Central banks shouldn't ignore their duty to provide anonymity

Cross section of a banknote with a cotton paper core surrounded by two layers of polymer [Source]

 
Central bankers are at their most comfortable when engaging in technical debates over the finer points of monetary policy. But over the next few years they may be forced out of their comfort zone into a thorny philosophical debate over anonymity and financial censorship. They are poorly equipped for such a debate.

When central bankers monopolized the issuance of banknotes in the 1800s and early 1900s, little did they know that a hundred years later anonymity would become an important public good. And because banknotes are the only generally-accepted way for law-abiding citizens to make uncensored anonymous payments, central bankers effectively became—by accident rather than design—the sole purveyors of these vital services.*

Banknotes are anonymous because it is very difficult to link banknotes to identities, say by monitoring usage of notes via a note's serial number. As for 'uncensored', this means that banknotes are available for anyone to use—i.e. they are highly resistant to censorship. There are no gateways involved, no need to get permission ahead of time by opening an account or installing some sort of proprietary software or hardware, and no way for the issuer to halt a payment while it is being made.

If you glance through the research papers that central banks typically publish, they're almost all on monetary policy. And why not? A stable medium of exchange is one of the most important services provided by a central bank, so they need to do their homework. But if you try to find research on the topics of anonymity and censorship resistance, good luck. What this tells me is that central bankers know very little about the unique set of services they are providing to the cash-using public, despite being the world's only suppliers. Not only have they blundered into their role of monopoly provider of anonymity and uncensored payments, they are trying their best to pretend the role isn't theirs.

Take for instance the European Central Bank's decision to stop printing the €500 note, which was motivated by the desire to cut down on crime. No doubt a significant chunk of €500 notes are used by criminals, but the ECB seems to have made no effort to quantify the anonymity services lost by the tax-paying non-criminal public. Because the ECB has never officially admitted its role as Europe's sole provider of uncensored payments anonymity, it lacks the sorts of datasets and institutional wisdom that are necessary for formally approaching problems about anonymity and censorship-resistance. So while their decision about the €500 wasn't necessarily wrong, it was surely uninformed.

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Related to all this is Tyler Cowen's recent article criticizing central banks that take an active role in developing their own cryptocurrencies. His critique includes the Fedcoin idea, or a public cryptocurrency available to anyone that is pegged by the central bank to the national unit of account. Cowen says that this "new and potentially risky responsibility" might tax central bankers' resources. The problem with this is that the responsibility of delivering anonymous and censorship resistant cash is an old one. In this context blockchain technology isn't anything special, it's just another technology among many that central bankers might use to upgrade the quality of the public services that they are already providing.

Banknote technology has been constantly improving over the decades. For instance, anti-counterfeiting technology began with serial numbers and elaborate engravings on notes in the 18th and 19th centuries. Even after banknote production was monopolized by governments, improvements continued into the 20th and 21st centuries with security threads, watermarks, holography, raised images, clear windows, latent images, microprinting, and luminescent ink. The substrate on which notes are printed has evolved from cotton and/or linen to polymer, or a hybrid of the two (see image at top). If central bankers had applied Cowen's advice to avoid new technology, banknotes would still be printed on cotton and lack modern anti-counterfeiting devices.

So think of encoding banknotes onto a public blockchain—the Fedcoin idea—as just another change in substrates. In the same way that the anonymity and censorship resistance embedded on a cotton substrate was replicated on a polymer one, why not test out the idea of replicating these features on a blockchain? Along with anonymity and censorship resistance, a public blockchain would capture the decentralization of banknote systems, and thus their robustness in the face of disasters, a feature I wrote about here.**

The advantage to digitally delivering these services rather than physically delivering them on polymer or cotton is that a payment no longer requires face-to-face meetings; it can occur over the internet. This would constitute a dramatic upgrade to the quality and breadth of the anonymity and censorship resistance services that are currently being provided by our central bank monopolists.

