Saturday, September 6, 2014

Draghi's fake zero-lower bound and those pesky €500 notes


Having reduced the ECB's overnight target rate to +0.05% and the deposit rate to -0.2%, Mario Draghi confidently told those assembled at Thursday's press conference that the ECB wants to “make sure that there are no more misunderstandings about whether we have reached the lower bound. Now we are at the lower bound.” So it's official, according to its leader the ECB has run out of powder and can't reduce interest rate anymore.

But that's simply not true. I figure that the ECB has at least a handful of interest rate reductions left in its arsenal before the true lower bound bites, especially given that it's now adjusting rates in smaller increments of 0.1% and not 0.25%. And if the ECB were to get rid of its pesky issue of €500 notes, it would have a whole extra round of reductions up its sleeve (more on that later). Shame on Draghi for claiming impotence when he actually has plenty of rate ammunition still left.

The lower bound starts to bind when interest rates are brought sufficiently low that all those banks who own ECB deposits suddenly start to convert them en masse into euro banknotes. Banknotes yield 0%, after all, so if the ECB were to reduce rates on deposits to, say, -10%, then the prospect of costlessly converting those penalized deposits into holdings of 0% yielding notes starts to get pretty tempting. Central bankers are petrified of hitting this cash tipping point, so they refuse to institute anything below a 0% rate on deposits. That's why they call it the zero lower bound.

But the true tipping point at which mass cash conversion kicks in doesn't happen at 0%, nor at -0.05%, and probably not even -0.5%. The reason for this is that cash comes with its own set of inconveniences. For banks, storing cash is costly: it requires a vault, guards, time and energy to count and sort the stuff, and finally it must be insured. The transfer of cash is also expensive: Brinks armoured cars must be hired and loading bays properly staffed. Compare this to an electronic deposit which can be costlessly stored, instantaneously transferred at no cost, and needn't be insured against robbery.

Banks, anxious to avoid these inconveniences, are more likely than not to accept significantly negative rates on central bank deposits before they switch to cash. Imagine, for instance, cheque payments being cleared with daily shipments of cash rather than a click-of-a-button transfer of central bank deposits. It would be hellish. Or consider the huge inconvenience of conducting interbank payments on behalf of clients by shuttling cases of paper notes across town. No, if next month Draghi were to announce a reduction in the interest rate on the main refinancing operations by 10 basis points to -0.05%, and another one the next month to -0.15%, and another one after that, there would be no mass desertion of deposits for cash. Rates would have to go significantly below those levels before the actual lower bound starts to bind. There is a lower bound, but its certainly not at zero.

How far below zero?

This is where the ECB's pesky €500 note comes into the picture. The ECB has differentiated itself from almost all other developed country central banks by issuing a mega-large note denomination, the €500 note. The chart below shows the largest denomination notes issued by G20 countries in US dollar terms, with the Eurozone easily leading the pack.


According to this WSJ blog post, the architects of the ECB decided to issue the €500 note because six of the founding members already had bills whose value exceeded exceeded €200: Holland, Belgium, Italy, Austria, Luxembourg and Germany, with the Bundesbank's 1,000 Deutsche Mark banknote tipping the scale at about €510. And since the ECB is explicitly modeled on the Bundesbank, that's how Europe got its €500 note.

Nor is the value of €500s in circulation minimal. The chart below shows the nominal value (not the quantity) of euro notes in circulation by each denomination, with the value of €500 notes being eclipsed by only that of the €50.


The €500 note creates a uniquely European problem because its large real value reduces the cost of storing cash and therefore raises the eurozone's lower bound. Think about it this way. To get $1 million in cash you need ten thousand $100 bills. With the €500 note, you need only 1,545 banknotes, or about one-eighth the volume of dollar notes required to get to $1 million. This means that owners of euros require less vault space for the same real quantity of funds, allowing them to reduce storage costs as well as shipping & handling expenses. In other words, the €500 note is far more convenient than the $100 note, the €100, the £100, the ¥10,000, or any other note out there (we'll ignore the Swiss). Thus if Draghi were to reduce rates to -0.25%, or even -0.35%, the existence of the not-so-inconvenient €500 very quickly begins to provide a very worthy alternative to negative yielding ECB deposits. The lower bound isn't so low anymore.

