Breaking Through the Zero Lower Bound

Miles KimballPresentation at the Bank Of Japan

June 18, 2013

Preface: Central Point

The zero lower bound is a policy choice, not a law of nature.

Preface: Where the Zero Lower Bound Comes From

• The zero lower bound arises when a government issues pieces of paper (or coins) guaranteeing a zero nominal interest rate over all horizons.

• This acts as an interest rate floor, making people unwilling to lend at significantly lower rates.

• An analogy is milk-price supports in the United States.

Preface: The Urgency of Understanding How to Eliminate the Zero Lower Bound

If the zero lower bound were eliminated, Japan could retain a zero inflation rate and still get all the monetary stimulus it needs.

Preface: The Urgency of Understanding How to Eliminate the Zero Lower Bound

From “Breaking Through the Zero Lower Bound”:

For countries such as Japan that are trying to raise their inflation rate because of concerns about the zero lower bound, studying ways to eliminate the zero lower bound (and their costs and benefits) is especially urgent, since increases in inflation are not easy to reverse.

Preface: “Electronic Money”

• Eliminating the zero lower bound involves distinguishing between paper currency and electronic money (which in 1930’s, Robert Eisler called “bank money”). Electronic money would be “the real thing.”

• The electronic yen, dollar, euro, pound, etc. would be the unit of account. It would also be legal tender.

• The government is a big enough market player that it could establish the electronic yen as the unit of account if all its dealings were on that basis.

• The fact that the government can determine the equilibrium on daylight savings time also makes it more likely that the electronic yen could be established as a unit of account.

• For public relations, the name “electronic money” for the policy has real advantages, because it suggests progress.

Outline

1. The Zero Lower Bound is a Problem2. How to Eliminate the Zero Lower Bound3. Optimal Steady State Inflation When There is

No Zero Lower Bound4. Comparing Negative Nominal Interest Rates to

QE5. Answering Potential Objections6. The History of Thought for Negative Nominal

Interest Rates and Electronic Money

1. The Zero Lower Bound is a Problem

A. The zero lower bound is a key motivation for steady state inflation above zero.

Ben Bernanke, March 20, 2013 press conference:So historically, the argument for having inflation greater than zero—we define price stability as 2 percent inflation as do most central banks around the world. And one might ask, “Well, price stability should be zero inflation. Why do you choose 2 percent instead of zero?” And the answer to the question you’re raising which is that if you have zero inflation, you’re very close to the deflation zone and nominal interest rates will be so low that it would be very difficult to respond fully to recessions.

1. The Zero Lower Bound is a Problem(continued)

A. The zero lower bound is a key motivation for steady state inflation above zero.

• Ben Bernanke, March 20, 2013 press conference: There is research, for example, which asks the question how often do you tend to hit the zero lower bound? And our belief few years ago was that it was a very rare event and now it has become more common.

• Larry Ball “The Case for 4% Inflation”: A 4% target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe.Vox http://www.voxeu.org/article/case-4-inflation

1. The Zero Lower Bound is a Problem(continued)

B. Many central banks are up against the zero lower bound in macroeconomic situations indicating output less than the natural level.

C. In the absence of the zero lower bound, the world economy’s Great Recession might have been much shorter.

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Figure 1: Policy Rates in Major Advanced Countries (2006-2012)

Sources: Haver Analytics

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Figure 2: Policy Rates in Other Advanced Countries (2006-2012)

Sources: Haver Analytics

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Figure 3: Average Policy Rate in 2012

Source: Haver Analytics

1. The Zero Lower Bound is a Problem (continued)

D. The Bank of Japan has been up against the zero lower bound for a long time. This could be an important factor behind the relatively poor macroeconomic performance of the Japanese economy in the last 20 years or so.

Japanese Treasury Bill Rates

Real GDP Per Capita in Japan

Log of Real GDP Per Capita in Japan

Japanese Price Level (Log of GDP Deflator for Japan)

Assessing Japanese Monetary Policy: Has NGDP (the Velocity-Adjusted Money Supply) Been Smooth?