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With the emergence of bitcoin and the slowly percolating Fedcoin debate, central bankers are thinking for the first time in ages about designing cash-like systems from scratch. And since these systems may eventually replace the physical stuff, central bankers will have to accept the fact that they are the only providers of anonymity and censorship resistant payments services, and that maybe they should get their act together and think hard about the value of these services to the public. A great start can be found in former Fed policy maker Narayana Kocherlakota's Monetary Mystery Tour, which ends with the exhortation: "Need more economists working on these issues!"

Bringing this back to Cowen's article, I don't agree that central bankers should refuse to test the idea of a central bank-issued cryptocurrency because this represents a new and risky technology. That would be shirking their duty as a monopolist provider of the unique services embedded in paper cash. Central bankers should only say no to Fedcoin because they've done a rigourous cost-benefit calculus that takes into account the social value of anonymity and censorship resistance to the public, and that effort has resulted in a conclusion that the status quo—the provision of these public services on a polymer or cotton substrate—is the best option. 

Having blundered into their role as monopoly provider of anonymous payments, here's hoping that the cryptocurrency revolution means that central bank's finally take that role more seriously. If they don't, maybe they should just give up their monopoly.

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*Can bitcoin serve as a suitable replacement for cash? Unlike cash, bitcoin can't be used to make anonymous payments. Bitcoin payments are pseudonymous—so they don't quite make it over the line. The other problem is that bitcoin is not pegged to national units of account. Thanks to its terrific volatility, bitcoin has failed emerged as a genuine medium of exchange, so it can't take on the responsibility of providing law-abiding citizens with a generally-accepted anonymous and censorship-resistant medium for making payments.
**I am by no means wedded to blockchains as a way to digitally capture anonymity,censorship resistance, and robustness. There are other ways to go about this that do not involve blockchains.

Kocherlakota on cash

Narayana Kocherlakota, formerly the head of the Federal Reserve Bank of Minneapolis and now a prolific economics blogger, penned a recent article on the abolition of cash. Kocherlakota makes the point that if you don't like government meddling in the proper functioning of free markets, then you shouldn't be a big fan of central bank-issued banknotes. For markets to clear, it may be occasionally necessary for nominal interest rates to fall well below zero. Cash sets a lower limit to interest rates, thus preventing this rebalancing from happening.

I pretty much agree with Kocherlakota's framing of the point. In fact, it's an angle I've taken before, both here and in A Libertarian Case for Abolishing Cash. Yes, my libertarian and other free-marketer readers, you didn't misread that. There is a decent case for removing banknotes that is entirely consistent with libertarian principles. If you think usury laws are distortionary because they impose a ceiling on interest rates—and there are some famous libertarians who have railed against usury—then an appeal to symmetry says that you should be equally furious about the artificial, and damaging, interest rate floor set by cash.

Scott Sumner steps up to the plate and defends cash here. He brings up some good points, but I'm going to focus on his last one. Scott says that a cashless economy would create a "giant panopticon" where the state knows everything about you. I quite like Nick Rowe's response in which he welcomes Scott to the Margaret Atwood Club for the Preservation of Currency. In Atwood's dystopian Handmaid's Tale, a theocratic government named the Republic of Gilead has taken away many of the rights that women currently enjoy. One of the tools the Republic uses to control women is a ban on cash, all transactions now being routed digitally through something called the Compubank:

I agree that we don't want to abolish cash if it is only going to lead to Atwood's Compubank. But Scott misses the fact that even though Kocherlakota wants the government to exit the cash business, he simultaneously wants fintech companies to take up the mantle of anonymity services provider. Like Sumner, Kocherlakota doesn't seem to want a Compubank.

For instance, in a recent presentation entitled The Zero Lower Bound and Anonymity: A Monetary Mystery Tour, Kocherlakota highlights the potential for cryptocoins Zcash and Monero to substitute for central bank cash. Unlike bitcoin, these cryptocoins provide full anonymity rather than just pseudonymity. If you want to learn more about Zcash, I just listened to a great podcast with Zcash's Zooko Wilcox-O'Hearn here. As for Monero, Bloomberg recently covered its spectacular rise in price.

