Tuesday, December 30, 2014

Cancelling Currency According to Cochrane

Rogoff has a paper discussing the costs of and benefits of a cashless payments system.   Cochrane responded with the following:

So, quiz question for your economic classes: Suppose we have substantially negative interest rates -- -5% or -10%, say, and lasting a while. But there is no currency. How else can you ensure yourself a zero riskless nominal return?  
  • Prepay taxes. The IRS allows you to pay as much as you want now, against future taxes. 
  • Gift cards. At a negative 10% rate, I can invest in about $10,000 of Peets' coffee cards alone. There is now apparently a hot secondary market in gift cards, so large values and resale could take off. 
  • Likewise, stored value cards, subway cards, stamps. Subway cards are anonymous so you could resell them. 
  • Prepay bills. Send $10,000 to the gas company, electric company, phone company. 
  • Prepay rent or mortgage payments. 
  • Businesses: prepay suppliers and leases. Prepay wages, or at least pre-fund benefits that workers must stay employed to earn. 

Here are the ones I can think of:  
Comments section: how many more can you think of? 
He goes on:

So, bottom line, we cannot have strongly negative nominal rates without a legal revolution essentially negative-indexing the entire economy and payment system, and upending centuries of law giving you the right to pay bills at face value.

I suppose a finance academic would focus on a zero riskless nominal rate of return.   As a monetary economist, I focus on the supply and demand for money.   

If there is a shortage of money, it is very disruptive and fixing it is a good idea.   The solutions are to increase the quantity of money or reduce the demand to hold money.   Most money usually pays relatively low nominal interest , and so reducing that yield is one obvious method of reducing the demand to hold money.   Shifting from paying people to hold money, to a zero nominal yield, to charging them to hold money seems pretty straightforward.  Money provides services, and people would be willing to pay for them.  In some situations, they should pay for those services.

Of course, the other method of fixing a shortage of money is to expand the quantity of it.   And the lower the yield paid on money, the more profitable that approach would be.   However, if the interest rates banks can earn by lending money, including holding various sorts of bonds, are exceptionally low, then it is possible that monetary equilibrium would require a negative nominal interest rate paid on money balances.   The interest rates on other sorts of assets, especially those assets banks buy, would be somewhat higher.    

With extremely low credit demand and a very high demand for money, it might be possible that equilibrium would involve banks earning negative yields on at least some of their assets.  That implies that someone is able to borrow at negative rates, while the banks pay still lower yields to their depositors.

While I don't see much value in a monetary regime that generates a 10% trend deflation rate, I think it is likely that equilibrium would require that nearly all nominal interest rates be negative.   And further, zero nominal interest rate currency would be very disruptive.

If hand-to-hand currency was privately issued, since it is hardly practical to charge people for holding it directly, then in a very low credit demand environment, banks would stop issuing currency.   The result would be a cashless payments system.   

Now, I don't have any problem with banks issuing currency at a loss if that is what they want to do.   But I don't think they should be forced to do so.   And if no one wants to issue a zero nominal interest rate asset, then there won't be one for people to hold.   

Of course, that isn't the world we live in.   The government issues a zero-nominal interest rate asset--hand-to-hand currency.   And it declares that it is legal tender for all debts.   This is especially relevant because all of the bank issued money must be paid off on demand with government currency.   The entire monetary order is based upon the government currency.  

Since holding government currency--effectively lending to the government at  a zero nominal interest rate--is always possible, this government intervention creates a floor on the nominal interest rate-the cost of storing paper currency.   

On the other hand, the evolved commodity money systems of the past also had a similar zero nominal bound--the cost of storing the monetary commodity.  

Anyway, the point of my digression is twofold   First, the purpose of negative nominal interest rates on money isn't to prevent people from having a riskless nominal rate of return.   It is to reduce the demand to hold money so that it will be in balance with the quantity of money supplied.   

And second, there is no problem with people being able to hold assets that other people want to issue.  The problem is limiting the demand to hold assets when there is a shortage of them.

So, I am going to start with Cochrane's second example.    People could supposedly get a riskless zero nominal rate of return by purchasing gift cards.    Cochrane even notes that there is already a secondary market in gift cards.    My wife tells me that you can sometimes buy a $100 card on sale for $90.   That is a pretty good rate of return, I guess.   

First, if retailers want to issue gift cards at face value, and so provide investors a zero nominal return, that is fine.   Of course, there is a risk--suppose the retailer fails?    Did Cochrane forget that?    