1. Quartz 21—>Optimal Monetary Policy: Could the Next Big Idea Come from the Blogosphere?

2. http://blog.supplysideliberal.com/post/50646128943/quartz-21-optimal-monetary-policy-could-the-next-big

3. Influenced by Market Monetarism. 4. Focuses on the behavior of NGDP, the velocity

adjusted money supply (MV=PY)

Why NGDP (the Velocity-Adjusted Money Supply) Should be Smooth

1. To a first approximation, optimal monetary policy is to keep the economy at the natural level of output.

2. Inflation data only gradually reveal where the natural level of output is.

3. Therefore, a good approach in absence of ZLB is: a. Very-short-run interest rate targetb. Medium-run NGDP target with steady growth at a rate

that factors in estimates of of what tech progress, pop, capital stock, etc. mean for growth in natural output. (Choice of the estimated growth rate for natural output is a key task of the central bank.)

c. Long-run inflation target at zero.

Log of Nominal GDP for Japan

Nominal GDP for Japan Since 1994

1. The Zero Lower Bound is a Problem (continued)

E. When not facing the zero lower bound, central banks of advanced countries have done well in short-run stabilization, freeing up fiscal policy to focus on long-run issues.

F. The Bank of Japan has a clear mandate to do more monetary stimulus right now. The zero lower bound makes that harder.

G. In particular, the zero lower bound makes it hard to get the time path of monetary stimulus right.

Why the Zero Lower Bound Makes It Hard to Get the Time Path of Monetary Stimulus Right

• The short-term interest rate is the intertemporal relative price between spending now and spending a little while (say a year or two) in the future.

• To get considerably more stimulus now than a year or two in the future, it is important to have a low short-term interest rate that makes goods now look inexpensive compared to goods a year or two from now.

The Constraint the Zero Lower Bound Puts on the Time Path of Stimulus

The zero lower bound creates a constraint between amount of stimulus now and amount of stimulus later. Typically, when below the natural rate, with a binding ZLB, • To get enough stimulus now, there would have

to be too much stimulus later.• To get the right amount of stimulus later, there

would have to be too little stimulus now.

How the Zero Lower Bound’s Constraints on the Time Path of Stimulus Cause Credibility Problems

(1)

• Paul Krugman, “Credibility and Monetary Policy in a Liquidity Trap (Wonkish)But how credible is the idea of credible future monetary commitments, of the type needed to make this work? Bear in mind that the central bank needs to “credibly promise to be irresponsible”, as I originally put it — that is, to commit to creating or allowing higher inflation.

How the Zero Lower Bound’s Constraints on the Time Path of Stimulus Cause Credibility Problems

(2)

• Paul Krugman, “Credibility and Monetary Policy in a Liquidity Trap (Wonkish), contin.Now bear in mind that in order to make a commitment to inflation work, central bankers not only have to stand up to the pressure of inflation hawks — which is much harder when you’re having to testify to Congress than it is if you’re a Harvard professor — but, even harder, they need to convince investors that they’ll stand up to that pressure, not just for a year or two, but for an extended period.

How the Zero Lower Bound’s Constraints on the Time Path of Stimulus Cause Credibility Problems

(3)

• Paul Krugman, “Credibility and Monetary Policy in a Liquidity Trap (Wonkish), contin.Now, the thing about fiscal expansion is that people don’t have to believe in it: if the government goes out and builds a lot of bridges, that puts people to work whether they trust the government’s commitment to continue the process or not. http://krugman.blogs.nytimes.com/2011/03/18/credibility-and-monetary-policy-in-a-liquidity-trap-wonkish/

Removing the Constraint and Restoring Credibility

• If the zero lower bound is eliminated, the constraint between stimulus now and stimulus later is also removed.

