, wouldn't that undermine the ideas you put forward above?

    2. As in banking so in every industry. Consumers can't buy cheeze whiz directly from Kraft. Only large retailers and wholesalers can. A central bank, whether it is a government monopoly or a privatized clearinghouse, will usually only offer banking product to wholesale banks, and then wholesalers to retail banks, and then finally retail to the consumer. Do you consider the fact that you can't buy Cheeze whiz from Kraft to be "cheeze whiz" fascism?

    3. If the central bank was a privatized clearinghouse, what would the base money be? Gold bullion?

    4. Base money could be gold. Or maybe the clearinghouse could issue deposits that are linked to some index like the CPI and use open market operations to enforce their target, much like modern central bank money.

    5. To read comments on this (nice) post, I hit CLTR+F, typed "gold" and hit "Enter".
      I doubt a free banking system would sit and wait while interest rates are sliding towards negative. The interesting case is where they - like the ECB now - would consider going slightly negative (say -0.25%). What to do? I'd simply pull my money out and put it in a non-lending bank that takes a 0.1% fee to do nothing with my money.

      Personally as long as I can buy precious metals, I couldn't care less what some private bank is doing. As they say, be your own bank. Their tricks wouldn't bother me in the slightest.

  6. Since you now appear to be claiming at least implicitly that "cheese whiz" embodies sufficient "moneyness" for it to be sensibly comparable to present day circulating currencies, I hope we can look forward to some new infographics that illustrate the ever-increasing centrality of this vital petro-dairy commodity to the workings of the modern economy. Seriously,there's a big difference between acknowledging the fact that some particular, historically contingent (market) hierarchy existence today, and accepting the inherent legitimacy of that particular hierarchy as-if it were a permanent/ natural feature. Otherwise, what basis is there for the Austrian critique in the first place? James raises very reasonable questions about the practicality/sustainability of the system that you propose, and imo those questions merit an equally reasonable and serious response.

    1. Lol.

      Ok, forget hierarchy. Imagine that central banks don't exist and Local Exchange Trading Systems keep central ledgers of IOU debtors and creditors. These LETS may implement hand-to-hand currency convertible into LETS IOUs at 1:1. When the economy-wide expected rate of return plunges below 0, a given LETS member will only go into debt (ie spend) if they can charge a negative interest rate. But if this member charges a negative rate, those who hold his/her IOUs will insist that the debtor member exchange these IOUs for 0% currency. The upshot being, no LETS member will spend for fear of being in debt to the community at 0% (when the proper rate is, say, -2%).

      So even in a non-hierarchical world, LETS face pressures to avoid offering cash at the outset. Should the cash option be available, LETS may very well devise ways to ensure ahead of time that a negative rate on cash can emerge should we enter a negative rate world.

  7. Lol to you! Correct me if I'm mistaken, but in the scenario above you seem to be adopting the term "spending" to refer to the the process whereby a "free" financial institution discharges its liabilities to its depositors. But simply redescribing these institutions as LETS rather than plain-old "banks" (or CHAs) doesn't do anything to answer James' original question. In a world in which individual LETS could unilaterally choose to start discharging all pending claims against them using some medium with less "moneyness" than the medium that was originally deposited/invested/committed by the LETS' claimants, the difference between a LET "note" and a LET "iou" would fall somewhere between subjective, cosmetic, and non-existent. And if LETS enjoyed such prerogatives, and presumably were similarly free to provide only as much transparency as "the market will bear," then (barring the existence of some collusive LET cartel or a global mono-LET monopoly), there would be no reason to expect that different LETS circulating instruments with varying levels of "moneyness" would be accepted or exchanged at any consistent rate. The market mechanisms that would encourage LET discipline, innovation, and stable "moneyness" preservation, would be appx. the same as those that operated during various short-lived free banking periods in the past (e.g., LET vulnerability to large and unpredictable spikes in claimant demands for liquidity/circulating instruments). Presumably the system-levels costs of such an arrangement would also be similar (pervasive LETS claimant vulnerability to total loss of claims, lower overall demand for LETS claims, lower overall LETS capacity to fund growth and innovation in the "real economy" etc.), but that's a story for another day. The issue for today is James' original question: in any world that permits LETS to unilaterally suspend their own convertibility obligations when it's convenient, virtually everyone would want to be a LETS -- and given the volatility/unpredictability of the LETS payment/exchange instruments in such a system, virtually no one would want to be LETS customer or investor. How do you square that circle?

    1. " The issue for today is James' original question: in any world that permits LETS to unilaterally suspend their own convertibility obligations when it's convenient, virtually everyone would want to be a LETS -- and given the volatility/unpredictability of the LETS payment/exchange instruments in such a system, virtually no one would want to be LETS customer or investor. How do you square that circle?"

      I wasn't aware that that was James' original question, but that's a good question.

      I'm not talking about unilateral suspensions of convertibility. The clause would only give the bank, or LETS debtor, the ability to suspend convertibility, (or call in cash, or penalize cash) when nominal interest rates fall below 0. It would be a conditional clause, exercisable only rarely, and not upon the issuer's convenience.

      "Correct me if I'm mistaken, but in the scenario above you seem to be adopting the term "spending" to refer to the the process whereby a "free" financial institution discharges its liabilities to its depositors."

      By spending, I mean a LETS member going into a deficit relative to the rest of the community by buying stuff from the community, something they'll be hesitant to do if they can't themselves charge negative interest rates when necessary. In a banking context, a bank will be unwilling to spend on financial assets if it can't set negative interest rates when rates of return plunge below 0%.

  8. JP,

    I don't buy the premise and I'm shocked that you'd entertain the idea that equilibrium interest rates could be negative. Defies everything we know about interest theory (unless you are a Keynesian). Time preference=positive, liquidity preference=positive, productivity of capital=positive. No amount of deflationary expectations could drive those negative.