All the more reason to remove the €500 note in order to provide the ECB with further downward flexibility in interest rates. If the existence of the €500 note means that Draghi can't push rates below, say, -0.35% without mass cash conversion occurring (ie. another four easings of 0.1% each starting from today's +0.05% rate), but the removal of said note from circulation allows him to drop that rate to -0.65% before the cash tipping point, then he's bought himself an extra three rate reductions by removing the €500. (Hell, by removing the €200 note next, and then the €100 after that, and then... he'd be able to continue reducing rates until deflation had been reversed and 2% inflation re-instituted)

Who loses by the  €500's removal? Regular folks won't suffer much, but denizens of the underground economy probably will. The large-denomination euro is a convenient medium of exchange for criminals, corrupt government officials, and anyone seeking to avoid paying taxes. For instance, in 2010 the UK's Serious Organised Crime Agency required local banks to cease supplying British customers with €500 notes when it found that 9 out of 10 notes were used for illegal activities. Just look at the different demand patterns for the €50 and the €500 in the chart above for evidence. The €50 shows seasonal spikes at Christmas. That's because people withdraw notes at Christmas to make sure they are equipped for unexpected expenses while traveling. Demand for the €500 doesn't budge at Christmas. That's because crime isn't a seasonal enterprise, it's a year-around affair.

So to sum up, Draghi is confused if he thinks he's actually hit the lower bound. Sure, he's brought rates down to zero, but the actual lower bound is a handful of rate cuts below that. The man has got more ammo than he realizes. And second, Draghi can get his hands on even more ammo by getting rid of that silly €500 note. It's existence only greases the wheels of criminal commerce, and insofar as further rate reductions could very well be necessary to help keep Europe out of a painful deflation, its mere existence raises the lower bound and thereby prevents those reductions from happening, thus hurting the regular European. That's two good reasons to get rid of the dang thing!



Related posts on cash and the lower bound problem: 

The zero-lower bound as a modern version of Gresham's law
Does the zero lower bound exist thanks to the government's paper currency monopoly?
No need to ban cash to avoid the zero-lower bound problem

24 comments:

  1. " For instance, in 2010 the UK's Serious Organised Crime Agency required local banks to cease supplying British customers with €500 notes when they found that 9 out of 10 notes were used for illegal activities"

    I'm no criminologists but I have my doubts that forcing drug dealers to use lower denomination bills is going to have much effect on drug related crime.

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    Replies
    1. You'd basically be removing one of the major media of exchange in the criminal economy -- it might even cause a recession in the criminal economy, at least until criminals find a suitably liquid replacement. If they fall back on the 100 euro note, their costs will have permanently increased.

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    2. First. Great article.

      But I think the impact on crime of losing the 500 euro note is being overstated. In reality large criminal organisations that use the 100 USD bill (in South America, Mexico for example) don't seem to be at a significant (<-) disadvantage.

      It also needs to be laundered (it is quite useless as a form of general payment and you must explain its origin when depositing in the bank) making it problematic.

      But minor point. Doesn't take away from your main points in the article.

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    3. Thanks SocTrap. Good points on criminal losses. Even if they are marginal, I still like the idea of removing the 500 for lower bound reasons.

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    4. Well, possibly - maybe at the margin.

      But if you need 5 times as much storage room to hold 1m euros because you need to store it in smaller denominations, then that still sounds like it would be quite a small part of the costs of running an illegal drug dealing operation.

      A bigger issue to me: Even if the ECB really did have rates pinned at zero, and if issuing larger denomination notes did significantly increase the attraction of holding cash - I am of the view that this could be address by more CB purchases of assets that are not direct substitution for money - and this makes more sense than tinkering with the denominations of money.

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    5. I'm in favor of continuing to carry out monetary policy in terms of interest rates, not QE, since we know that the former works (it has for many decades) while the latter is new and untested. Tinkering with denominations is one of the costs of ensuring that we can continue to use interest rates at negative levels, but it pales in comparison to the mass experimentation that is QE.

