Is It Time To Eliminate Paper Currency?

The answer is yes according to Ken Rogoff:

Has the time come to consider phasing out anonymous paper currency, starting with large denomination notes? Getting rid of physical currency, and replacing it with electronic money, would kill two birds with one stone.

First, it would eliminate the zero bound on policy interest rates that has handcuffed central banks since the financial crisis. At present, if central banks try setting rates too far below zero, people will start bailing out into cash. Second, phasing out currency would address the concern that a significant fraction, particularly of large denomination notes, appears to be used to facilitate tax evasion and illegal activity.

Not so fast. One can solve the zero lower bound (ZLB) problem without eliminating paper currency. All that is needed is to either (1) allow the exchange rate between deposits and paper currency to fluctuate or (2) have a systematic approach to monetary policy that is very aggressive when the treat of the ZLB is looming. The former would create a discount on paper notes during slumps so that the Fed could impose a negative nominal interest rate on deposits and get away with it. The latter would use a nominal GDP level target which would both raise money velocity via expectation management and commit the Fed to do whatever is necessary to hit the level target. Both approaches should take care of the ZLB problem. Miles Kimball has written extensively about the first approach and Scott Sumner done the same for second one. Read here for the details of these plans.

How to Get What Paul Krugman Really Wants

Paul Krugman called for a higher inflation rate at a ECB conference this week. His plea for more inflation is understandable given the failure of the ECB's 2% inflation target to shore up the faltering Eurozone economy. He believes raising the inflation target to 4% will do the trick. But is higher inflation really what he is after?

The answer is no. What he really wants is a foolproof way to ensure there is enough aggregate demand to keep the economy at its full-employment level. He sees a higher inflation target as the way to accomplish this objective. There is another way, though, to achieve his goal without raising the inflation target. To see how it works, let us turn to Israel who was able to keep the growth path of aggregate demand stable during the crisis without changing its inflation target.The figure below shows how the Bank of Israel accomplished this task. It reveals that the central bank temporarily allowed inflation to rise above target when real GDP started falling during the crisis:

By doing this, the Bank of Israel kept total Shekel spending stable as seen in the next figure:

So the Bank of Israel used temporarily higher inflation to offset the decline in real GDP as a way to keep aggregate demand stable. This arguably prevented the Israeli economy from going through the prolonged slumps experienced by the U.S. and Eurozone where this approach was not tried. This nominal stability is what Paul Krugman really wants and it does not require a permanent rise in the inflation rate. It only requires a willingness by the central bank to allow temporary movements in the inflation rate to offset changes in real GDP.

Now the skeptic may question whether the central bank has the ability to do this on a consistent basis. Can a central bank really move the inflation rate in such a timely manner? Maybe the Bank of Israel got lucky. That is a fair point. Fortunately, there is a relatively easy way for a central bank to accomplish this task: target the path of nominal GDP. By doing this the central bank will by default allow temporarily higher inflation when real economic growth slows down and vice versa. This approach will not require the central bank to micromanage the inflation rate--it will automatically adjust. Moreover, by stabilizing total money spending it will also by default be promoting a stable monetary environment where shocks to money demand (or velocity) are offset by changes in money supply and vice versa. This can be seen in the figure below which shows the deviation from trend of velocity and the money supply for Israel:

In short, Paul Krugman can get what he wants without raising the average rate of inflation. Central banks simply have to commit to stabilizing the path of total money spending or nominal GDP. And that is what the Bank of Israels appears to effectively have done over the crisis. The Fed and ECB should take note.

P.S. Evan Soltas was the first person to recognize the Bank of Israel appears to be doing defacto NGDP level targeting

NGDP Targeting as a Fashion Statement

It is hard to believe, but it has been almost four years since William Luther turned nominal GDP targeting into a fashion statement. Below is my attempt to further his effort. I plan to wear this shirt around my neck of the woods. I will report back how my Tennessee and Kentucky neighbors respond to it. The back of the shirt is my trump card if they start calling me a socialist.

P.S. Yes, you too can order the shirt here.

Risk Sharing as a Way to Improve Financial Stability

There have been many proposals to improve financial stability going forward. Some of them are bound to disappoint, while others have great potential. A great example of the former are proposals for macroprudential regulation. These proposals would have central bankers regulate financial firms based on systemic risks rather than firm-specific risks. The idea is to dampen the inherit procyclicality of the financial system and make it more resilient to shocks. This includes adjusting capital requirements, allowable leverage, and other risk-preventing measures based on the state of the business cycle. A big problem with this approach is that it assumes regulators are omniscient in their knowledge and can outsmart markets. It also assume financial regulators will be uncorrupted and benevolent dictators in the adminstration of the duties. If you believe both of these assumption will hold then you have not been paying attention to financial markets over the past decade.

A better way to foster financial stability is to create mechanisms that do not depend on regulators getting it right. Two recent proposals that do that are ones based around automatic risk sharing for debt contracts. The idea is to automatically make lenders share in both the risk and return that individuals and firms face when they borrow. This is akin to making debt contracts more equity-like in nature.

