The US Federal Reserve’s new determination to keep buying mortgage-backed securities until the economy gets better, better known as quantitative easing, is controversial. Although a few commentators don’t think the economy needs any more stimulus, many others are unnerved because the Fed is using untested tools. (For example, see Michael Snyder’s collection of “10 Shocking Quotes About What QE3 Is Going To Do To America.”) Normally the Fed simply lowers short-term interest rates (and in particular the federal funds rate at which banks lend to each other overnight) by purchasing three-month Treasury bills. But it has basically hit the floor on the federal funds rate. If the Fed could lower the federal funds rate as far as chairman Ben Bernanke and his colleagues wanted, it would be much less controversial. The monetary policy cognoscenti would be comfortable with a tool they know well, and those who don’t understand monetary policy as well would be more likely to trust that the Fed knew what it was doing. By contrast, buying large quantities of long-term government bonds or mortgage-backed securities is seen as exotic and threatening by monetary policy outsiders; and it gives monetary policy insiders the uneasy feeling that they don’t know their footing and could fall into some unexpected crevasse at any time.
So why can’t the Fed just lower the federal funds rate further? The problem may surprise you: it is those green pieces of paper in your wallet. Because they earn an interest rate of zero, no one is willing to lend at an interest rate more than a hair below zero. In Denmark, the central bank actually set the interest rate to negative -.2 % per year toward the end of August this year, which people might be willing to accept for the convenience of a certificate of deposit instead of a pile of currency, but it would be hard to go much lower before people did prefer a pile of currency. Let me make this concrete. In an economic situation like the one we are now in, we would like to encourage a company thinking about building a factory in a couple of years to build that factory now instead. If someone would lend to them at an interest rate of -3.33% per year, the company could borrow $1 million to build the factory now, and pay back something like $900,000 on the loan three years later. (Despite the negative interest rate, compounding makes the amount to be paid back a bit bigger, but not by much.) That would be a good enough deal that the company might move up its schedule for building the factory. But everything runs aground on the fact that any potential lender, just by putting $1 million worth of green pieces of paper in a vault could get back $1 million three years later, which is a lot better than getting back a little over $900,000 three years later. The fact that people could store paper money and get an interest rate of zero, minus storage costs, has deterred the Fed from bothering to lower the interest rate a bit more and forcing them to store paper money to get the best rate (as Denmark’s central bank may cause people to do).
The bottom line is that all we have to do to give the Fed (and other central banks) unlimited power to lower short-term interest rates is to demote paper currency from its role as a yardstick for prices and other economic values—what economists call the “unit of account” function of money. Paper currency could still continue to exist, but prices would be set in terms of electronic dollars (or abroad, electronic euros or yen), with paper dollars potentially being exchanged at a discount compared to electronic dollars. More and more, people use some form of electronic payment already, with debit cards and credit cards, so this wouldn’t be such a big change. It would be a little less convenient for those who insisted on continuing to use currency, but even there, it would just be a matter of figuring out with a pocket calculator how many extra paper dollars it would take to make up for the fact that each one was worth less than an electronic dollar. That’s it, and we wouldn’t have to worry about the Fed or any other central bank ever again seeming relatively powerless in the face of a long slump.
This idea for giving the Fed and other central banks unlimited firepower has an interesting history, which I will discuss below. But first let me spell out some details of how a system of electronic dollars as the key yardstick for our economy might work to clarify what I have in mind. First, following its usual procedures, every six weeks or so the Fed would choose a fed funds rate target. This fed funds rate target could be anything, positive or negative. That would be the interest rate banks would earn. In order to make sure banks can earn more than they pay depositors so that they can provide useful services such as ATM’s without having to have a fee for everything, the interest rate paid directly by the Federal Reserve on electronic dollars held by individuals would be somewhat lower, say 1% per year lower. This interest rate on electronic dollars paid directly by the Fed would a little more likely to be negative. Finally, for paper dollars, the interest rate would be made at least another 1% per year lower by having the discount for paper dollars gradually change over time. In a recession, this would mean that the discount for paper dollars would gradually widen, but in good times (when real interest rates tend to be higher) the discount would narrow until the paper dollar was again at par with electronic dollars, where it would stay until the next recession.
Let me turn now to the intellectual history of the idea of ending the primacy of paper money, as I have tried to piece it together. Noted economist Greg Mankiw, in his April 18, 2009 New York Times opinion piece “It May Be Time for the Fed to Go Negative,” describes this idea of an unnamed graduate student:
Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.
That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.
Whatever its technical merits, as a real world proposal this idea is clearly not ready for prime time, as indicated by Mankiw’s parenthetical remark:
(I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won’t help.)
But the basic idea of getting rid of the paper money barrier to negative interest rates didn’t die. Matthew Yglesias, in his Dec. 12, 2011 Slate article “How Eliminating Paper Money Could End Recessions” pointed out that eliminating paper money entirely would make it possible for the Fed to stimulate the economy with negative interest rates whenever it needed to. He was encouraged, no doubt, by the popularity of the idea among techies of a “cashless society,” which, according to Google’s “Ngram Viewer” began gaining appearing in books as far back as the mid-1960’s. David Wolman’s critically praised The End of Money: Counterfeiters, Preachers, Techies, Dreamers–and the Coming Cashless Society (published just this past February) continues this line of thinking.
Since Matthew Yglesias’s proposal was a serious and important one, it was attacked. Stefan Karlsson, guest blogger for the Christian Science Monitor, in “Would Electronic Money End Recessions” argues that eliminating paper money would dramatically increase government power:
Ironically, though the paper money standard that replaced the gold standard was originally meant to empower governments, it now seems that paper money is perceived as an obstacle to unlimited government power for three reasons:
1) When people make cash payments, their purchases aren’t tracked, giving them privacy from government surveillance
2) If payments are made in cash, it will enable them to make payments without paying taxes.
