Getting Leeway on the Lower Bound for Interest Rates by Giving the Central Bank Standby Authority over Paper Currency Policy
I have been thinking about Frances Coppola’s blog post “The Problem of Cash,” and her contention, late in the collection of storified tweets “Twitter Round Table on Our Disastrous Policy of Pegging Paper Currency at Par,” or more directly, here, that taxing currency in bank vaults as well as bank reserves on deposit at the central bank might be enough to allow seriously negative nominal interest rates, even if the value of paper currency is kept at par with electronic money. Let me discuss that possibility in this post. (Before going on, I recommend reading my brief post “Paper Currency Policy: A Primer” if you haven’t already.)
Since currency is a government issued asset, except for the name (and of course names do matter) a tax on vault cash is equivalent to a government-imposed negative interest rate on vault cash. So we are talking about imposing a negative interest rate on all high-powered money within the banking system. Moreover, there should be no problem declaring that any business that stores currency for customers commercially is included in this tax (=negative interest rate) on stored currency. (One might even go so far as to require those providing safety deposit boxes that would be natural for currency storage to inspect for currency among the items for deposit and count and report and pay tax on that currency, just as if it were vault cash.) Given that policy, the only way to get a zero interest rate from currency would be to store it somewhere outside the official banking sector, hidden at home or in the backyard, in illegal cash-storage businesses (that should be paying the tax on vault cash but are not), or in businesses for general storage that escape the tax.
Large-scale cash storage at home, in illegal cash-storage businesses, or in general-storage businesses would be a change from the way people do things now. All of these would face security issues (and for the later two, trust issues) that would need to be resolved. Therefore, it might be possible to dissuade people from paying the fixed costs of resolving those issues if they knew the central bank would be able to reduce the value of that currency outside the banking system if need be.
In other words, suppose the central bank had standby authority to let paper money depreciate relative to electronic money if it saw a pattern of substantial withdrawals of currency from the banking system at the macroeconomic level. It is possible that might be enough to prevent currency from being the go-to safe asset to such an extent as to prevent the fed funds rate and Treasury bill rate (or their equivalents in other countries) from getting down to, say -3%.
Because there is some adjustment cost to people’s usual habits in breaking par in paper currency policy and letting paper currency depreciate relative to electronic money, it makes sense to hold off doing so until it is clear that it is necessary. Just knowing it had the standby authority to break par in paper currency policy if massive cash withdrawals indicated it was necessary would be enough to give the central bank confidence to lower the fed funds rate or its equivalent below zero. Though the dangers at issue are different in the two cases (massive currency storage that creates a lower bound on interest rates in one case, inflation in the other) this is not entirely dissimilar to the way in which knowing it has the authority to raise interest on excess reserves if the economy looks as if it is danger of overheating at some time in the future makes the Fed willing to pursue balance sheet monetary policy (QE) more aggressively now. And promising not to break par in the paper currency policy unless necessary makes it more likely that the central bank would be granted authority over paper currency policy in the first place.
(Note that the enabling legislation for the standby authority over paper currency policy should also declare electronic money legal tender and do whatever else is needed to encourage people to use it as the unit of account later on in the event that par is broken. Also, in the period when the central bank is trying to avoid breaking par, movement of paper currency out of the country or out of the zone in which commercially stored currency can be taxed must be restricted.)