Saturday, May 9, 2015

McAndrews on negative nominal rates

Jamie McAndrews of the New York Fed has a thoughtful and clear speech on negative nominal rates and the benefits of currency. (Some previous posts on the subject here  here and here.)

A few high points:

1. Needed: anonymous electronic transactions.

Many (not all) negative interest rate proposals call for the elimination of currency. Currency is dying anyway due to the great advantages of electronic transactions. I bemoaned the loss of privacy and political freedom when the NSA, the IRS, and pretty soon Twitter and the Chinese Department of Hacking have a record of everything you've ever bought or sold. Jamie brings up another important point:
The anonymity afforded by currency transactions prevents a buyer from suffering from any actions taken after the transactions that could exploit the knowledge gained by the seller of the buyer’s identity. For example, identity theft, or theft of credit or debit card information, is avoided through the use of currency. This is an economic benefit that is distinct from valuing privacy from a civil liberties point of view. If currency cannot be used in transactions, buyers are at a disadvantage, and many otherwise beneficial transactions (not related to buyers seeking to engage in tax evasion or otherwise illicit activity) would not take place.
Anonymity has value in many transactions. Anonymity equals finality.

It's not hard to have anonymous electronic transactions. Stored value cards could work well as electronic cash. If regulators allowed it, it would be simple enough to set up a money market fund that allows anonymous investing. Regulators don't allow it.

2. Hysterisis of institutions and the lesson of the 70s

There are fixed costs in setting up many institutions that adapt to negative nominal rates. For example, the option to hold currency:
.. Often, the costs of holding currency securely, by having a safety deposit box or a vault, are fixed costs. Once one has a vault, or has rented a safety deposit box, the costs of storing additional currency in it, up to its capacity, is nil. This suggests that there is a dynamic element to the economics of avoiding negative interest rates: the longer the negative rates are expected to persist, and the lower they are, the more favorable are the returns to investing in a vault. Once the vault investment has been made, maintaining negative rates would likely become more difficult.

An even more far-reaching change that many have suggested would be the creation of a new institution to handle and store currency on behalf of others; this could dramatically reduce the costs of holding currency...
Jamie adds to the clever ways to synthesize zero rate investments, and a cost I hadn't thought of
For example, suppose that one holds a credit card under existing U.S. rules: one can withdraw funds from an account that is earning a negative rate, and pay one’s debt to the credit card company in advance of when it is due, earning a zero return during the prepayment period....

... if one were to receive a check from the U.S. government for a tax refund, one could simply put it in a safe place and earn zero interest on it during the time the check remained undeposited...

...leaving the check undeposited, much like the hoarding of currency, is a negative outcome for society. ... This may impose unexpected costs on the check writer, triggering unplanned overdrafts and associated charges...

...having talented individuals looking for these opportunities is a dead-weight loss to society. We would rather have them use their talents for more socially productive purposes.
We went through this once before. In the 1970s, pricing and financial institutions were set up with small positive interest rates in mind. It took a period of prolonged inflation to induce people to spend all the fixed costs to adapt to high interest rates, including widespread indexation, money market funds, interest-paying checking accounts, and so forth. In turn, the easing of these "frictions," quickly removed the hoped-for benefits of inflation. For example, prices and wages were sticky when there was less inflation. Turn on inflation, and once people put the effort in to index contracts, price and wage stickiness fade, and inflation has much less output and employment effect.

So, the same sorts of legal and financial investments that allowed an economy to adapt to high nominal interest rates can also allow it to adapt to negative interest rates -- at large cost, in time and effort, in rewriting contracts, and in foregoing many advantages of currency. But are we sure the benefits will not disappear at the same time?

3. Financial institutions and negative rates
The health of banks and many other financial institutions depends on earning a spread between what the institutions earn on their assets and what they pay on their liabilities. Negative rates can squeeze bank profits.
and a lot of non-banks too. There is a plausible channel here that negative nominal rates hurt a large swath of financial institutions -- at least until they rewrite all their contracts and persuade all their clients to accept negative rates. This is a channel by which lowering rates could hurt economic activity.

By the way, I learned that those negative rates aren't so negative,
..the central banks that have negative policy rates offer zero rates on many of their deposits from banks, imposing negative rates on the “marginal” deposits. In this way, commercial banks can, in general, charge their retail depositors deposit rates of zero and earn zero at the central bank on at least a large portion of their reserve holdings.
4. Speaking of cause and effect signs...
..people could infer [from a negative interest rate] that the central bank itself has low expectations for inflation and is lowering nominal rates into negative territory as a way to “ratify” the low expected inflation environment. Such an inference would complicate the central bank’s effort to achieve its objective because it could encourage and entrench the public’s expectations for deflation. That could complicate the potential exit from the negative rate regime
Maybe with abundant excess reserves, the Fisher equation is stable -- and that lowering nominal rates will cause inflation to decline. Jamie isn't quite ready to burn at the heretic's stake on this issue, but you can see him edging closer to the fire.


  1. "Negative rate proposals call for the elimination of currency."

    Some do, but most don't. For instance, Buiter and Kimball propose imposing an exchange rate between currency and central bank deposits. Paper currency would stay in circulation. It's also possible to allow for negative rates by making changes to the algorithm that governs the issuance of high denomination notes.

    The elimination of currency really isn't a policy worth debating because it isn't in the cards. If there is a negative rate policy waiting in the wings, it is the Buiter/Kimball proposal. It would be more interesting to read your thoughts on the latter than the highly unlikely banning of cash.