Under usual circumstances, when a retailer sells a card it is getting a loan.   Leaving aside discounting the cards, it is a zero interest loan.    And so, now the retailer has the money.  What do they do with it?   If the interest rate on money is sufficiently negative, then the retailer will find borrowing money at a zero interest rate and then paying to hold it  unattractive   Of course, perhaps the retailer can invest by purchasing assets that have a positive yield.   Or maybe they will accumulate inventory to be prepared for the greater sales when the cards are spent.   It doesn't matter.    As long as the retailer doesn't hold the money, the lower (below zero) nominal interest rate has done its job.   

Now, if this becomes too burdensome for the retailers, then they might stop issuing the cards.  Or, they might issue them but charge a premium and require that they be used by a certain date.   

In my view, in a privatized system, if banks quit issuing private hand-to-hand currency because it was not profitable, then I would expect that retailers would expand their sales of gift cards.     They might even issue paper currency.   For example, Walmart might issue something like Walmart currency that can only be "redeemed" for products at Walmart.    But in the end, Walmart would only issue gift cards or currency if it wanted to--found it profitable.    

And what does Walmart do with the money it receives?   If it holds it, that is a problem.   But that is what the below zero interest rate on money aims to deter.   If Walmart purchases other assets or purchases inventories of goods, constructs new buildings, or whatever, the problem is solved.

Consider Cochrane's fourth example--pre-paying utilities.   Now, my utility companies vary the amount billed according to use.   If you prepay, then you get a credit balance on your account.   And then, at the normal billing time, they debit the balance.   You get a bill that says that you don't owe anything this month and it tells you your new, lower credit balance.    If you have a debit balance, they add to it as each bill comes  due.   They charge penalties, of course, if you are too late.

Now, few people intentionally hold credit balances with utilities.   I am not sure if it is illegal for utilities to pay interest on such balances.   I suspect if some utility started to do so and began to finance its operations with the credit balances of customers, they would run into legal problems. (Industrial firms operating banks is frowned upon.)  Regardless, if the utility had to pay to keep money in its checking account, I think they could figure out a way to charge people for holding credit balances.   

Just because many firms will allow for credit balances in an account hardly means that they have some kind of legal obligation to allow people to do so.  I have had a credit balance sometimes with my dentist.  Does that mean that anyone can come in off the street and open an account with the dentist?   Can they later come in and say that they are switching dentists and they want their money back?   

Regardless, even if the utility companies allowed people to have credit balances on their accounts and didn't charge any fee, the question remains, what does the utility do with the money?    All the negative yield on money is supposed to do is reduce the amount people want to hold.   If the utility spends the money on other financial assets or spends it to construct a new plant, the negative yield on money has done its job.

Cochrane also says that people could prepay their mortgages or their rent.   Now, I hardly count regulations allowing the refinance of mortgages without penalty to be some tradition from the centuries.   Regardless, if someone pays down their mortgage, what they have is not a riskless asset but more equity in their home.   They are bearing more risk.   

But what are the monetary consequences?   Paying down bank mortgages tends to contract the quantity of money.  However, any single bank receiving such repayments will accumulate reserves.   And the interest rate on that form of money is negative as well.  

For most institutional setups, that is what is driving the negative yields on deposits.   Banks are motivated to purchase other assets due to these negative yields on reserves.   (My own preference is for the interest rate on reserves to float at a  few basis points below the interest rate on  short Treasury securities.)

Further,  I don't see why a landlord would need to say, "you are paid up for 6 months," rather than credit a account with a prepayment and then debit it as the rent comes due.  In other words, like my electric company does.  

Of course, if landlords want to allow people to do this at a zero interest rate, that is fine.   What does the landlord do with the money?   If they find borrowing at a zero interest rate desirable and then spend the money on financial assets or buying more houses, then the problem is solved.  The point of the negative yields on money is to reduce the demand to hold money.

Businesses are going to prepay suppliers?    Well, I guess.   But if this is a spot transaction, then the likely result of prepaying in an environment of negative yields on money, is that the price you pay will be higher.   I will give you $100,000 now and how much copper will you give me in six months?   Less than if I took delivery now?   Maybe I should buy now.  

But again, if the suppliers will accept deposits on their account, then that is fine  What do the suppliers do with the money?   Prepay wages?    What do the workers do with the money?    Prefund benefits?   What does that mean?   A firm pays an insurance company early?   What does the insurance company do with the money?

And finally, there is Cochrane's first example.   Nominal interest rates cannot fall below zero because the IRS allows people to pre-pay their taxes.   What does the U.S. Treasury do with the money?   If it uses it to pay off government bonds, then there is no problem.   Holding onto money at a negative yield would hardly be attractive to the Treasury.   And those receiving it in exchange for the government bonds would have the money.  What do they do with it?   The point of a negative yield on money is to reduce the demand to hold money.