As Monero illustrates, cryptocoins are incredibly volatile. Is anonymity too important of a good to be outsourced to assets that behave like penny stocks? I'm not sure. And as Nick Rowe points out, the concurrent circulation of deposits (pegged to central bank money) and anonymity-providing cryptocoins would create havoc with the traditional way of accounting for prices. Retailers would probably still set prices in terms of central bank money but anyone wanting to purchase something anonymously would have to engage in an inconvenient ritual of exchange rate conversion prior to consummating the deal. Perhaps these are simply the true costs of enjoying anonymity?

Kocherlakota doesn't mention it explicitly, but should cash be abolished in order to remove the lower bound to interest rates, a potential replacement would be a new central bank-issued emoney, either Fedcoin or what Dave Birch has dubbed FedPesa. A good example of a Fedcoin-in-the-works comes from the People's Bank of China, which vice governor Fan Yifei expects to "gradually replace paper money." As for Birch's FedPesa, a real life example of this is provided by Ecuador's Dinero electrónico, a mobile money scheme maintained by the Central Bank of Ecuador (CBE) for use by the public.

Should a government decide to abolish cash and implement a central bank emoney scheme in its place, it would be possible to set negative interest rates on these tokens while at the same time promising to provide both stability and anonymity. One wonders how credible the latter promise would be. The CBE requires that citizens provide national identity card before opening accounts. And consider that the PBoC's potential cyptocoin will be designed to provide "controlled anonymity," whatever that means. Unless significant safeguards are set, it's hard not to worry that a potential Atwood-style Compubank is waiting in the wings.

An alternative way to coordinate a smooth government exit from the cash business is Bill Woolsey's idea of allowing private banks to step into the role of providing banknotes. In this scenario, the likes of HSBC, Bank of America, Wells Fargo, Deutsche Bank, and Royal Bank of Canada would become sole providers of circulating banknotes. Wouldn't this simply re-establish the zero lower bound? Not necessarily. As I wrote back in 2013, the moment a central bank sets deeply negative interest rates, private banks will face huge incentives to either 1. get out of the business of cash or 2. stay in the game while modifying arrangements, the effect being that the zero lower bound is quickly ripped apart.

The provision of anonymity services via the issuance of private banknotes has some advantages over cryptocoins like Zcash. Since they'd be pegged to central bank money, private banknotes would provide 'fixed-price' anonymity. Nor would the public have to constantly do exchange rate conversions between one currency type or the other. On the other hand, Zcash payments can be made instantaneously over long distances; you just can't do that with banknotes. And of course, there's also the stablecoin dream, i.e. the possibility that private cryptocoins like Zcash might themselves be stabilized by pegging them to central bank cash, as Will Luther describes here (for a more skeptical take, read R3's Kathleen B here)

Because of what he calls "over-issue" problems, Kocherlakota is more confident in the prospects for cryptocoins than private banknotes. I'm not so worried. The voluminous free-banking literature developed by people like George Selgin, Larry White, and Kevin Dowd teaches us that as long as silly regulations are avoided, the promise to redeem notes at par in a competitive environment will ensure that the quantity of private banknotes supplied never exceeds the quantity demanded. Don't look to the so-called U.S. Wildcat banking era for proof. During that era, note-issuing banks were too encumbered by strict laws against branch banking and cumbersome backing rules to effectively supply notes, as Selgin points out here. Rather, the Scottish and Canadian banking systems of the 1800s provide evidence that banks can responsibly issue paper money.

Wouldn't the private provision of banknotes require the passing of new laws? Funny enough, U.S. commercial banks can already issue their own banknotes. In a fascinating 2001 article, Kurt Schuler points out that federally-chartered banks have been free to issue notes since 1994 when restrictions on note issuance by national banks was repealed as obsolete by the Community Development Banking and Financial Institutions Act. So the floodgates are open, in the U.S. at least, although as of yet no bank has taken the lead.