The first risk-sharing proposal comes from Amir Sufi and Atif Mian in their new book. In it, they call for a risk sharing mortgage. Here is the Wall Street Journal's discussion of their proposal:

With such instruments, if a home’s value rose, the lender would share in the gain; if it fell, so would the principal balance as well as the interest payment. That way, both parties to the contract—and not just the homeowner—would have potential upside as well as downside... Adopting shared-risk mortgages would mean shifting the focus of both government and the financial system to equity from debt. Right now, Mr. Sufi said, the government tacitly backs debt through the mortgage-interest deduction, federal deposit insurance and support of highly rated assets. But if those implicit subsidies were removed or eased—admittedly a tall order—shared-risk mortgages might appeal more to potential lenders. The United Kingdom has been offering a form of such equity loans. Under the U.K.’s “Help to Buy” program, home buyers can put down 5%, receive an equity loan for 20% of the property’s value, and take out a traditional mortgage for the rest.

Lenders probably would not be thrilled about it, but it nicely align incentives up front. That is, lenders would be more careful to whom they lent and this would minimize the chances of downward equity adjustments occurring in the first place. Given how important mortgage financing is to the U.S. economy, this proposal by itself should make a big difference.

The second recent risk-sharing proposal was made by Kevin Sheedy at the Brookings Papers on Economic Activity conference. There, he presented a paper where he makes the argument for risk-sharing via a nominal income target:

Financial markets are incomplete, thus for many households borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating households' nominal incomes from aggregate real shocks, this policy effectively completes financial markets by stabilizing the ratio of debt to income. The paper argues the objective of replicating complete financial markets should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.

As a long-time advocate of nominal GDP targeting, this risk sharing proposal is near-and-dear to my heart. As Sheedy notes, it is not a new argument for a NGDP target (see Selgin, 1997), but it is an often overlooked one.

It would be great to see these proposals adopted before the next crisis hits. Unfortunately, it is more likely less effective approaches to financial stability like macroprudential regulation will be widely implemented.

What Caused the Great Recession: Household Deleveraging or the Zero Lower Bound?

Today I got into a discussion with Amir Sufi on Twitter about what really caused the Great Recession. Was it the vast amount of household deleveraging or the economy being constrained by Zero Lower Bound (ZLB)? Amir Sufi and his coauthor Atif Mian have a new book where they make the argument the key catalyst was household deleveraging.

For example, in a new article they argue the 2001 recession was far milder than the 2007-2009 recession because the related the stock market crash affected mostly rich individuals who had very little debt. On the other hand, during the Great Recession it was a housing market that collapsed and this affected middle and lower-class individuals who were highly indebted. This key difference in debt, they argue, is why the economy contracted so much more in 2007-2009. 

While it is true there was far more U.S. household debt leading up to the Great Recession and that cross country evidence shows that countries with more debt were generally hit harder during the crisis, I think they are confusing a symptom with the cause. In my view, the underlying cause was interest-rate targeting central banks running up against the ZLB. (Yes, there are ways around it for a determined central bank but most did not fully explore these options.) The failure by central banks to get around the ZLB caused most of the household deleveraging, not the other way around. Monetary policy, in other words, was too tight during the crisis.

I have embedded an annotated version of our twitter discussion below the fold:

The Seesaw Approach to Monetary Policy

In my last post, I made the following comment:

A NGDP target aims to stabilize total dollar spending. It is one target that has embedded in it both the supply of and the demand for money (i.e. total dollar spending = money supply x velocity of money). The beauty of a NGDP target is that the Fed does not need to know what is exactly happening to the money supply or money demand. All the Fed only needs to worry about is the product of the two components. There is no need to track the money supply or estimate money demand. By focusing on total dollar spending, the Fed will be fostering a stable monetary environment where movements in money supply and money demand are offsetting each other.

Another way of saying this is that by targeting the growth path of NGDP, the Fed will be taking a seesaw approach to monetary stability. That is, endogenous changes in the money supply will be automatically offset by changes in money velocity and vice versa. This is illustrated below:

 

Now to be clear, most money is inside money--money endogenously created by banks and other financial firms--and the Fed only indirectly influences its creation. However, it does so in an important way by shaping the macroeconomic environment in which money gets created. Consequently, it can have a large influence on inside money creation. For the same reason it can also influence how stable is the velocity of money. By successfully stabilizing the expected growth path of total dollar spending, the Fed will be causing this seesaw process to work properly.

Here is the interesting thing. Even though the Fed was not officially targeting NGDP, it effectively seem to be practicing the seesaw approach to monetary policy over much of the Great Moderation period. This can be seen in the figure below which shows the growth rate of Divisia M4- money supply and the growth rate of its velocity. Note how these two series tend to offset each other as implied by the seesaw approach:

Source

Now note the area in the the grey bar. During this time the figure shows there was no offsetting movements. The money supply and velocity both fell--the seesaw process was broken. It was during this time that the Fed failed to stabilize total dollar spending and this allowed the emergence of the Great Recession.

One way, then, to view the Fed's job is that it should aim to keep the monetary seesaw process working properly. For a long time it did that, but failed spectacularly in 2008-2009. It would be whole lot easier going forward if the Fed explicitly adopted a NGDP level target.

P.S. The seesaw process is another way of looking at Milton Friedman's Thermostat Approach to monetary policy, as noted by Nick Rowe.