• This means it is possible to stimulate the economy now without convincing people the central bank will overstimulate the economy in the future.

• As Krugman said about fiscal policy, low enough negative short-term interest rates will work, regardless of what people believe about the future.

• If beliefs about the future reduce the stimulus from monetary policy, in the absence of the zero lower bound, the short-term interest rate can simply be lowered further to compensate.

Matthew O’Brien: “Is Abenomics Doomed—Or Will Japan Un-Doom Itself”

The Nikkei's boom has been a story about money, and so has its bust. Last November, then-frontrunner Shinzo Abe ignited the melt-up in the Nikkei when he promised to push the Bank of Japan (BOJ) to finally end deflation "unlimited" easing. The rally continued through Abe's election as prime minister in December, and then it really took off after investors saw who he tapped to lead the BOJ. Haruhiko Kuroda might look the part of a mild-mannered academic, but the former finance minister has, like Ben Bernanke, been a longtime critic of the BOJ's strange surrender to stagnation. (As Brad DeLong points out, Japanese real GDP per capita lost ground with the U.S. in the 1990s after decades of almost catching up). For his part, Kuroda uttered the three magic words of central banking -- whatever it takes -- and then backed it up by announcing the BOJ would do quantitative easing until inflation hit 2 percent. Investors rejoiced.

Matthew O’Brien: “Is Abenomics Doomed—Or Will Japan Un-Doom Itself”

• It didn't help that, as Lars Christensen points out, the Bank of Japan began sending out its own mixed signals about whether it would keep its foot on the gas around this time. International investors who had been counting on open monetary spigots in America and Japan suddenly realized that maybe they couldn't. And Japanese investors, who have become accustomed to stops-and-starts from the Bank of Japan in its heretofore half-hearted battle against deflation, weren't sure if they were seeing history repeat again.

• In other words, "regime changes" only work if there isn't any doubt that central bankers will do, well, "whatever it takes," to change it.

• http://www.theatlantic.com/business/archive/2013/06/is-abenomics-doomedor-will-japan-undoom-itself/276870/

2. How to Eliminate the Zero Lower Bound

A. The Best Place to Act Against the Massive Paper Currency Storage that Would Enforce the Zero Lower Bound.

B. “A Minimalist Implementation of Electronic Money”http://blog.supplysideliberal.com/post/50888412664/a-minimalist-implementation-of-electronic-money

C. “How to Set the [Effective] Exchange Rate Between Paper Currency and Electronic Money [in Banks]”

http://blog.supplysideliberal.com/post/51048739791/how-to-set-the-exchange-rate-between-paper-currency-and

D. Dealing With Political Constraints

A. The Best Place to Act Against the Massive Paper Currency Storage that Would Enforce the Zero Lower Bound

1. Restrictions or fees on paper currency withdrawals have the disadvantage of preventing withdrawals for spending as well as withdrawals for storage. Also the ability to withdraw has great option-value for people.

2. Storage of paper currency can be done in a very low-tech way by anyone. Also, criminals already have experience in secret storage of paper currency.

3. A temporary, time-varying fee on the deposit or re-deposit of paper currency can effectively stop massive paper currency storage. See below on the time-variation (including why it can be temporary).

The 3 Elements of a Minimalist Implementation of Electronic Money

1. Levying a deposit charge when banks deposit paper currency with the central bank. For example, with a 5% deposit charge, a deposit by a bank of ¥10,000 of paper currency would yield ¥9,500 in additional electronic reserves.

2. Discounting vault cash applied to reserve requirements by the same percentage as the deposit charge.

3. Establishing a legal right for any individual, business, government agency, or creditor to refuse payment in paper currency at par. (That is, paper currency would no longer be legal tender.)

C. The Deposit Fee Creates an Effective Exchange Rate Between Paper Currency and Electronic Money

1. To avoid the deposit fee, banks would offer paper currency to customers at a discount. Hence, if banks were making any deposits with the central bank, the deposit fee would establish an exchange rate between paper currency and electronic money.

