Sunday, January 4, 2015

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.


  1. so far much of the discussions seem to revolve around a closed economy. what are your predictions for an open economy (large or small) when it unilaterally decides to eliminate cash?

    1. There is a good possibility that foreign cash might begin to circulate in any country that decides to eliminate cash. Even if this happens, the domestic central bank's deposits are likely to remain the nation's medium of account, so it shouldn't affect the nation's ability to break through the ZLB.

  2. on "alternative escape routes" -

    1. May as well include what I said there:

      "I think its questionable to assume that these various issuers of zero interest liabilities will not respond with some form of proactive liability management - instead of passively allowing themselves to be stuffed with funds they can only invest at a negative spread. Banks for example factor mortgage prepayment risk into their pricing (and charge prepayment penalties for it at least in Canada), and negative interest rates won't suddenly pre-empt that pricing strategy. Other examples offered by Cochrane similarly could be subject to pricing or quota controls.

      The hot potato theory seems to assume that such evasive liability management responses will not be forthcoming.

      Liability management fends off the hot potato.

      It still ends up being about interest rates."

    2. The first order of business on those zero interest liabilities would be to introduce appropriately constraining term structures in order to limit the liability - e.g. short duration gift certificates (which is already the case to some degree), similar duration rules for outstanding cheques, and so on. Makes the "problem" more manageable for the issuer.

    3. Yes, limiting duration is one step to preventing issuers from being stuffed with funds, although there has to be a way to prevent constant rolling over. Fees would do the trick. I'm not sure what you mean by 'fending off the hot potato', since it wouldn't prevent a central bank from creating inflation.

  3. This “problem” and the types of solutions available is actually a transformation of something that already exists for banks at the zero bound without negative interest rates.

    The monetarist prescription (simplified) as I understand it is that the Fed should have done more QE or better yet should have committed to permanent QE. This presumably is hinged to belief in the hot potato.

    But the hot potato thinking seems to assume that banks will not take action in their own liability management. It is all a question of degree. Whether banks earn 25 basis points, 0 basis points, or minus some number of basis points on reserves, they will respond with liability management pricing techniques (which they already have) that will shift the potato back in the other direction. What they will not do is force their own asset allocation and capital deployment rules in the direction of taking on new risk that requires an additional allocation of capital, other things equal.

    Liquidity management does not drive capital management in banking.

    1. JKH: I'm not really following you here. Are you saying that a reduction of interest rates to something like -4% won't cause inflation? That banks will somehow counteract the actions of the central bank?

    2. It’s an oblique point about banks that perhaps I’m overemphasizing here.

      The point is that the banking system as a whole will do whatever it takes to deflect or “fend off” the hot potato effect - in the sense that it will respond in the most effective ways it can to protect interest margins in the case of negative interest rates and that this importantly will include liability management as much as or more so than asset management. That deflects the hot potato transmission from bank reserves back to customer deposits. Significant asset initiatives (i.e. new risky assets) require additional bank capital, other things equal. But QE does nothing directly to increase bank capital, other things equal – not in the very direct way that it increases reserves. So banks will attempt to re-price their administered rate liabilities and/or charge fees, etc. in order to protect their margins.

      Banks individually also understand that the reserve system is closed to them collectively, and that playing hot potato with reserves can be counterproductive beyond a point. An individual bank is aware than loading up on junk bonds (as an extreme example) won’t chase reserves out of the system. Reserves will return somewhere. Also, junk bonds require capital, and QE doesn’t provide capital in the way it provides reserves.

      Anyway, banks will attempt to deflect or “fend off” the hot potato effect away from transmission through their own asset portfolios (including reserves) and back toward the liability side. They will try to redirect the QE transmission mechanism from reserves to deposit liabilities in other words.

      Perhaps this is more generally understood, but I don’t see much reference to it in write-ups about QE effects. Banks are special in this particular way, in the sense that QE expands the broad money supply that exists on bank balance sheets - in the first order of things - since most bonds sold don’t come originally from bank portfolios. So the distinction between reserve portfolios and deposit portfolios seems relevant when imagining how QE “works” with positive or negative rates.

      And then I’m saying that the general response of zero rate liability issuers of many types in the face of negative interest rates would be similar to how banks would react with respect to protect interesting margins against reserve portfolios paying negative interest. And banks already act this way to some degree - even earning positive 25 points on reserves – in the sense that this return constitutes a tiny contribution to their interest margins and potentially means an inadequate return after expenses and taking into account funding liabilities that must still exist somewhere on their balance sheets against those reserves (even though reserves are risk free from a credit standpoint). So instead of concentrated, aggressive initiatives on the asset side, they will also fine tune pricing on the liability side.

      Of course, other financial institutions have their own capital allocation paradigms. But those institutions are primarily the active sellers of bonds into QE, and therefore will have something in mind for their own portfolio management. Banks aren’t in that favored position, as they are passive recipients of the first order deposit and reserve effect of QE. And households have their own less sophisticated intuitions about “capital allocation” (meaning “saving allocation”), but at that point maybe the pure liquidity effect begins to kick in more so as a deposit hot potato.

      (Separate observation: capital allocation for the private sector (requiring saving) is in a sense complementary/analogous to fiscal policy in the government sector (deficits create private sector saving). In this sense, monetary policy is fighting for priority over fiscal policy and capital allocation norms.)

      So I’m not saying inflation is not possible – just commenting on how this is likely or not likely to happen, and where the money effect will most likely come from.

    3. Sorry for the delay, swamped these days. Can you tell me what exactly you disagree with in my post? Is it my first point or the second point? What specific line is jumping out at you?

    4. I think the comment I had made elsewhere and quoted above is in agreement with your post. If cash were eliminated, there are a number of initiatives that vendors can take in order to convert what might be in effect zero interest liabilities to interest rate sensitive liabilities. That way, they avoid being gamed by those who may be seeking out ways of creating relatively high yielding zero interest assets in an environment of generally negative interest rates.

      Banks in particular if they earned negative interest on reserves would take measures to protect their interest margins through negative rates and/or fees etc. on the liability side of their balance sheets. My point there more generally is that banks will attempt to deflect the “hot potato” impetus of any low or negative interest rate on excess reserves back to the deposit side of the bank.

      So I’m agreeing with your post directionally in terms of these kinds of countermeasures when currency is withdrawn, and just adding something about bank reserves and deposits. That point is that whether or not currency disappears, it is important to differentiate between the reserve and deposit sides of banking when looking at monetary inflation.

    5. And it looks like your first point (Sumner's point I guess) is the medium of account argument that supports your second point (the list of countermeasures). The two together make sense to me at least directionally.

      I have no idea how well this would work in total. But again, its not going to work that well through bank reserves directly, because banks have so many options to protect their interest margins without expanding their balance sheets through assets initiatives that might be driven by negative interest rates on reserves.

      Again, I realize this is only a tangential observation to the main points of your post.

    6. JKH, thanks for the clarification. Sometimes I need to be hit over the head with a bat before things settle in my brain.

      I understand now what you mean by emphasizing 'liability management' vs 'asset management', and I pretty much agree with you on that count.