The cleanest solution to this problem is to move entirely to digital currency. But, for many reasons, including privacy concerns, that will not really be an option for the foreseeable future. Alternatively, phasing out large-denomination banknotes has much to recommend it – including clear benefits in terms of tax evasion and crime prevention. During an emergency period of negative interest rates, getting rid of large notes would significantly raise the costs of wholesale cash hoarding by financial firms, pension funds, and insurance companies. If on top that, one imposes administrative charges on large-scale redeposits of cash at the central bank, it should be possible to have a far more effective negative-interest-rate policy than is possible under current institutional arrangements.
Another alternative is to create a crawling-peg exchange rate between electronic money (bank reserves at the central bank) and paper notes. The idea would be to move toward an equilibrium in which all contracts and taxes are denominated in electronic currency, but transactions could still be executed with paper money. When the central bank’s policy rate is negative, it would no longer exchange electronic currency for paper notes at a one-to-one rate. Instead, if the interest rate on electronic currency was -5%, the value of paper cash tendered at the central bank would depreciate at a rate of -5%.
As for banking profits, if small retail depositors are excluded and wholesale clients have no way to hoard cash without incurring high storage and tax costs, banks should be able to pass the negative rates on to depositors. Yes, there are a number of second-order issues associated with this approach, which I address in detail in my 2016 book The Curse of Cash. But the real-world experience with negative rates so far suggests that these issues would not be a problem.
The Wrong Target
Aside from a negative-rate policy, another idea is to give monetary authorities more scope to cut interest rates – namely, by raising inflation targets. But this approach is less elegant and probably far less effective. For starters, raising the inflation target from 2% to 4% probably buys a lot less space than one might think. Contracts would almost surely adjust more frequently, in which case interest-rate cuts would need to be even larger to achieve the same effect as before; even during normal times, there would be costs of higher inflation, owing to the greater dispersion of relative prices.
Another problem is that changing long-established targets could undermine central-bank credibility. After all, the ECB and the BOJ have not even been able to reach 2% inflation, let alone 4%. And even if inflation were to reach 4%, that still wouldn’t necessarily provide enough room for maneuver in the event of a deep recession or financial crisis.
One naive objection to negative interest rates is that they are unfair to savers. But modern technologies make it easy to exempt small depositors so that only a very small percentage would be affected. Moreover, an effective negative-rate policy would benefit savers with more diversified portfolios, because it would push up equity, housing, and long-lived-asset prices, thereby countering the sharp drop that usually occurs in a deep recession or financial crisis. It would also increase long-term interest rates by driving inflation and growth. And, most important for most workers and families, a negative-rate policy could help restore employment and income growth after a deep recession or crisis.
This is not to suggest that a negative-rate policy obviates the need for other forms of stimulus – higher government spending, tax cuts, or both – during recessions. But it would restore some of the balance between monetary and fiscal policymaking, the former being generally much faster and more reliable. Finally, if a negative-rate policy sounds radical, you don’t even want to know about all the radical ideas that fill the pages of the major economics journals. Like deep recessions and financial crises, all would entail severe risks. At least with a negative-rate policy, we will have solved the problem of central-bank impotence at the zero bound, which would be of immediate use for Europe and Japan – and could help the US in the future.
Time to Act
The challenges facing central banks stem both from their effectiveness in reducing inflation and from their ineffectiveness in dealing with the zero lower bound. They are now vulnerable to populist attacks that threaten to undermine their independence. Some would have central banks finance massive increases in government debt indefinitely, while others, in the case of the US, want to slash interest rates when the economy already seems to be running hot. The idea that high inflation in advanced economies is strictly a twentieth-century problem is extremely dubious. “This time is different,” until it’s not.
In fact, the case for having an independent central bank that is hardwired to control inflation remains strong, buttressed by the experience of countries where central-bank independence has been compromised. If central-bank independence is rescinded and monetary policy politicized, it will be only a matter of time before high inflation returns. And if that happens, it may be even harder to put the inflation genie back in the bottle.
In the 1920s and 1930s, governments tried to reestablish the gold standard, which had been abandoned during World War I. They soon learned that once investors witness a bond being broken, it is exceedingly difficult to regain their confidence. The same problem would face countries that tear down central-bank independence and then try to resurrect it. At a minimum, they would face years of sky-high interest rates before public trust is restored.