3) The existence of physical cash makes it impossible to lower nominal interest rates below zero because if they are below zero then people will withdraw their money from banks.
Thus, Stefan Karlsson argues that if you think it was a mistake to replace the gold standard with paper money, it is a mistake to go further to replace paper money with electronic money. His “hard money” views are made even clearer when he ends by talking about hyperinflation in 1923 Germany and 2009 Zimbabwe.
Indirectly—in their emotional appeal rather than in the arguments themselves—Karlsson’s words serve as a reminder that tangible currency has an important psychological resonance for people, as shown also by many interesting psychological experiments about the meaning of currency for people. See for example the PsyBlog post “How Does the Cleanliness of Money Affect Our Spending.” The formation of the eurozone was an attempt to harness the emotional resonance of currency in the service of European unity—something that Rudi Bachmann and I argue was a mistake in our recent Quartz article “Symbol Wanted: Maybe Europe’s unity doesn’t rest on its currency. Joint Mission to Mars, anyone?” Appreciating the psychological resonance of tangible currency, I have been careful to preserve paper currency in my reworking of Matthew Yglesias’s proposal—though in a smaller role than it currently fills. Keeping paper currency in even this reduced role limits the power of the state, which has both good aspects (privacy, as Karlsson emphasizes), bad aspects (making crime easier) and aspects that some people think are good and some people think are bad (making tax evasion easier, which Karlsson thinks is good and I think is bad). But my view is that we should take one step at a time. Subordinating paper money to electronic money as an economic yardstick is a big enough step for now; the question of whether to further demote paper currency can wait.
In a recent critique of Matthew Yglesias’s proposal, Tyler Cowen lists many reasons why it would be hard to abolish paper currency entirely, suggesting in fact that a black-market paper currency might arise (possibly of some foreign currency) if the government tried to banish paper currency entirely. Responding to Tyler Cowen, JP Koning suggests the possibility of keeping paper money legal but restricting paper currency to small bills to make it harder to warehouse large dollar amounts. But Scott Sumner gives the most trenchant response to Tyler Cowen, pointing out that the real problem is the “unit of account” role of paper currency, not the role of paper money as a way to buy things, which is Tyler Cowen’s major concern:
Money is not special because it is a big part of wealth, or a big part of credit. Indeed it’s not even special because it’s the medium of exchange [a way to buy things]. It’s special because it’s the medium of account [an economic yardstick].
My reworking of Matthew Yglesias’s proposal is intended as a way to preserve the function of paper money as a way to buy things while having paper money abdicate its role as an economic yardstick.
Perhaps the most serious attack on Matthew Yglesias’s idea came from a different direction, in Ryan Avent’s opinion piece in the Economist “The buck shrinks here.” Avent makes a claim that I think is a mistake, on which he bases the rest of his analysis:
… inflation and negative interest rates are basically the same. Both take an amount of money in the possession of an individual and erode its purchasing power over time.
He then goes on to argue that negative interest rates will arouse at least as much political opposition as inflation, because both mean that money loses its value. Avent’s mistake is that he focuses on the least important of money’s three functions: serving as a store of wealth. The other two, much more important functions of money are the obvious function of being something to buy things with on a daily basis—a “medium of exchange”—and the function I emphasize above: serving as a yardstick or “unit of account.” As far as money as a store of wealth goes, people already keep most of their wealth in either things, such as houses, cars and other consumer durables, or in stocks and bonds—precisely because money is not now, and has not been in the past, a very good store of wealth for any substantial period. And as a society, we shouldn’t want money to be a good store of wealth over the long haul: we need people to put their wealth to work, either directly or indirectly building companies to help the economy to grow, not burying piles of paper in the sand. Moreover, the temporarily negative interest rates the Fed would need to forestall recessions would only worsen money as a store of wealth for short periods of time—in national economic emergencies.
What the opponents of primacy for electronic money fail to realize is that making electronic money the economic yardstick is the key to eliminating inflation and finally having honest money.The European Central Bank, the Fed, and even the Bank of Japan increasingly talk about an inflation rate like 2% as their long-run target. Why have a 2% long-run target for inflation rather than zero—no inflation at all? Most things are better with inflation at zero than at 2%. The most important benefit of zero inflation is that anything but zero inflation is inherently confusing and deceptive for anyone but the handful of true masters at mentally correcting for inflation. Eliminating inflation is first and foremost a victory for understanding, and a victory for truth.
There are only two important things that economists talk about that are worse at zero inflation than at 2% inflation. One that has attracted some interest is that a little inflation makes it easier to cut the real buying power of workers who are performing badly. But by far the biggest reason major central banks set their long-run inflation targets at 2% is so that they have room to push interest rates at least 2% below the level of inflation. With electronic dollars or euros or yen as the units of account, there is no limit to how low short-term interest rates can go regardless of how low inflation is. So inflation at zero would be no barrier at all to effective monetary policy. It might be that we would still choose inflation a bit above zero to help make it easier to cut the real (inflation-adjusted) wage of poor performers at work, but I doubt it. So I predict that making electronic dollars the unit of account would pave the way for true price stability with long-run inflation at zero instead of 2%. The main benefit of making electronic currency the centerpiece of the price system would be that central banks would never again seem powerless in the face of a long slump. But even setting that gargantuan benefit aside, the benefits of true price stability alone would easily make up for any inconvenience from the abdication of paper currency in favor of the new rulers of the monetary realm: electronic dollars, euros and yen.