Kocherlakota on cash

Narayana Kocherlakota, formerly the head of the Federal Reserve Bank of Minneapolis and now a prolific economics blogger, penned a recent article on the abolition of cash. Kocherlakota makes the point that if you don't like government meddling in the proper functioning of free markets, then you shouldn't be a big fan of central bank-issued banknotes. For markets to clear, it may be occasionally necessary for nominal interest rates to fall well below zero. Cash sets a lower limit to interest rates, thus preventing this rebalancing from happening.

I pretty much agree with Kocherlakota's framing of the point. In fact, it's an angle I've taken before, both here and in A Libertarian Case for Abolishing Cash. Yes, my libertarian and other free-marketer readers, you didn't misread that. There is a decent case for removing banknotes that is entirely consistent with libertarian principles. If you think usury laws are distortionary because they impose a ceiling on interest rates—and there are some famous libertarians who have railed against usury—then an appeal to symmetry says that you should be equally furious about the artificial, and damaging, interest rate floor set by cash.

Scott Sumner steps up to the plate and defends cash here. He brings up some good points, but I'm going to focus on his last one. Scott says that a cashless economy would create a "giant panopticon" where the state knows everything about you. I quite like Nick Rowe's response in which he welcomes Scott to the Margaret Atwood Club for the Preservation of Currency. In Atwood's dystopian Handmaid's Tale, a theocratic government named the Republic of Gilead has taken away many of the rights that women currently enjoy. One of the tools the Republic uses to control women is a ban on cash, all transactions now being routed digitally through something called the Compubank:

I agree that we don't want to abolish cash if it is only going to lead to Atwood's Compubank. But Scott misses the fact that even though Kocherlakota wants the government to exit the cash business, he simultaneously wants fintech companies to take up the mantle of anonymity services provider. Like Sumner, Kocherlakota doesn't seem to want a Compubank.

For instance, in a recent presentation entitled The Zero Lower Bound and Anonymity: A Monetary Mystery Tour, Kocherlakota highlights the potential for cryptocoins Zcash and Monero to substitute for central bank cash. Unlike bitcoin, these cryptocoins provide full anonymity rather than just pseudonymity. If you want to learn more about Zcash, I just listened to a great podcast with Zcash's Zooko Wilcox-O'Hearn here. As for Monero, Bloomberg recently covered its spectacular rise in price.

As Monero illustrates, cryptocoins are incredibly volatile. Is anonymity too important of a good to be outsourced to assets that behave like penny stocks? I'm not sure. And as Nick Rowe points out, the concurrent circulation of deposits (pegged to central bank money) and anonymity-providing cryptocoins would create havoc with the traditional way of accounting for prices. Retailers would probably still set prices in terms of central bank money but anyone wanting to purchase something anonymously would have to engage in an inconvenient ritual of exchange rate conversion prior to consummating the deal. Perhaps these are simply the true costs of enjoying anonymity?

Kocherlakota doesn't mention it explicitly, but should cash be abolished in order to remove the lower bound to interest rates, a potential replacement would be a new central bank-issued emoney, either Fedcoin or what Dave Birch has dubbed FedPesa. A good example of a Fedcoin-in-the-works comes from the People's Bank of China, which vice governor Fan Yifei expects to "gradually replace paper money." As for Birch's FedPesa, a real life example of this is provided by Ecuador's Dinero electrónico, a mobile money scheme maintained by the Central Bank of Ecuador (CBE) for use by the public.

Should a government decide to abolish cash and implement a central bank emoney scheme in its place, it would be possible to set negative interest rates on these tokens while at the same time promising to provide both stability and anonymity. One wonders how credible the latter promise would be. The CBE requires that citizens provide national identity card before opening accounts. And consider that the PBoC's potential cyptocoin will be designed to provide "controlled anonymity," whatever that means. Unless significant safeguards are set, it's hard not to worry that a potential Atwood-style Compubank is waiting in the wings.

An alternative way to coordinate a smooth government exit from the cash business is Bill Woolsey's idea of allowing private banks to step into the role of providing banknotes. In this scenario, the likes of HSBC, Bank of America, Wells Fargo, Deutsche Bank, and Royal Bank of Canada would become sole providers of circulating banknotes. Wouldn't this simply re-establish the zero lower bound? Not necessarily. As I wrote back in 2013, the moment a central bank sets deeply negative interest rates, private banks will face huge incentives to either 1. get out of the business of cash or 2. stay in the game while modifying arrangements, the effect being that the zero lower bound is quickly ripped apart.

The provision of anonymity services via the issuance of private banknotes has some advantages over cryptocoins like Zcash. Since they'd be pegged to central bank money, private banknotes would provide 'fixed-price' anonymity. Nor would the public have to constantly do exchange rate conversions between one currency type or the other. On the other hand, Zcash payments can be made instantaneously over long distances; you just can't do that with banknotes. And of course, there's also the stablecoin dream, i.e. the possibility that private cryptocoins like Zcash might themselves be stabilized by pegging them to central bank cash, as Will Luther describes here (for a more skeptical take, read R3's Kathleen B here)

Because of what he calls "over-issue" problems, Kocherlakota is more confident in the prospects for cryptocoins than private banknotes. I'm not so worried. The voluminous free-banking literature developed by people like George Selgin, Larry White, and Kevin Dowd teaches us that as long as silly regulations are avoided, the promise to redeem notes at par in a competitive environment will ensure that the quantity of private banknotes supplied never exceeds the quantity demanded. Don't look to the so-called U.S. Wildcat banking era for proof. During that era, note-issuing banks were too encumbered by strict laws against branch banking and cumbersome backing rules to effectively supply notes, as Selgin points out here. Rather, the Scottish and Canadian banking systems of the 1800s provide evidence that banks can responsibly issue paper money.

Wouldn't the private provision of banknotes require the passing of new laws? Funny enough, U.S. commercial banks can already issue their own banknotes. In a fascinating 2001 article, Kurt Schuler points out that federally-chartered banks have been free to issue notes since 1994 when restrictions on note issuance by national banks was repealed as obsolete by the Community Development Banking and Financial Institutions Act. So the floodgates are open, in the U.S. at least, although as of yet no bank has taken the lead.

If governments are going to remove the zero lower bound by getting out of the business of providing anonymous payments, I say let a thousand flowers bloom. If the void is to be filled, don't put up any impediments to the creation of anonymity-providing fintech options like Zcash, but likewise don't prevent old fashioned banks from getting into the now-vacated banknote game either. Let the market decide which anonymity product they prefer... and celebrate the fact that the government's artificial floor to interest rates has been dismantled.

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P.S. It would be remiss of me to omit pointing out that there are sound ways to dismantle the zero lower bound without removing cash, Miles Kimball's plan being one of them.