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  2. Another interesting one JP. I'm a fan of Jason Smith's blog as well, and the "currency component of the base" plays an important role in the information theory based macro equations he's developed. I think I'll alert him to your post here... I wonder if he's every looked into the denominations of that currency.

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    Replies
    1. Thanks, Tom. I stop by his blog every now and then.

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    2. And now I have a post on it -- the 500 € notes seem to be irrelevant to the price level (I'll look into the impact on interest rates next):

      <a href="http://informationtransfereconomics.blogspot.com/2014/09/500-sounds-like-lot-of-money.html'>http://informationtransfereconomics.blogspot.com/2014/09/500-sounds-like-lot-of-money.html</a>

      (And thanks for reading!)

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    3. Thanks Jason, I'll check it out.

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  3. First post where I thought, "Damn, JP is angry."

    You know it's serious when Draghi has cracked the mantle of Canuck politeness.

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    Replies
    1. lol, yeah he really got my goat on this one. But Draghi is not all bad --- I thought he handled the 2012 intra-euro run pretty well. http://jpkoning.blogspot.ca/2013/11/blackberry-needs-draghi-moment.html

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    2. I've personally tested Nick Rowe's patience on more than one occasion, so I know it can be done... but then he's an immigrant, so maybe that doesn't count. I've probably tested JP's too, but I went that crucial extra distance with Nick. :D

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  4. While there is little doubt that settling up checks with bundles of currency would be costly, in a negative nominal interest rate world, banks could still hold reserve balances for clearing and currency for investment purposes. Consider the more usual situation. Banks hold low or zero interest reserves for clearing, and then loans and other securities for investment purposes.

    ReplyDelete
    Replies
    1. Bill, basically what your saying is that there is no zero lower bound problem. It seems to me that at some very negative rate, no one bothers to hold reserve balances for clearing.

      Cash is a far more marketable instrument than a loans and/or security -- it has the potential to do many of the same sorts of things that a reserve balance can do. So in a negative rate world cash might entirely displace reserves. In the 'usual situation', investments/loans lack the physical characteristics that might allow them to be a good clearing medium, plus the Fed's monopoly power prevents that shift.

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    2. "It seems to me that at some very negative rate, no one bothers to hold reserve balances for clearing."

      Yes, but this very negative rate is unrelated to the lower bound that everyone cares about, the lower bound on interest rates in general. That is determined by the storage cost of cash (assuming there's no shortage of cash) and nothing else.

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  5. (copied from Worthwhile Canadian Initiative comment thread)

    JP Koning,

    the blowfish analogy doesn't really work. The CB isn't just blowing out money, it is simultaneously sucking in assets.

    In fact, if it [the CB] was a blowfish, it would make more sense to describe the sucking in part as an expansion of its balance sheet, rather than as a shrinking of it.

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    Replies
    1. The main point is to think of the central bank as a beast that always has the potential to reverse its previous actions, thus the blowing/sucking imagery. Printing presses don't maintain any connection to the product they've printed.

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  6. "So it's official, according to its leader the ECB has run out of powder and can't reduce interest rate anymore."

    But he didn't actually say that did he?

    Maybe he's viewing it as a state of play rather than a point reached.

    And he's emphasizing rather than committing any further action or inaction.

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    1. If you read through the transcript of the press conference (the questions at the end) he pretty much stated that he cannot reduce interest rates anymore.

      http://www.ecb.europa.eu/press/pressconf/2014/html/is140904.en.html

      "...because we announced about the interest rates that they would be for all practical purposes at the lower bound, but technical adjustments could be possible, and that’s what we did. And now we are at the lower bound, where technical adjustments are not going to be possible any longer."

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  7. I missed that, thx

    Although the language isn't exactly crystal clear. He says toward the end:

    "Now, I define a technical adjustment. Really, the reason why I use that is that, for all practical purposes, we were already at the lower bottom. So people wouldn’t really expect any big change in interest rate. But you are right. Perhaps my definition is unduly limiting the movement that we had."

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