If governments are going to remove the zero lower bound by getting out of the business of providing anonymous payments, I say let a thousand flowers bloom. If the void is to be filled, don't put up any impediments to the creation of anonymity-providing fintech options like Zcash, but likewise don't prevent old fashioned banks from getting into the now-vacated banknote game either. Let the market decide which anonymity product they prefer... and celebrate the fact that the government's artificial floor to interest rates has been dismantled.

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P.S. It would be remiss of me to omit pointing out that there are sound ways to dismantle the zero lower bound without removing cash, Miles Kimball's plan being one of them.

Does the Fed lack the technical means to dive into negative rate waters?

The Federal Reserve may be in a bit of a bind.

With the Bank of Japan reducing rates to -0.1%, many commentators are calling on the Fed to reverse its policy of rate normalization and follow Japan into negative territory.  The problem is this. Thanks to the rules laid out in the Federal Reserve Act, the Fed may lack the technical means to dive into negative rate waters. Let me restate this in different terms. If the Federal Reserve were to reduce the rate at which it pays interest on reserves (IOR) to -0.25% or so, the overnight rate may not follow very far. Monetary policy is useless, or at least less effective than it would otherwise be.

Not only would monetary policy lose some of its potency when IOR falls below 0%, but an unapproved fiscal transfer from the Fed to another set of government institutions could occur. This is because negative IOR has the potential to provide a large subsidy to a narrow range of governments sponsored-entities that are allowed to keep 0%-yielding deposits at the Fed. At deeply negative rates, this subsidy could get very large, turning the Fed's substantial profits into large losses. The result, a steady fall in its share capital, might undermine Fed independence and the credibility of monetary policy.**

Why these odd effects? As Nick Rowe says in this delightful post, in a world with negative interest rates everything old is new again, only it's a mirror image. And in a world of negative U.S. rates, the mirror image of the Fed's leaky floor is a sticky ceiling. And just like the leaky floor (more on this later) dragged the overnight rate down to 0% when IOR was positive, the sticky ceiling effectively pulls the overnight rates back up to 0% when IOR is negative. To see why this would happen, we need to take a quick tour of the legal and technical history behind IOR.

Until October 2008 the Fed was legally prohibited from paying interest to banks. Any bank manager who left reserves on deposit at the Fed earned 0%. This changed with the passage of the  Financial Services Regulatory Relief Act of 2006 which bolted Section 19(b)(12) onto the Federal Reserve Act allowing banks to "receive earnings to be paid by the Federal Reserve Bank." As a direct result of 19(b)(12), the Fed has been paying interest of 0.25% for a number of years, a rate that was recently increased to 0.5%.

Not only did Section 19(b)(12) provide the Fed with the ability to pay interest on reserves, it also gives it the technical means to pay negative rates on reserves. Now there is some controversy whether the wording in Section 19(b)(12) authorizes a negative rate; for instance, it mentions the paying of earnings to banks, not the payment of negative earnings:

World is cascading to - rates. Does Congress need to authorize Fed to "charge" IOR? ('06 law says "pay") @dandolfa @jp_koning @mileskimball

— Diego Espinosa (@dvespinosa) January 29, 2016

...and here is Stephen Williamson on the issue.

Ex-Fed official Narayana Kocherlakota points out that various members of the Fed Board of Governors, including William Dudley and Stanley Fischer, have already hinted at negative rates as a potential tool, the implication being that the Fed has high confidence in a certain interpretation of the Act that would legally justify the move, otherwise they would not have spoken. Don't forget that Fed general counsel Scott Alvarez will have to sign off on the question of legality. Alvarez is the one who allowed a truck to be driven through Section 13.3 during the credit crisis, legalizing the bailout of Bear Stearns and AIG via Maiden Lane.

