Sunday, October 28, 2012

Cowen on Currencyless Payments

Miles Kimball said something about abolishing currency being the cure for  aggregate demand problems and Tyler Cowen decided to respond.   Cowen quoted Matt Yglesias on the matter.  And also Ryan Avent.

I am not sure what Kimball said (I guess I should start following him on Twitter.)   Still, I think Cowen's discussion is confused.

Would abolishing currency end aggregate demand problems?    Not necessarily.    A shortage of the deposit accounts that allow for electronic or check payments would result in reduced spending on output and so an aggregate demand problem.  

The solution to that problem is to either increase the quantity of the deposits or else reduce the demand to hold them by reducing their yield.   The yield on deposits can be negative.  That is, people can be charged to hold money in the form of these deposits.

Currency is a problem because deposits can be redeemed for currency.   If the yield on deposits becomes too low, then people will be motivated to redeem them for currency.  To avoid those redemptions, those issuing deposits, banks and central banks, cannot lower the interest rate on deposits much below zero.   That only leaves the option of expanding the quantity of deposits.  

At least in the short run, expansions in the quantity of money could be unprofitable.   If those issuing deposits purchase a limited set of safe and short financial assets (like T-bills,) then their yields could be driven as low as, or even lower than, those on deposits.   If, on the other hand, longer term or riskier assets are purchased, then there is a chance of loss.    (Market Monetarists insist that a central bank should take that risk, though we also favor a target--the level of nominal GDP--that makes this problem less severe.)

If there was no currency, then those issuing money could purchase short and safe assets, and as the yield on those assets was reduced, lower the interest rate paid on deposits.   Alternatively, they could purchase longer term and riskier assets, while reducing the interest rate paid on deposits, increasing their interest margin to compensate for the greater risk.

How does this work in practice?   Step one is to cease redeeming deposits with currency.   During the 19th century, this was a common practice.   When did it happen?   During bank runs.   Of course, during that time, interest rates on short and safe assets spiked as banks sold them in a scramble for cash.   And each bank and all banks were seeking to get people to deposit currency back into the banks as soon as possible so that that redeemability could be resumed.

If there is no problem with printing up currency to meet demand, but those issuing money consider it unprofitable because the risk-adjusted yields on the assets they will buy are too low, then there is a second step beyond stopping currency redemptions.   The second stop is to make currency no longer be acceptable for deposit at par in the future.   Deposit the currency now at par or else only at a discount in the future.   This discount compensates the currency issuers for the low yields on their asset portfolio.

Cowen makes the error of assuming that suspending the issue of currency is the same thing as taxing currency.   He then makes various speculations of what would happen if there were a currency tax.

However, the point isn't to suppress the use of currency.   It is rather to make sure that there is sufficient spending on output.    If there is some spending of currency on output, then that is just fine.   The goal is to make sure that total spending, mostly by check or electronic payment, is adequate.  (For market monetarists, that is on the target growth path.)

What could go wrong?   Suppose once banks no longer redeem deposits for currency, people begin to buy currency with deposits on the market.   Currency goes to a premium.   People will only sell a $20 bill for $25.   The buyer writes a check for $25 and receives the $20 bill.   The seller of the currency deposits the $25 check, and can now write checks or make electronic payments for $25.    A $20 bill can be indirectly be exchanged for goods and services whose total price sums to $25.

While avoiding the low (or negative) interest rates on deposits might make holding currency attractive now, the fact that it will never be accepted for deposit, except at a discount, should be kept in mind.   Still, we can imagine that the currency would never be deposited again, and that the currency permanently floats against deposit money.   There is no reason to worry about that.   Surely, even if most currency was thrown away, some of it would continue be held by collectors.

Cowen imagines that some currency substitute might develop even if currency use were suppressed by taxation.  Suppose that people began to use gold or silver coins.   It is entirely reasonable that low or negative interest rates on deposits (and other short and safe assets) would motivate people to invest in gold.   The result would be an increase in the price of gold.  In a certain world, the price of gold would immediately rise to a point such that its expected rate of decrease equals the negative yield on other assets.   More realistically, the price of gold would rise to a point where the risk of capital loss makes additional purchases unattractive.   To some small degree, those who were already holding gold become wealthier and may choose to consume more.   This quasi-Pigou effect would tend to raise the natural interest rate, and so the return that can be earned on the assets that banks and central banks purchase.

Cowen says that there would still be a bond-currency margin, even if currency were taxed.   Consider the scenario above.   Yes, there would be a bond-gold margin, whether the gold was in bars or coined.   If people chose to hold paper currency divorced from the banking system, there would be a currency-bond margin.   But with the price of currency being free to vary with supply and demand, there is no problem.    The price of currency (relative to deposits and short and safe bonds) rises until the risk of capital loss, or the certain future decreases in its price, allows the market to clear.

Finally, what about the possibility that deposits would disappear if there is a currency suspension and no expectation of a return to currency redeemability at par.   I think that this scenario is implausible.   How many people would quit their jobs because the money deposited in their accounts cannot be withdrawn but solely spent on goods and services?   How many retailers would refuse to accept checks or electronic payments by check card because they can only make deposits and then write checks of their own and cannot make currency withdrawals from their bank?

Personally, I favor the complete privatization of hand-to-hand currency.   It should only be issued by private banks, and deposits and currency should be redeemable for deposits at the central bank.   Banks would cease issuing currency if it was not profitable.   And they should have a call option that allows them pull outstanding currency out of circulation or else only accept it at a discount in the future.   What discount?   One based upon the interest paid (or costs of holding) deposits during the interim period.

If issuing deposits at any given interest rate becomes unprofitable, then the interest rate on the deposits simply needs to be decreased.   The quantity of deposits and the yield on them can be adjusted in a way that avoids any shortage of them with spending on output at an appropriate level--on target.

Of course, if people become more optimistic about the future and are inclined to save less and invest more, and if people are willing to use credit for transactions rather than deposits, then this will make issuing money more attractive and holding money less attractive.   The result would be a higher interest rates on deposits.  It would also make issuing hand-to-hand currency more attractive, and so, any conveniences associated with using paper currency for some transactions could again be obtained.

Interestingly, if privately-issued hand-to-hand currency did not receive deposit insurance, and was made junior to deposits, it might be possible for relatively risky currency to be issued and used for small-denomination, face-to-face transactions even while the interest rates on the more senior deposits, and especially insured deposits, are negative.   In fact, allowing retail firms to issue their own unregulated hand-to-hand currency when interest rates are low would be a relatively simple solution to a currency shortage.   Dating the currency would make it a poor store of wealth, and so avoid problems with hoarding, even while allowing for the convenience of using hand-to-hand currency for some transactions.


  1. Hi Bill, excellent post. Those are some pretty creative ideas about how to lower interest rates below zero in the presence of hand-to-hand currency. My idea was to reduce the convenience of hand-to-hand currency by only redeeming deposits in denominations of $5.

    What does the term currency-bond margin mean?

  2. Those holding wealth have a decision on the margin of whether to hold currency or bonds. (At least, that is what I think Cowen meant.)

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