The “fiscal cliff” of mandated tax increases and spending at the end of this year is simply the peculiar American version of the struggle of advanced countries around the world to deal with mountains of debt. The euro zone debt crisis can be depended on to provide constant grist for the news mill, as Quartz’s Euro Crunch obsession demonstrates. Japan’s debt is a quieter, but in many respects, larger time bomb, as Anthony Fensom explains in “Forget Europe: Is the Real Debt Crisis in Japan?” backed up by an official International Monetary Fund warning. And our mother country across the pond is not immune.
What people don’t fully appreciate is the extent to which hobbled monetary policy has exacerbated these debt crises. The high levels of unemployment that have dragged down tax revenues and elevated government spending—as well as making it harder for individual households to get out of debt—could have been cut short if monetary policy had more vigorously fought the slumps that have faced the US, the euro zone, Japan and the UK. And whatever the Fed, ECB, Bank of Japan and Bank of England could have done (more Quantitative Easing, anyone?), there is little doubt that they did less than they might have because of their inability to push short-term interest rates more than a hair into negative territory. In his November 2000 academic article “Overcoming the Zero Bound on Interest Rate Policy,” Carnegie-Mellon economist Marvin Goodfriend explained with admirable directness: “No one will lend money at negative nominal interest if cash is costless to carry over time. Therefore, the power of open market operations to lower short-term interest rates to fight deflation and recession is strictly limited when nominal rates are already low on average.” In other words, if a central bank tries to push short-term interest rates very far below zero, people will shift to storing their own massive piles of paper currency, which makes it a lot harder for central banks to do their jobs.
In “How Paper Currency is Holding the US Recovery Back,” I explained how subordinating paper money to electronic money can end recessions and stop inflation. Freeing up monetary policy then makes it possible to raise taxes or cut spending to deal with debt without throwing the economy back into a deep recession. And as Matthew Yglesias points out, with the means to keep the economy at the natural level of output—at the sweet spot between recession and the overheating that accelerates inflation, we “… could happily move on to more interesting topics, such as: How do countries get rich rather than simply escape recession?”
The key is to allow for an exchange rate between paper currency and money that is recorded electronically in bank accounts. I am proposing that in times of economic emergency, the rate at which electronic money could be converted into paper currency would be allowed to vary over time. Let me use the pound as an example, and a 4% per year rate of depreciation of paper money. The exchange rate would start out at par: withdrawing £100 from a UK bank account would yield £100 of paper money, as usual. But after three months, if you withdrew £100 from a UK bank account, you would be handed about £101 in paper money. After six months, you would get about £102 in paper money, and so on. Of course, the exchange rate would apply for deposits as well: after six months, depositing £102 of paper money would add £100 to what was shown in your bank account. Retailers might accept paper money at par for longer than banks, but after a while, they too would ask for more in paper money than would be charged to a debit or credit card. But the extra paper money banks would give for withdrawals would make that a wash. The exchange rate between paper pounds and electronic pounds wouldn’t directly change how far anyone’s paycheck would go. What it would do is allow the Bank of England to set short-term interest rates anywhere above negative 4%. That is, since the value of paper pounds would be shrinking at the rate of 4% per year in relation to electronic pounds, the Bank of England could push interest rates so low that the number of electronic pounds in a bank account would gradually shrink at a somewhat slower rate.
What a negative interest rate means is that there is no way for someone saving money to stay even using a totally safe saving strategy, either in a bank account, or by saving currency. Negative interest rates help to fight recessions, and once the economy recovers, interest rates will soon return to normal. Indeed, even someone living off of interest income is likely to be helped more by the quick recovery of the economy, leading to interest rates above zero, than if interest rates had not been able to go negative, but had stayed at zero for a long time.
Negative interest rates stimulate investment when firms find that building a new factory or buying new equipment in even a wounded economy earns a better return than putting money in the bank or keeping paper money in a safe. Negative interest rates have another powerful effect as well. They cause savers to seek higher returns in foreign stocks, bonds and other assets. For the UK, the purchase of foreign assets would put pounds in the hands of people outside the UK whose only good use for those pounds is to either to buy UK products or to pass off the unwanted pounds to someone else until someone spends them on UK products. So negative interest rates stimulate exports.
Right now, most major economies are struggling to get enough aggregate demand stimulus for their economies. And one nation’s exports—an addition to aggregate demand, are another nation’s imports—a subtraction from aggregate demand. So the powerful effect of negative interest rates on exports means that the first movers in the transition to electronic money gain aggregate demand at the expense of the laggards. But that should just spur the laggards to make the transition to electronic money as well; then the whole world will have all the aggregate demand stimulus it can possibly use (and more, if care isn’t taken not to overdo the stimulus). Or if other nations stubbornly resist the transition to electronic money, the first movers could still come out ahead even if they invited other countries to do exchange rate interventions that would give them less of a boost in exports, but a bigger boost to investment in factories and equipment. (One reason the first movers would come out ahead is that such exchange rate interventions would involve the laggards lending to the first movers at even lower negative interest rates than would otherwise prevail. That means the laggards would, in effect, be paying the first movers an arm and a leg to take the funds.)
The fact that the transition to electronic money rewards the first movers and punishes the laggards makes it much more likely that this transition will actually happen in the near future. Once any major economy gets the ball rolling, others will soon follow. And nations should be vying to be the first. My use of the UK as an example above is not random. The UK could easily be the first nation to make the transition to electronic money. Such a dramatic move would be easier to push through in a parliamentary system of government, with a powerful Chancellor of the Exchequer, than in the American system of government, replete with checks, balances, and gridlock. As Joe Weisenthal writes, the Bank of England has a creative incoming Governor in Mark Carney—who is now Governor of the Bank of Canada—and a Chancellor of the Exchequer willing to go outside the monetary policy box far enough to appoint a Canadian. The economy of the United Kingdom needs help. It is the mother country for modern economics as well as for American politics. There are many UK economists who can fully appreciate the opportunity the transition to electronic money would provide. This transition is in many ways a small one compared to the great monetary transitions of the past: paper money is just a way station on the road between barter and coins and a full embrace of the electronic money that is already a big part of our daily lives.