2. (1-deposit fee) = exchange rate at which paper currency trades for electronic money. (Ignoring transactions costs.)

3. Ideally, to encourage this, the central bank would charge the deposit fee on net deposits, thereby effectively allowing withdrawals of paper currency at a discount.

4. While this exchange rate would probably hold for all dealings with banks, it need not hold at retail shops. For a while, shops would accept money at par (a) to avoid credit & debit card fees, and (b) to be nice to customers.

C. The Log Exchange Rate Between Paper Currency and Electronic Money is the Integral of the Chosen Interest Rate for Paper

Currency

What Having a Non-Zero Interest Rate on Paper Currency Means

• Whatever the interest path chosen for paper currency implies that, say, ¥10,000 should cumulate has to be the exchange rate for paper currency vis a vis electronic money at that point times ¥10,000.

• Thus, starting from par at the inception of an electronic money system, the principles of compound interest (with some combination of positive and negative interest rates) determine what the exchange rate between paper currency and electronic money must be.

C. If, Given Recovery, the Average Nominal Rate Over Time is Positive, the Exchange Rate Can Return to Par.

Three Options for the Time Path of the Effective Interest Rate on Paper Currency

1. Return to par as quickly as possible, consistent with keeping the zero lower bound non-binding at all times: – Paper currency interest rate = monetary policy target

interest rate (or maybe a little lower) during times of economic emergency.

2. Implement the Friedman rule: – Paper currency interest rate = target rate all the time

3. Constantly depreciate paper currency to earn seignorage without inflation. (e-yen=unit of account)– Attractive if it is otherwise hard to tax the shadow economy.

The Spread Between the Monetary Policy Target Rate and the Paper Currency Interest Rate

• The Central Bank should move the target rate (e.g., fed funds rate in the US) in tandem with the interest on reserves (when negative not just excess reserves), the discount rate and the paper currency interest rate.

• The spread between other rates and the paper currency interest rate will matter to financial firms. This can be a separate policy choice with electronic money.

• Currently, negative nominal interest rates yield a very low (negative) spread of other rates over the paper currency rate of zero. An electronic money system can avoid the resultant side-effects of negative rates that occur under current paper currency policies, since the paper currency interest rate would be a policy variable.

D. Dealing With Political Constraints: Negative Nominal Rates Themselves

1. People are not used to negative nominal interest rates Both the reasons and the mechanics will require a great deal of

explanation

2. The usual complaints that expansionary monetary policy hurts virtuous savers will be magnified when rates are negative. As part of communication, it needs to be emphasized that

Low rates help borrower in the economic hard times Low rates help the economy Interest rates should reflect the social benefit of saving; saving is

not what society needs when the economy is in a slump. Low rates for a short time will bring higher rates later by fostering

economic recovery:

“Negative rates for a few quarters are better than zero rates for years and years.”

D: Dealing with Political Constraints: Legal Tender as a Potent Symbol

3. Suppose you can’t get an immediate parliamentary vote to give individuals, businesses, government agencies and creditors the right to refuse paper currency at par. Two work-arounds:

a. Announce that legal tender will have to be abolished in the future.

In the event, it will become clear legal tender largely benefits speculators, and it will be easier to get the measure passed.

b. Issue bearer bonds with a variable interest rate in convenient denominations as a substitute currency. Stop issuing legal tender currency

The old currency would then become an exotic asset worth more than par, but it would not create a zero lower bound because of its expected depreciation back toward par.

A Detail: Government Agencies Must Not Give People a Way Around Negative Rates

• Government agencies need to actually exercise their right to refuse payment in paper currency at par.

• Accounting for government agency income and expenses in paper currency needs to apply the exchange rate for paper currency.

• In Japan, this includes the Postal Savings system. Otherwise, the Postal Savings system itself would continue to create a zero lower bound.