Let's assume that there is no legal controversy and the Fed sets negative IOR of -0.25% tomorrow. That's where the Fed's real problems start. Because as I said at the outset, the overnight rate won't follow IOR down in lock-step, it may even stick to the 0% ceiling. On top of this is the aforementioned subsidy provided to those institutions that have access to interest-free deposits at the Fed, namely the government-sponsored entities Freddie Mac, Fannie Mae, and the Federal Home Loan Banks (I'll describe this subsidy later).

As I said at the outset, the sticky ceiling problem is the opposite of the well known leaky floor problem. Over the last few years the various U.S. overnight rates have traded below IOR. These leaks are odd since IOR is supposed to set a lower bound to the overnight rate. After all, why invest your funds at 0.05% overnight when you can get 0.25% at the Fed? We can blame the leakage on our three government-sponsored entities (GSEs): Freddie, Fannie, and the Federal Home Loan Banks. These GSEs are allowed to keep accounts at the Fed but are prohibited from collecting interest. Rather than earn nothing, the GSEs have been lending their reserves overnight to banks who have access to IOR. These banks have been engaging in arbitrage whereby they borrow GSE funds at 0.05%- 0.15% and invest them at 0.25%, a nice gig if you can get it.

From whence this prohibition on interest? 19(b)(12), the same bit of legalese that authorizes IOR, emphasizes that only "depository institutions" can receive interest, and since Freddie, Fannie, and the Federal Home Loan Banks are not depositories, they do not qualify (this article speculates why).

Which means that if the Fed is going to stretch Section 19 authority for payment of interest  to allow for the payment of negative interest rates, then the GSE prohibition on receiving positive interest means that they will likewise be exempt from paying negative interest.

The ultimate effect of all this is that if and when the Fed decides to brings IOR to -0.25%%, the overnight rate is going to do a flip—rather than trading below IOR it will start to trade above it. Why the inversion? In positive rate land the IOR exemption meant that it really sucked to be the GSEs. But in negative rate land it's great to be a GSE. When all other banks must endure a -0.25% penalty, an exemption from IOR becomes an asset, not a liability. Banks, sensing a way to improve their returns, will compete to purchase 0% shelter from the GSEs. Say they offer to lend funds to the GSEs in the overnight market at  -0.17%, an 8 basis point improvement to IOR of -0.25%. GSEs would be hard-pressed to not accept this gift. After all, they'd be borrowing at -0.17% in order to lend to the Fed at 0%, which means 17 basis points in risk free profit. Taken to the extreme, a profit-maximizing Fannie, Freddie, and the Federal Home Loan Banks will compete to borrow the entire $3.3 trillion in reserves held at the Fed, driving overnight rates back up towards 0%. No matter how deep the Fed brings IOR into negative territory, the overnight rate stays stuck at a shallow level thanks to the GSEs.

You may recognize that the sticky ceiling problem is just another (perhaps weaker) version of the good old zero-lower bound problem, but in the role of 0% cash as antagonist, 0% deposits held at Fannie, Freddie, and the Federal Home Loan Banks have been substituted.

Now it could be argued that GSE arbitrage will force the overnight rate within a hair of negative IOR. For instance, if  IOR is at -0.25%  the overnight rate might trade at -0.24%. If so, the problem is less about monetary policy impotence and more about the massive subsidy being granted to the GSEs. These institutions have a large incentive to hoover all the reserves held by non-GSEs in order to earn risk free returns. Rather than earning 0.25% on reserves held by banks, the Fed will get 0%. And since the Fed's profits--what economists call seigniorage--typically flows to the taxpayer via the Treasury, taxpayers would be subsidizing Fannie, Freddie, and the Federal Home Loan Banks to the tune of millions, a fiscal transfer lacking the appropriate Congressional approvals.*

If the GSEs take the free gift, this will have very real effects on the Fed's financial health.  With IOR at -0.25% the steady rolling-over the Fed's assets will result in a decline in their yields, maybe even negative returns. As the spread between the return on assets and cost of liabilities shrinks, the Fed's seigniorage will drop dramatically. In  normal times, a certain portion of this seigniorage goes to rebuilding any impairments to the Fed's capital base while the rest flows through the Treasury to the taxpayer, either in the form of reduced taxes or services. With a 0% loophole being offered to the GSEs, the Fed risks running permanent operating deficits which in turn will lead to a steady erosion in its capital base. If the equity writedowns gets too large this may reduce the Fed's credibility in the eyes of the market, thus reducing the effectiveness of monetary policy.**