If the Treasury were to receive money to prepay taxes, then it is borrowing money at a zero interest rate.   It should be no surprise that the Treasury is usually happy to do this, since it is usually funding most of the national debt with interest bearing bonds.   If the interest rate on money is negative, and there are no more government bonds to pay off, and the Treasury simply holds onto the money, then the Treasury takes a loss.   It is borrowing money at a zero interest rate and then lending it at a negative interest rate by holding money.   

And this would be a problem.   The demand for money would not fall.  Those prepaying taxes would reduce their demand to hold money, but it would be just matched by an increase in the balances the government holds.   Traditional conventions for measuring the quantity of money would count this as a decrease in the quantity of money.   

Again, if there is no national debt to be repaid, then unless Congress can be convinced to lower taxes or raise outlays, the Treasury would take a loss.   And the demand to hold money would not be reduced.  (Again, this would actually show up as a decrease in the quantity of money.)  

And, of course, maybe, just maybe, the Treasury would provide taxpayers with a credit account for pre-paid taxes and charge them interest on it--maybe something like what the taxpayers would have to pay if they kept their funds in their own checking account.

In a world where the interest rate on money is negative, or really, a world where those receiving payments have no good investment opportunities, then making some open ended commitment to allow unlimited prepayment would be costly to those parties choosing to provide that opportunity.   They will likely stop.

And, other than the government, it is obvious that none of these transactions create a riskless asset.   These are all loans to private institutions that could fail. 

In my view, there is really little value in assets with no nominal risk.   The value is in assets with no real risk.   Reducing the real risk of nominal assets requires a decent monetary regime.   One that just holds the nominal quantity of money stable and allows the price level to adjust so that the real quantity of money accommodates the real demand to hold money implies real risk   A monetary regime that adjusts the nominal quantity of money to the demand to hold money at a stable price level or growth path of nominal GDP is not free.   There should be no expectation that the monetary regime must create a monetary asset that has little real risk and a zero, much less positive, real yield.    It depends on the cost of operating the regime and the demand for credit.  

Government bonds do have a low credit risk under most circumstances, and with a good monetary regime, the real risk due to aggregate supply shocks and aggregate demand shocks is dealt with reasonably well.   If the demand for government bonds becomes so high that a negative nominal yield is necessary to clear the market for government bonds, then a negative nominal yield on government bonds is the least bad option.    Creating a monetary disturbance so that there is a sufficient liquidity effect to keep the nominal interest rate on government bonds above zero would be foolhardy.

Now, if the real interest rate on government bonds is negative, then it certainly seems that running  budget deficit would be sensible. Not because it would raise the yield on government bonds to benefit the government's creditors--charging them less for this low risk asset.   But rather because government spending programs would cost future taxpayers less than current taxpayers.   That this would provide investors with a low risk asset at a lower charge should not be the goal of fiscal policy.   

While government bonds may have little credit risk for the lenders, this can be nothing other than a shift of risk to the taxpayers.   Suppose destructive government regulations cause real output to fall ten percent.    How are government bond holders protected from this disaster?   The taxpayers must pay more taxes for fewer services. 

And so, budget deficits and a national debt are adding risk to future taxpayers.   If the interest rate on the national debt was negative forever, then that would be a good reason to expand the national debt.  However, what if the interest rate on short government bonds is negative right now, but likely will turn positive in the near future.   Should the government refinance the national debt immediately, borrowing short rather than long?   This should make the interest rate on short term government bonds less negative and so provide investors a better return.   Or should the government try to lock in relatively low long term rates?    

Should the government cut taxes or increase government spending, running a deficit now?  To me, I am much more confident that if the government is purchasing long lived assets, and the long interest rate at which it can borrow is lower, then it is reasonable to buy assets that would be purchased in the future anyway right now.   Start the project now, when financing costs are low.

I don't have the answers exactly as to how the government's fiscal policy should respond to low or even negative nominal and real interest rates.   I am sure that the monetary regime should not be held hostage to the answer to these questions.   I favor a monetary regime that will allow the yields on government bonds to turn negative when there is a sudden increase in the demand for government bonds.   I favor a monetary regime that will allow the interest rate paid on money to turn negative if necessary to keep the quantity of money demanded equal to the quantity of money supplied, as what might happen with a large drop in credit demand.   

Having the monetary system based upon a zero nominal interest tangible government currency seems inconsistent with those principles.

By the way, I don't favor outlawing government currency.   People should be free to do what they want with old Federal Reserve notes, just like they are free to do what they like with old Confederate currency.   I just favor demonetizing it.    

1 comment:

  1. Seems easier just to keep inflation around 3 percent and still use cash. That worked 1982 to 2007.
    I know of no successful modern economy that exhibits deflation.