The "zero lower bound" (ZLB) constraint on interest rates exists because of the presence of non-interest bearing forms of money in the economy, of which the most important is physical cash. Were all money entirely electronic and interest-bearing, negative nominal rates would have become reality years ago. But where there are non-interest bearing forms of money that are near-perfect substitutes for interest-bearing forms, the view is that at the ZLB investors will switch funds to non-interest bearing forms of money rather than accept loss of principal. In short, they will hoard cash.
The effect of the ZLB constraint is to force central banks to adopt all manner of peculiar ways of forcing real interest rates below zero, because cutting policy rates directly (particularly the interest rate on excess reserves) would have undesirable contractionary effects due to the reluctance of banks to impose negative interest rates on depositors. banks believe, with some justification, that the general public objects to paying banks to keep their money safe and provide an efficient payments service. The prevalent belief is "I shouldn't have to pay to use my own money".
This neatly sums up the problem with cash. Physical cash is a free good: people do not expect to have to pay to use it, though holding it as an investment carries both cost (vaulting charges, inflation) and risk (theft, fire). And yet it could be argued that retaining physical cash as a non-interest bearing form of money when nominal interest rates on all other forms are negative is a subsidy to people who prefer cash. As I've noted before, negative interest rates are a tax. If the general economic environment is such that money is taxed, why should holders of physical cash be exempt?
At present, bank demand deposits are also exempt from the negative rates tax. But it is coming - and not just because of central bank policy. The profitability of retail banks is so awful that fees on current (checking) accounts will soon be necessary. Now, it is reasonable to suppose that for most people the convenience of modern current account banking, with electronic payments services, internet banking and the like, would outweigh the annoyance of having to pay for it. After all, free current account banking was only introduced in the 1980s: prior to that people paid fees on current accounts. The effect of this of course was to discourage use of bank accounts and encourage cash transactions: but then at the time cheques took two weeks to clear, cash deposits weren't available for three days and the only form of automated payment was standing orders, for which banks charged fees. Nowadays transaction services are far faster and more extensive, so unless negative rates were considerable, would people really return to paying bills in cash? I doubt it. There are other, better substitutes: mobile phones, for example, are providing electronic payment services that bypass bank accounts and are effectively interest-free. If banks imposed negative interest rates on current accounts - whether because of their own profitability problems or as a response to central bank policy - we should expect to see considerable growth of non-bank electronic payment platforms. Cash is not the only problem, and these days perhaps not the main one.
But what about negative rates on time deposits? Why would people deposit money in banks if they would be charged for it? Well, they would if they wanted safety. That money is subject to a government guarantee - admittedly limited, but as long as you stay below the limit your money is safe. So is the substitutability of physical cash really such an issue? After all, it's hardly a safe investment - and nor is physical gold, either. You can put large amounts in a bank vault, of course, but then you will pay vaulting charges. Or you could invest in a fire safe. Or do as the Romans did, and bury coin hoards. I suppose if the US Treasury really did mint platinum coins (yes, plural - that way they could be issued to the market instead of directly to the Fed) these might be quite useful as a non-interest bearing imperishable hoard for those who are dragons at heart, even though they would be government debt really. But since they would be substitutes for interest-bearing forms of government debt, and the direction of policy is pushing both real and nominal interest rates below zero, producing coins at the moment would not be particularly clever. It would encourage investors to switch from other forms of government debt and amount to the US Treasury undermining Fed macroeconomic policy. (Mind you, as an alternative to a totally unnecessary and very harmful sovereign default it has considerable merits.)
Buiter came up with three ways of eliminating the cash problem:
- Eliminate cash, or restrict its issue to very low denominations.
- Make cash interest-bearing in a similar way to coupons on bearer bonds. Of course with negative rates no-one would cash the coupons, so Buiter discusses Silvio Gesell's idea of time-stamping notes, forcing the holder to pay tax on expiry. How to stop time-expired notes from continuing to circulate in the grey economy caused considerable discussion on his first post. I think it would be virtually impossible. After all, they can't control counterfeit money, so what hope would they have of controlling this?
- Create a parallel "cash" currency with a floating exchange rate to the official currency
There is one very good reason for eliminating or severely restricting cash, though, which has nothing to do with either central bank economic policy or bank profitability. It is the fact that there is one sector of society that REALLY likes cash, because of its anonymity. That sector is criminals. I include in this self-employed people who work "cash in hand" to evade tax, and the people who use their services. Governments across the world are trying to clamp down on all forms of tax evasion and avoidance at the moment. Restricting cash would in theory make payments traceable and improve the information available to tax authorities, fraud investigators and the police. Although there would still be the mobile phone problem.....a payment made from a pay-as-you-go mobile phone is as untraceable as cash. And I am unconvinced that restricting note issuance to low denominations would prevent criminals using it. I could envisage forms of "shadow money" circulating among the criminal fraternity, representing claims on known piles of real money that are seldom actually drawn upon - a sort of Mafioso ETF.
But there is another reason for looking towards the eventual elimination of cash - and that is because eventually we simply won't need it. We already have instantaneous transfers of money using smart cards, and with the recent advent of contactless cards these can now be used for very small transactions. And I've already mentioned mobile phone transfers. If all you need to get lunch and coffee, or buy a pair of shoes, is a smart card or a mobile phone, why would you bother to carry cash? And if all your essential bills can be automatically paid by direct debit, and one-off bills can be paid by internet or telephone transfer, you simply don't need cash at all. In my own business now I am finding that use of cash is declining: even for single lessons people will often prefer to make an internet or phone transfer rather than pay cash, and once I am able to accept card transactions (which inevitably at some point I will do) then I expect my cash receipts to fall to near zero.
There are three categories of people for whom the elimination of cash would cause problems:
- elderly people, who are uncomfortable with all this modern technology
- the very poor, who don't have access to bank accounts (about 8% of people in the UK are unbanked)
None of these are liable for much in the way of tax, which of course answers my question above regarding why cash should be exempt from tax. If the people who most rely on cash are not taxpayers, then it would be unfair to tax it.
Eliminating cash would eliminate a useful source of revenue for the central bank. But as people gradually stop using cash, the central bank's seigniorage income will decline anyway. There is no reason to force the pace, and good reasons not to. Prematurely eliminating cash would cause difficulties for some people. And it would be extremely unpopular, because people are not yet emotionally ready to accept a cash-free society. So for the moment, we need to accept that in a negative rate world grannies will stuff mattresses, skinflints will revert to cash, and some investors will behave like dragons. None of these should influence macroeconomic policy.
In my view negative rates are a bad idea because of their huge distortionary effects. I prefer Martin Wolf's suggestion that it would be better to allow inflation to be higher so negative rates were not necessary. But if central banks are so wedded to their inflation targets that they need to impose negative rates, and banks are so short of profits that they need to charge people for safe deposit and transaction services, they should do so. The existence of physical cash is no real problem.
Willem Buiter: Negative interest rates: when are they coming to a central bank near you?
The wonderful world of negative nominal interest rates, again
Miles Kimball: Marvin Goodfriend on electronic money
FT Alphaville: "Negative" has such unfairly negative connotations
Coppola Comment: The strange world of negative interest rates
The nature of money
The liquidity trap heralds fundamental change