Monday, July 28, 2014
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The 4% Non-Solution

PARIS – For some time now, there has been concern that central bankers have “run out of bullets.” Having lowered their policy rates to near zero, they have engaged in increasingly extravagant measures such as “quantitative easing” and “forward guidance.” Given the fog cast over real economic activity by the financial crisis, it is difficult to offer a definitive assessment of just how well or badly those measures have worked. But it is clear that there must be a better way to do things.

There is no longer any reason to let the zero bound on nominal interest rates continue to hamper monetary policy. A simple and elegant solution is to phase in a switchover to a fully electronic currency, where paying interest, positive or negative, requires only the push of a button. And with paper money – particularly large-denomination notes – arguably doing more harm than good, currency modernization is long overdue. Using an electronic currency, central banks could continue to stabilize inflation exactly as they do now. (Citigroup’s chief economist, Willem Buiter, has suggested numerous ways to address the constraint of paper currency, but eliminating it is the easiest.)

A second, less elegant idea is to have central banks simply raise their target inflation rates from today’s norm of 2% to a higher but still moderate level of 4%. The idea of permanently raising inflation targets to 4% was first proposed in an interesting and insightful paper led by IMF chief economist Olivier Blanchard, and has been endorsed by a number of other academics, including, most recently, Paul Krugman. Unfortunately, the problem of making a smooth and convincing transition to the new target is perhaps insurmountable.

When Blanchard first proposed his idea, I was intrigued but skeptical. Mind you, two years previously, at the outset of the financial crisis, I suggested raising inflation to 4% or more for a period of a few years to deflate the debt overhang and accelerate wage adjustment. But there is a world of difference between temporarily raising inflation to address a crisis and unhinging long-term expectations.

After two decades of telling the public that 2% inflation is Nirvana, central bankers would baffle people were they to announce that they had changed their minds – and not in some minor way, but completely. Just recall the market’s “taper tantrums” in May 2013, when then-Fed Chairman Ben Bernanke suggested a far more modest turn in monetary policy. People might well ask why, if central bankers can change their long-term target from 2% to 4%, they could not later decide that it should be 5% or 6%?

Given the likelihood of a confused, mistrustful public, it is hard to find any deep rationale for a 4% target. At least the existing 2% inflation target stands for something, because central bankers can portray it as the moral equivalent of zero. (Most experts believe that a true welfare-based price index would show significantly lower inflation than government inflation statistics indicate, because official data fail to capture the benefits of the constant flow of new goods into the economy.)

There is an analogy to the problems countries faced when they tried to re-establish the gold standard after World War I. Until the war, money was backed by gold and could be redeemed at a fixed rate. Though the system was highly vulnerable to bank runs and there was little scope for a monetary stabilization policy, people’s confidence in the system enabled it to anchor expectations.

Unfortunately, the system completely collapsed after the war broke out in August 1914. Revenue-desperate combatants were forced to turn to inflation finance. They could not simultaneously debase the currency and back it with gold at a fixed rate.

After the war, as things settled down, governments tried to return to gold, partly as a symbol of a return to normalcy. But the revived inter-war gold standard ultimately fell apart, in no small part because it was impossible to rebuild public trust. A move by central banks to a long-term 4% inflation target risks triggering the same dynamic.

Fortunately, there is a much better way. Moving to an electronic government currency would not require a destabilizing change in the inflation target. Minor technical issues could easily be ironed out. For example, ordinary citizens could be allowed zero-interest-transactions balances (up to a limit). Presumably, nominal interest rates would move into negative territory only in response to a deep deflationary crisis.

But when such a crisis does occur, central banks could power out of it far more quickly than is possible today. And, as I have argued elsewhere, governments have long been penny-wise and pound-foolish to provide large-denomination notes, given that a large share are used in the underground economy and to finance illegal activities. Moving to a twenty-first-century currency system would make it far simpler to move to a twenty-first-century central-banking regime as well.

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  1. CommentedG. A. Pakela

    How is it that economists confidently call for the Fed to raise and lower the inflation rate? The Fed is not capable of fine-tuning any particular inflation rate, and history bears this out. It took nearly two decades after the 1982-83 recession for inflation to fall into the 2% range. And those two decades featured real and nominal interest rates that were hundreds and even thousands of basis points higher than they are today. Back in the 1970s when the inflationary psychology was at its peak, firms could raise their prices and wages on an annual basis and in line with inflation with near impunity. In today's world, employees have little bargaining power and they are as likely to lose their job as to getting an inflationary wage increase. And so at even today's commodity driven, food and fuel driven inflation, it is the poor and lower income workers that suffer.

  2. CommentedAndrew Purdy

    A completely electronic currency opens the doorway to totalitarianism. It truly is the "mark of the beast currency" - especially if it is global. Not only does it allow interest rates to be negative in nominal terms, but it also allows the Government to make your points expire if you don't spend them, and allows money to be given a "color". By a "color" I mean money that can only be spent on particular items, like food stamps. The Government would give money a color so inflation in necessity items could be controlled (i.e. necessity items rationed). If you earn $2000 in salary in a pay period, they could allocate $400 to food, $600 to rent, and $200 to gasoline, and the remainder to everything else. Only the Central Bank could change the color of money, so each color could have a different negative interest rate and a different expiration date. Vendors who sell the items and get the cash would have to pay the banksters hefty fees to change the color of the money through the central bank. This would allow the banksters to become mega ultra richer than they are now, and everyone else would pay for it. Any politician in any Democratic society who proposes such as scheme must be voted out. We must have zero tolerance for totalitarianism, or the schemes which enable the same.