The Fed will have to plug this hole if it doesn't want to find itself neutered and/or subsidizing the GSEs. Maybe Fed officials can cap the amount of reserves that the GSEs are allowed to borrow, or use moral suasion to get the GSEs to drop out of the market. Better yet, maybe Fed Chair Janet Yellen can ask Congress to change 19(b)(12) so that, like all other banks, GSEs get to receive IOR (and are forced to pay it). Alternatively, maybe the laws can be altered so that the GSEs are prevented from keeping deposits at the Fed to begin with.

The legal option is a good idea for two reasons. First, it means that negative IOR effectively sets the overnight rate, restoring the pass-through from negative rates into financial markets and the real economy. It also removes the subsidy to the GSEs and the potential for large hits to share capital. Secondly, it fixes the Fed's leaky floor problem at positive rates of IOR. The Fed has already set up an overnight reverse repo agreement (ON RRP) facility to borrow from those ineligible to receive IOR, the idea being to keep a sterner floor under overnight rates. But as Marvin Goodfriend writes, ON RRP

violates the minimal intervention principle of central banking by turning the Fed into a financial intermediary operating directly on a large scale beyond the banking system with the potential to distort short term credit allocation and enable disruptive flight-to-quality flows during periods of financial distress.

Far less obtrusive to fix the leak with a quick change to legislation than fully arming a new battle station.

In closing, if the Fed wants to go negative, it may have some technical details to worry about. Fed officials no doubt already know this. If they don't, the blame can be attributed to their all-out focus on so-called normalization. By throwing all their organizational capital into the creation of a mechanism for keeping rates on an upward trajectory (the ON RRP), the Fed has diverted resources and attention away from the design of a complementary mechanism necessary for a downward rate trajectory. In hindsight, perhaps the Fed should have been tasking half its lawyers, accountants, financial architects, and media personnel to the rate normalization project, and the other to the negative rate project. Time to play catch-up?

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Due to the difficulty of this subject matter, I've altered this post a few times since initially publishing it. The general idea has remained the same.

* In my original post, this paragraph didn't appear but was in the footnotes. I think it's important enough to bring up to the body of the text.
** Added on January 4.
*** Since originally posting this, I've softened my position on the sticky ceiling. I originally thought that the overnight rate would stay stuck at 0%, but I now feel it is likely to move closer to negative IOR. It would remain above IOR, however, so the idea of a sticky ceiling, while muted, is still relevant.

Yap stones and chartalism

Rai at the Bank of Canada - part of Canada's foreign reserves

As I pointed out in my previous post, all sorts of economists have incorporated the example of Yap stones into their monetary discourse. One of the more peculiar uses of these stones can be found in neo-chartalist L. Randall Wray's Understanding Modern Money (1998).

In Chapter 4 of his book, Wray claims that an economy becomes monetized by the introduction of state-issued tokens (what I call coupon instruments). To provide empirical support for his claim, Wray repeats the story about German administrators marking all Yap stones with paint (see previous post, #9). The Germans did so in order to motivate the Yapese to build roads. After all, in order to get the state to remove these markings from their valuable stones, the Yapese were required to provide their labour. The implications of Wray's chapter are that instead of requiring labour, the German government could just as easily have required payment in government-issued paper coupons. Thus Yap, which up till then had never been a monetary economy, would have suddenly become monetized.