    1. JP,

      "The problem right now is that the yield on cash and central bank deposits is too high, thus deflation. We need to reduce that yield somehow, whether it be the various lite techniques above or something else. I really don't think asset price bubbles should be used as a bogey man to prevent a basic CPI target from being hit."

      If the problem is that the yield on cash and bank deposits is too high, then government should sell securities that have a much higher yield to get people out of cash and bank deposits.

      If the problem is bubbles in market prices, then government should issue securities of the non-marketable variety.

      If the problem is one of incentives - government offering a risk free rate of return by selling bonds - then government should sell equity instead.

      Finally, destruction of currency will not benefit either the creditor or borrower.

      Do you have a link for the Buiter / Kimball proposal?

  2. In principle you can always push up central bank interest rates by increasing inflation, and/or by making inflation less predictable. Negative rates give the CB the luxury of more options.

    Regarding the cost of adapting to negative rates (e.g. modifying software), it depends on how quickly it's done. With enough advance warning the cost approaches zero, since everything gets replaced anyway.

  3. No need to get rid of currency, unless the rate gets extremely negative. There are storage costs and liquidity that must be taken into consideration. It is not a free transaction to take your money out of the bank and put it into crates and keep those crates safe. And if there is something expensive to buy to take those crates of money back to the bank to make an electronic transaction.

    Also, when a person says "negative rates", which rates? Overnight deposits at the central bank? In which case there a whole lot of rates well above 0, and one rate below 0.

    1. Douglas,

      "Overnight deposits at the central bank? In which case there a whole lot of rates well above 0, and one rate below 0."

      If both the overnight deposit rate is the same as the discount window rate (both negative) then it's a wash - whatever negative rate the central bank assesses on a bank's deposits can be recovered by the bank by borrowing funds from the Fed's discount window at the same negative rate.

  4. As it is, contrary to what many economists posit, use of paper cash is exploding.

    There is now about $1.35 billion in U.S. cash in circulation, up about $500 billion since 2008. About $4,200 in circulation for every resident of the U.S. Yes, I know, all that additional paper cash is in suitcases doing drug deals, 'cause we see that in Miami Vice re-runs.

    But use of cash long ago exploded in deflationary Japan, now running about $6000 (dollar equivalent) in circulation for every resident, and paper Euros in circulation is rising rapidly in Europe, now in deflation.

    When there is deflation, people save in cash. When they have piles of cash, they start doing cash transactions to avoid Mr. Tax Man. Soon, you have a bifurcated economy, above-ground and underground. The Banana States of America, here we come!

    Yes, we can make an electronic police state, and outlaw cash.

    Pre-paid cash cards are an interesting idea, but since one would buy the cash cards using electronic cash, who would really believe it is secret or anonymous?

    There is even another worry to the cashless society: Blowback for any purchase you make from the PC crowd. There are restaurants in California that have lost business as their owners or high-ranking employees made un-PC political donations.

    In a cashless society, if could become known where you spend your money. Did you do some un-PC shopping? Order too much liquor? Go to a skin bar? Buy Chevron products? "Support" DoW Chemical when you bought some cleaning products? Buy some pot?

    Egads, so every conversation, e-mail and purchase you make, there is a record. The makes the old Eastern European oil ice states look like amateurs.

    Wouldn't it be better to 1) Get rid of the NSA, and 2) use cash and "endure" moderate inflation (which actually has some benefits as well as costs).

  5. Negative rates are barmy for two reasons. First, the objective is to impart stimulus, but whence the assumption that stimulus should come JUST IN the form of expanding loan based activity (primarily investment)? I.e. given that extra demand is needed, the most reasonable assumption is that ALL FORMS of activity (public sector AND private sector, investment goods and non-investment goods) should expand.

    Second, negative interest rates can in theory lead to negative output. E.g. if I borrow at minus 4% and buy some asset which deteriorates in value in real terms by 2% over a year, and then I re-sell it, I make a profit (of 2%).

    1. Ralph,

      Negative interest rates have several connotations.

      1. If someone is willing to pay for a bond more than it's principal and interest payments are worth, then the market interest rate for that bond can be considered negative. In that case, the borrower is still making positive interest payments to the owner of the bond. It's just that the owner of the bond has paid more for the bond than the total of all interest payments and principle payments that will be made.

      This isn't as crazy as it sounds. In the corporate world, debt is a claim on the liquidation value of a company. If the liquidation value of the company is significantly large compared to it's operating cash flow, bond buyers may push up bond prices to ridiculous levels to gain claim on that liquidation value even while stock holders sell off in droves due to low / negative earnings.

      2. Under a positive interest rate the flow of interest payments goes from borrower to lender. Under a negative interest rate this would presumably be reversed.

      3. Destruction of currency. Many "negative interest rate" proposals never address debt and interest at all and instead jump to currency by creating an expiration date or some other means to reduce the amount of currency in circulation.

      4. Effective interest rates and defaults. Obviously if someone defaults on a loan and never pays it back, the holder of the loan receives a negative return on investment even though the loan agreement was for a positive interest rate.

      The negative interest rate you describe falls under #2 above - bank (or other lender) lends you money at a negative interest rate.

  6. From a political POV it should be interesting to see how one reconciles the claim that voter ID is prejudicial with the notion of requiring everyone to have a digital account. If it's discriminatory for the former isn't it discriminatory for the latter? Both entail the allegedly arduous task of getting an ID, plus the non-cash economy places an added burden of setting up a digital bank account.


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