• The Postal Savings system needs to apply a negative nominal interest rate when the Bank of Japan does.

3. Optimal Steady State Inflation in the Absence of the Zero Lower Bound

A. Shoeleather costs can be entirely avoided if the Friedman rule is implemented (interest rate on paper currency = target interest rate). Even if a country chooses to continue returning to

par and staying there for a while as long as interest rates are positive, it will be following the Friedman rule more closely. than existing policy.

B. Menu costs are a minimum at zero inflation.

3. Optimal Steady State Inflation in the Absence of the Zero Lower Bound

C. Relative price variability and the associated misallocation is minimized at zero inflation.

D. Confusion from misunderstanding the difference between real and nominal are minimized when inflation is zero.

E. Inflation-induced tax distortions caused by legislative confusion about real vs. nominal is minimized when inflation is zero.

F. Inconvenience from a variable yardstick is minimized when inflation is zero.

3. Optimal Steady State Inflation in the Absence of the Zero Lower Bound

G. Because zero inflation is focal, it is less subject to variability than other values of inflation. So it zero inflation will minimize costs from expected and unexpected inflation variability.

3. Optimal Steady State Inflation in the Absence of the Zero Lower Bound: Remaining Benefits of Positive Inflation

H. Zero inflation makes it harder to adjust real wages downward, compared to positive inflation. Annual bonuses comprising a significant share of

annual income that are easier to adjust downward as well as upward can be encouraged.

Japan already has a great deal of experience with wage adjustment under zero inflation conditions.

What are the Costs of Negative Nominal Interest Rates and Electronic Money Themselves?

A. People are not used to an exchange rate between paper currency and electronic money.

In some countries most transactions are already in electronic form, and there is a secular trend in this direction.

B. Current business models of some financial firms are built around positive nominal interest rates, but zero inflation requires negative rates sometimes for stabilization.

However, logically, financial firms should care most about spreads, which could be very similar in an electronic money system to how they are now when away from the zero lower bound.

Helping Financial Firms Adjust Prudently to a New World of Negative Interest Rates Safely.

1. Go big or go home? Would -3% or -5% help financial firms realize they need to adjust their business models (and explain the changes to customers) better than -.5%?

2. Money market mutual fund reform needed to push money market mutual funds away from any implicit promise not to “break the buck.” (Proposals already on the table.)

3. No real downside to high bank (& shadow bank) equity (“capital”) requirements to ensure financial firms aren’t causing macroeconomic risk.

See The Banker’s New Clothes by Anat Admati and Martin Hellwig The higher equity requirements can be implemented without

disruption for existing firms simply by prohibiting dividends and share purchases until the requirements are met.

4. Comparing Negative Nominal Interest Rates to QE

• Negative nominal interest rates are powerful enough that they can be used as a substitute for QE, not just as an adjunct. Indeed, I would recommend explicitly saying nominal interest rates are a way to avoid having to use QE.

• QE is better than nothing, but how does QE compare to negative interest rates in the absence of a zero lower bound?

4. Comparing Negative Nominal Interest Rates to QE

A. Large purchases and later sales of long-term government bonds can be costly because of a buy high/sell low problem. Using IOR instead of unwinding would just delay the recognition of this problem. Another way of looking at the same problem is that buying up long-term

government bonds goes against the government as a whole locking in low long-term rates.

The losses to the private sector from buy high/sell low tend to benefit those who are relatively wealthy.

This problems with QE can be avoided by focusing on risky asset purchases.

B. QE, like all methods that face the zero lower bound, has a constraint making it hard to stimulate enough now without committing to stimulate too much later. This may be the biggest problem.

C. QE squeezes spreads abnormally. It would be surprising if that did not cause some distortions. In any case, those squeezed spreads push the economy into unknown territory.

D. By contrast, we already have plenty of experience with negative real rates, so the only unknowns with negative interest rates have to do with nominal illusion.