Wray is in some difficulty here since Yap stones already circulated as media of exchange (see Goldberg in previous post). Thus the emergence of a monetized economy came prior to any German state-inspired monetization. This possibility is particularly harmful to Wray since he has adopted throughout his book an extreme, or "vulgar", version of chartalism in which the only way to monetize an economy is to introduce a state-issued coupon instrument. In a note, Wray tries to wriggle out of his predicament, claiming that:

Furness, almost certainly in error, called these 'stone currency' and imagined that they were used as some sort of primitive 'medium of exchange'; however, his description uncovers no evidence that there were any markets. (73)

Wray is contradicted by the anthropological evidence provided by Gillilland and Furness, who list all sorts of examples of rai acting as media of exchange. Rai were used to purchase fish, housing materials, yams, labour, women, coconuts, and many other valuable items. Yap stones original circulation as commodity media-of-exchange therefore prove Wray wrong  in his extreme view that an economy can only be monetized via state-issued coupons.

Federal Reserve Bank of Cleveland's Michael Bryan wrote a paper called Island Money (2004) in which he adopts the chartalist idea that "money" is a marker, or a credit/debit, in order to explain rai. Owning a stone meant that one possessed a credit on the rest of the Yapese or, put differently, that Yap was in debt to the stone's owner. In this way rai functioned as "memory", a means by which to tabulate who owes whom. This is an old idea going back centuries but most popularly reincarnated in Narayana Kocherlakota's Money as Memory.

Now it is certainly true that credit IOUs have and continue to serve as some of society's most liquid instruments. Bank deposits are a great example. But to assume that only credit can qualify as "money" is to commit the same sin of monetary extremism that Wray commits. Bryan maintains that

rai are not known to have any particular use other than as a representation of value. The stones were not functional, nor were they spiritually significant to their owners, and by most accounts, the stones have no obvious ornamental value to the Yapese. If it is true that Yap stones have no nonmonetary usefulness, they would be different from most “primitive” forms of money... Usually an item becomes a medium of exchange after its commodity value—sometimes called intrinsic worth—has been widely established. Lacking intrinsic worth, Yap stones may be an especially useful object of study for students wishing to understand the significance of U.S. dollars, which, after all, have no value other than as a monetary unit; they’re what economists call an “fiat” money.

But as Goldberg has pointed out, Yap stones did have significant intrinsic value. There is no need, therefore, to accept Bryan's fallback view that within the so-called vacuum of intrinsic worthlessness, money could only earn value from its status as an IOU, or as so-called "memory".

The other problem with the Bryan's rai-as-credit story is their sheer size. Why choose something so awkward as a three meter wide stone to record an IOU? Any small token can be used to represent either smaller or larger debts. Casinos issue chips of the same size and shape representing amounts from $1 to $1000 — no casino deems it necessary to issue human-sized intrinsically valuable (gold plated?) $1000 casino chips. Rather than using huge stones as IOUs, the Yapese could have easily used verbal promises to record debts (see #8, previous post), or coconut shells emblazoned with markings. The simpler explanation for rai's value is Goldberg's: rai were intrinsically valuable for religious and aesthetic purposes.

I'm not saying that chartalism is wrong. I've pointed out before that I think the idea of coupon "money" makes some sense—even McDonald's could create chartal coupon instruments. So while you can count me in as a soft chartalist (I'm also a soft metallist, a soft monetarist, a soft Keynesian, a soft Austrian, etc), I'm not persuaded by the extreme versions of chartalism. The contortions its advocates are forced to undertake in order to explain monetary phenomena like Yap stones lead them astray.

Zero percent interest rates forever

Noah Smith asks what would happen if the Fed kept interest rates at zero forever. Specifically:

Suppose that the Fed targets only one interest rate, a short-term nominal interest rate, and that its only tool is Open Market Operations (it cannot provide any "forward guidance" or communicate with the public at all). Suppose that at date T, the Fed decides to keep the interest rate at zero in perpetuity, and remains unwaveringly committed to this decision for all time > T.

He asks this because Nayarana Kocherlakota, head of the Minneapolis Fed, once said, somewhat counter-intuitively, that over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. This seems odd at first blush because we've been conditioned to assume that low interest rates lead to inflation, not deflation.