  3. CommentedEmanuil Valkov

    Electronic currency has been in large scale distribution since 1980's. its collateral-paper USD. detaching it from the physical limitations of printing can only prove all the critics correct.
    Inflation hurts evaluation. Adequate evaluation between creation and distribution must be in tact if social peace is to remain. Human physiology has clear limitation in terms of productivity. Double up current inflation targets, means double down value for the same activity, which in terms mean double up activity for the same value.
    This enslaves large groups of the population in race against time, otherwise there will be no tomorrow. This is an ultimatum propelled with fear which won't last "with a push of a button".
    Electronic currency can, and sure will, open the gate way to self-destruction by endless spazmatic eruptions of inflation.
    People at large, must be reminded of the exchange power of their labour before being tempted (not forced) into hyperactivity (again). skipping deflation re-distribution is childishly naive concept for anyone with brief understanding in crowd behaviour of economically entangled social groups.

  4. CommentedTomas Kurian

    Further benefits of fully electronic currency would be:

    - possibility to subvence productivity instead of outsurcing

    17. Ways of productivity subvencing instead of outsourcing

    and ability to share the work between people as productivity is constantly rising.

    18. Method of passing productivity gains towards free time

  5. CommentedTomas Kurian

    Genom of Capitalism is advocating fully electronic currency and negative interest rates since January 2013.

    16. Periodic taxation of accumulated capital

    16.5 Evolution of monetary systems

  6. CommentedDouglas Carr

    For the 12 months ending July 2008, inflation (PCE) averaged 4.2%.
    that didn't turn out too well did it?

  7. CommentedMartin Evans

    Apart from the appalling Big Brother aspect of this it will produce a set of consequences which would be far more damaging than the central banks and economists admitting they don't know what the heck they're doing.

    At a minimum it would drive people into bubbles in other assets such as art, gold and stamps both to attempt to protect their assets from further confiscations and to protect the few fragments of control they still have over their lives. And these would be BIG bubbles due to the constant feedback loop of avoiding putting anything in banks.

    The same would happen in the underground economy which is not nearly so conveniently controlled as Professor Rogoff imagines.

    There is absolutely no reason to believe any consequence would be a growth in the real economy (except perhaps the security companies and safe makers).

    And for anyone who says they have no secrets from the state I would ask 'Which state ?' The one you feel is so benign but who now may want to control all your money or the malevolent one that might lurk in the future of anyone so willing to give up their rights.

    Far from a solution to avoid 'a confused, mistrustful public' (a patronising description of a convenient scapegoat) it would seem a desperate attempt to push forward the day of reckoning when, perhaps, the architects of our current dilemma have long gone to pasture.

  8. CommentedClaude Simon

    The best path that central banking should consider is zero real interests.
    Is inclusive capitalism the mode or not ?

  9. CommentedPaul Daley

    This sounds very much like arguments over the infallibility of the Pope; we dare not admit an error in Papal judgment for fear that the masses may totally lose faith in the guidance of the Church.

    An electronic currency may make sense and may facilitate the introduction of negative interests but there must be a better argument for it than this.

  10. CommentedProcyon Mukherjee

    Ample liquidity is an oxymoron, as we have been riding on it for several years now and inflation is still at the dumps at the Euro-zone.

    The ECB action, namely, Interest on excess reserves turning negative, allows the central bank to make adjustments on the liability side of the balance sheet, it would have some additional balance sheet effects to (may be) purchase assets now. The question is which assets to target and what impact would it have.
    Below zero, as the rate suggests, is perhaps the last arsenal for the ECB, but as the inter-bank lending has plateaued in recent times, it is not a trigger that would immediately change things.

    Money in circulation, in goods and services, not in the banks- but how to achieve this remains the question.

  11. Portrait of Michael Heller

    CommentedMichael Heller

    Sounds a great idea to me. If you have nothing to hide from the state why be afraid of electronic money? I do love the simplicity. I also love big bold ideas. I have concerns about one sentence though --

    "But when such a crisis does occur, central banks could power out of it far more quickly than is possible today."

    Since I don't like the thought of depending on central banks to take the front line in solving economic crises, I'm starting to feel less sure about whether it is even worth discussing this idea now. At the moment ECB is bailing out Europe with cheap money. It has become clear that the top priority structural reforms have not been fully or adequately undertaken. The structural reforms (streamlining the bureaucracy, taking off the state overload, economic liberalisation, privatisation, etc.) were implicitly the PRE-CONDITION for monetary easing.

    In conclusion, in the 'big ideas' box I'd like to reinstate the 'top priority'. I know that a big ideas guy like Joseph (Schumpeter, not Stalin or Stiglitz) would have agreed with me that today is not yet the moment for cheap money electronics, not when the capitalist ideal is being cheapened by the day.