5. Answering Potential Objections

A. “People will just use a foreign currency.” But people now use domestic paper currency

even when foreign paper currency has a higher expected return. (For example, why don’t Americans now have big piles of yen notes?)

If people did turn to foreign currency, that would just one more example of a low domestic interest rate causing capital outflows and therefore raising net exports, with stimulative effects. (In this case the fact that paper currency interest rates fall in tandem with other interest rates makes it a bit more powerful.)

5. Answering Potential Objections

B. “People will store commodities” The production of anything can stimulate the economy.

And storage of useful goods is actually socially optimal if other investments have a lower return. (There is nothing wrong with people buying canned goods in advance, when rates are low, for example.)

The production of money-like goods (e.g. gold) beyond their non-monetary social usefulness can be discouraged by taxing the storage of those goods.

Buying foreign-produced gold creates export demand for goods produced locally. Domestic production of gold can be tracked.

6. History of Thought for Negative Rates and Electronic Money

A. Silvio Gesell’s Stamped Currency. (1906)B. Robert Eisler’s Depreciating Paper Currency

(1932)C. Marvin Goodfriend’s Advocacy of Stamped

Money. (2000)D. Marvin Goodfriend’s Discussion of

Suspension of Payment in Paper Currency. (2000)

6. History of Thought for Negative Rates and Electronic Money

E. Willem Buiter’s Discussion of a Wide Range of Mechanisms for Avoiding Massive Paper Currency Storage. (2004, 2007, 2009)– Abolish paper currency– Tax currency and stamp it (like Silvio Gesell)– Depreciating paper currency (like Robert Eisler)

F. Greg Mankiw’s Discussion of Random Invalidation by Serial Number (2009)

G. Matthew Yglesias’s Advocacy of Abolishing paper Currency (December, 2011)

6. History of Thought for Negative Rates and Electronic Money

H. Miles Kimball’s Advocacy of a Crawling-Peg Exchange Rate Between Electronic Money and Paper Currency, as here (November 2012).

I. The Urbanization Project’s Elucidation of a Crawling Peg Designed to Generate Substantial Seignorage Without Inflation. (Miles Kimball, Paul Romer, etc. November 2012)

J. Focus on policy tools to inhibit paper currency storage. (Frances Coppola and Miles Kimball January 2013)

Options for International Exchange Rates and Paper Currency Exchange Rates

• Robert Eisler wanted a fixed international exchange rate in the bank money, with a flexible paper currency exchange rate.

• Miles Kimball’s basic plan has flexible international exchange rates and a crawling-peg paper currency exchange rate.

• For the euro-zone, Kimball proposes a “one-central bank, multiple currencies” model with an electronic Deutsche mark, with the euro serving as the paper currency for Germany as well as for the rest of the zone. So in effect,

Electronic euro = paper euro = paper mark, But the electronic mark (which would be the unit of account

in Germany) is distinct and has a crawling-peg exchange rate with the others.

Conclusion

• The zero lower bound is a policy choice. • The zero lower bound is costly.

– ZLB interferes with stabilization policy– ZLB is a big enough problem it motivates higher inflation than

would otherwise be optimal• The zero lower bound can be eliminated through

– A time-varying charge for depositing paper currency at the central bank

– A discount for vault-cash as applied to reserve requirements– A legal right to refuse payment in paper currency (or coin) at

par.• Electronic money would be “the real thing”: the unit of

account and legal tender.

Bonus Slides

• Denmark: A Case Study

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Figure 4: Denmark Rates (End of Period, % per annum)

Sources: Danmarks Nationalbank

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Figure 5: Denmark Interbank Interest Rates (next-day uncollateralized)

Sources: Danmarks Nationalbank

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Figure 6: Government Yield Curve for Denmark (January 2013)

Sources: Bloomberg

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Figure 7: Deposits of Commercial Banks at the Danmarks Nationalbank

Sources: Danmarks Nationalbank