Redeemability without Currency

Worries about the zero bound on nominal interest rates are solely an artifact of basing the monetary system on hand-to-hand currency.    The nominal interest rate on such currency is generally zero.    Why would anyone lend when they can just hold onto their "money?"

In practice, nearly all payments are made by check or electronic equivalent using some kind of deposit account.   These deposit accounts are cleared using central bank deposit accounts (reserve balances at the Fed in the U.S.) or automatic clearinghouses.   The automatic clearinghouses, however, create net clearing balances that are also settled up with central bank reserves.

There is no reason why the bulk of the payments system cannot pay interest, and much of it does.   If interest can be paid, generally, the nominal interest rate can be negative.

Of course, banks are obligated to redeem their deposits with hand-to-hand currency.   Similarly, the Fed redeems balances in reserve deposit accounts with hand-to-hand currency.    It is these redemption obligations that makes a monetary order that is mostly about changes in deposit balances that can potentially pay or "charge" interest into one that is based upon the zero-nominal interest hand-to-hand currency.

Suppose this characteristic of the monetary order is dropped.    Obviously, hand-to-hand currency is convenient for many purposes, but it is hardly essential for most people.  

As long as checks and electronic payments clear through the central bank, each individual bank is limited to issuing the amount of deposits its customers want to hold.    Any individual bank that creates excessive deposits will suffer adverse clearings as the deposits are spent or transferred to some other bank.   Overall monetary equilibrium operates as usual, depending on how the central bank chooses to manipulate the quantity of reserves and the interest rate paid upon them.

However, the system is a bit odd in that those holding deposits in banks would have a debt instrument that is payable in something that they cannot directly access.    From a bank's point of view, it must pay off these debts using its balance in its reserve account at the central bank.  

From the depositor's point of view, all that can be done with the funds is to shift them to another bank.    As long as only banks can hold balances with the central bank, from a depositor's point of view, he or she is owed something that is only directly payable into something that he or she cannot directly hold.

One way to avoid this difficulty is to make deposits redeemable into something other than hand-to-hand currency.     For example, suppose deposits are redeemable into T-bills at their current market price as well as reserve balances at the central bank.    An individual depositor can "withdraw" T-bills.   Funds are then removed entirely from the banking system.

Since T-bills are not priced in terms of the deposits of an individual bank, but rather in terms of the deposits of the banking system, all of which are tied to the balances of the central bank, this constrains the individual bank.    While an individual bank could purchase T-bills to meet redemption obligations, this would only be possible if the bank can settle the check or electronic payment it uses at the central bank.

Of course, this "redemption" provides nothing more than what the individual depositor can do anyway.   Any individual depositor can remove funds from the banking system by spending the funds on something.     Making deposits redeemable in T-bills (or gold) at market prices provides no real benefit to the depositor.   A depositor who wants to reduce money holdings can always buy T-bills or gold.   Still, perhaps it will help overcome puzzlement about a debt that is only payable in something than cannot be directly held.

With such a system, where there is no obligation to redeem deposits with hand-to-hand currency, there is nothing keeping the nominal interest rate greater than zero.   There would be no zero nominal bound on interest rates.    (Of course, if market conditions are such that a negative nominal interest rate has inflationary consequences, then avoiding such consequences would require a positive nominal interest rate.)

If the monetary order were changed so that it is no longer based upon hand-to-hand currency, but the central bank continues to provide such hand-to-hand currency, then if nominal interest rates need to be negative, the central bank will face large demands for currency.   Once the interest rate on reserve balances falls below the cost of holding vault cash, banks will demand vault cash.     Similarly, if the interest rate "paid" on deposits becomes more negative than the cost of storing currency in vaults by the general public, the demand for currency by the general public would rise.

In order for the nominal interest rate to become negative, the central bank would have to say "no."   It would have to quit issuing currency.   The result would be somewhat similar to the sorts of suspensions of convertibility that occurred periodically in the 19th century, except that under this institutional framework, there is no obligation to issue hand-to-hand currency.

What would be happening is that the issue of hand-to-hand currency would simply be too costly.    As interest rates on earning assets (such as T-bills) fall, they will eventually be too low to cover the cost of maintaining the currency in circulation.    When nominal interest rates are negative, clearly, issuing zero-nominal yield currency and using it to fund a portfolio of T-bills priced above par is a losing proposition.

If the central bank dropped out of the hand-to-hand currency business, and commercial banks issued hand-to-hand currency under normal conditions, then there would be no "policy" decision regarding currency.   If nominal interest rates fall, and even turned negative, then the profitability of issuing hand-to-hand currency would fall as well.   When nominal interest rates became too low, then banks would quit issuing hand-to-hand currency.   Deposits, on the other hand, perhaps with negative nominal interest rates, would continue to be profitable.   The greater part of the economy, would be able to operate with minimal disruption.

Finally, consider the alternative.     In the privatized scenario, banks could continue to issue hand-to-hand currency by using it to fund riskier, higher yield assets.    Suppose a bank created a poorly capitalized subsidiary and funded junk bonds with hand-to-hand currency.  While the interest rate on safe, short term to maturity securities, like T-bills, might be negative, and safe (perhaps even FDIC insured) deposits might have negative interest rates, currency could still be issued.    Such currency would be a poor store of wealth.   In fact, those receiving it would probably deposit it just about as fast as they received it in payment.

Now, suppose that instead of this privatized alternative, the central bank wants to continue to provide hand-to-hand currency that is perfectly safe from credit risk.    What can it do?    Just like the private banks, it could shift from holding a portfolio of safe, low risk T-bills, to holding a portfolio of riskier assets--say longer term government bonds.    Of course, if the central bank chooses to provide a perfectly safe asset with a zero-nominal yield, then everyone will hold that rather than lend at negative nominal interest rates.   And so, the central bank has created the zero nominal bound.

Reflecting on that situation, maintaining macroeconomic equilibrium could require the central bank to issue large amounts of zero-interest currency and bear substantial risk.   Should it?   Is it the role of government to bear risk for people?

I don't think so.