I'm going to try and give an answer that financial types will understand. The spoiler is... over the short term we'd have inflation, but Kocherlakota is probably right that after some time passes, an artificially low federal funds rate will lead to a steady deflation.

Imagine that you're an investor who can hold either deposits at the central bank or units of some durable good. In order for these two assets to be willingly held by both you and your fellow investors, each must provide attractive returns. If one of these assets provides excess returns, arbitrage dictates that you'll all try to switch to that asset until those excess returns cease to exist.

A bank deposit's return can be decomposed into an interest component, expected capital appreciation (or depreciation), and a liquidity yield. Liquidity is a special benefit that a deposit provides since it more marketable than most assets. The durable good, assume it costs nothing to store, provides a return in the form of capital appreciation (or depreciation), but no interest and a liquidity yield that is so minimal that it may as well be nothing.

At the outset, the returns on the two assets are already equal. But the central bank suddenly lowers the interest component of the return it pays on deposits to nothing, catching the investment community by surprise. As an investor you're distraught. The deposit you held just prior to the announcement yielded, say, 5%, and now it yields just 0%. You'd like to sell it for the durable good, since the return on the durable good (which is composed, say, of expectations of 10% price appreciation) is superior. But investors holding the durable good won't sell to you, simply because the return they require on the 0% deposit must be similar to the return on the durable good they already own. And it isn't.

To convince them to accept your 0% deposit for their good, you must increase its return. You can do this by increasing the expected capital appreciation provided by the deposit. By marking down the current price of the deposit relative to its expected future price, you provide your trading partner with the necessary potential capital appreciation. Whoever buys the deposit can be sure that even though it yields an interest rate of 0%, it will provide a commensurate capital return of 5% or so.

In knocking down the market price of the deposit, you've caused immediate inflation. The purchasing power of money (the deposit) has fallen such that you can't buy as many durable goods with it as you could before. At the same time, you've cleared the stage for future expectations of deflation. That's because in low-balling the offer price for your deposit to attract buyers, you've increased the expected capital appreciation provided by the deposit. You've caused inflation in order to promise deflation.

Maybe the entire process happens immediately. But economists like to divide things into the short and long run. In the short run, all you'll see is inflation as the market gropes for a new and lower clearing price for deposits. At first, perhaps, most investors think that the central bank will only keep rates at 0% for a year and then set them back at their normal rate. But when the next year comes and the bank surprises the market by keeping those rates at zero, once again you'll have to rapidly lower the price of your deposit so as to provide potential deposit buyers with enough capital appreciation to compensate for the disappointing yield on deposits.

This yearly pattern of lowering the price you offer on your deposits continues until the market is no longer surprised by the central bank's intentions to keep rates at 0% for eternity. Only then will the inflation end. Deposits, which by now have been bid down to some terminally low level, will slowly and steadily appreciate. This is the "consistent deflation" that Kocherlakota describes.

There is one interesting caveat here. I started out the example by pointing out that one component of a deposit's return is its liquidity yield. Because the market puts a premium on liquid assets —a liquidity premium, so to say —deposits and other liquid assets can provide lower interest rates than not-so-liquid assets.

But if deposits (or any other money-like object) are constantly plunging in value, they cease to be attractive as medium of exchange. In general, people prefer to transact with relatively stable monies. Thus each time you mark down the deposit's value, its liquidity premium deteriorates as the market searches out for other assets that can serve as better mediums of exchange. With the decline in its liquidity yield, the overall return from holding deposits declines even further. This inferior return can only be compensated by a promise of more capital appreciation ie. yet another fall in today's market price relative to expected future prices. This process feeds on itself as the falling value of a liquid assets renders it less liquid which causes it to fall further in price. At some point, the deposit risks being demonetized.

What comes first? Will the deposits reach a terminally low price from which they commense their rise? Or will they become demonetised and valueless? What about the assets that back deposits... might these provide some lower limit for the price of a deposit, even if it pays 0% loses its entire liquidity premium? Fun questions, but I'll leave those for someone else.


Related blog posts:
Karl Smith here and here, and Andy Harless here.