Martin Sandbu wittily suggests that advocates of competing contingency plans for central banks resemble Pythonesque political factions. He thinks a compromise could be a marriage made in heaven. But as a paid up member of the Popular Liberation Front of Judea (money-financed cash transfers), I feel obliged to object: not all ‘radical’ ideas are equal. In the interests of brevity (and factionalism), I will not dwell on the substantial areas where I agree with Martin, but rather on where we may diverge:

1. There are good arguments for ‘abolishing’ cash. For example, if you think cash aids illegal economic activity. If a case can be made that human trafficking could be reduced by abolishing cash, I would advocate it.

2. Martin is also right to stress that network effects can result in inefficient equilibria and sometimes ‘forcing’ change is in the collective interest – in the same way that software firms can force upgrades on their networks of users, which cause transitional costs. That said, in the case of cash, the competing electronic network exists – anyone who wants out already has the option – as John Kay demonstrates.

3. ‘Aiding’ monetary policy is not a good reason for abolishing cash. Monetary policy is highly effective without negative rates, and rates can be significantly negative in real terms without abolishing cash.

4. I don’t buy Martin’s gun analogy. It is clever to think of the demand for guns as a network effect. But as I originally noted, although some things we choose to use voluntarily are not good for us, cash does not obviously fall into this category.

5. Regarding negative interest rates, the effect of a change in interest rates on the economy is not independent of the level. Reducing real interest rates from 4% to 0% might well be a stimulus to US demand. But reducing nominal interest rates to -1% from +0.25% may not be a stimulus, and may in fact raise desired savings rates. I see no empirical or theoretical reason to confidently expect that reducing the Fed funds rate to -1% would boost US demand. It might, it might not. David Einhorn’s doughnut theory cannot be so easily dismissed.

6. By contrast, a ‘tax rebate’ (cash transfer) to households equivalent to 2-3% of GDP financed by the central bank creating bank reserves, would be a significant stimulus to demand in most of the developed world. Theory and evidence overwhelmingly confirm this: it is an increase in household net wealth and all the empirical evidence suggests ‘tax rebates’ increase demand.

In conclusion, if we want to compete away cash through technology – great. If we want to reduce note denominations or even force electronic payments on the cash-based parts of the economy to reduce crime – great. But doing so in order to have negative nominal interest rates seems like a lot of effort – and risk – in aid of a highly uncertain benefit.

An aside for nerds: Martin suggests that by logical extension of these arguments raising rates might be a stimulus. Again, I would say that this is more plausible than we usually think, and likely depends on the level of interest rates and the impact of rates on the demand and supply of credit, which is neither linear nor straightforward. For example, let’s say the Fed raises required reserves of the banks to 10% of assets. Furthermore, assume that the Fed leaves the fed funds rate unchanged, and continues to pay funds rate on excess reserves. The Fed then decides to raise the interest rate on required reserves to 5%. Would this be a stimulus to the US economy? The interest rate on excess reserves should determine market interest rates, and is unchanged. The rate on required reserves is in effect a transfer payment to banks – it boosts their income. So if borrowing rates are unchanged and bank profits rise (and by extension, bank share prices), this is an economic stimulus. This highlights the importance of income effects, and also how negative interest rates could have the reverse effect – as Martin demonstrates in his example where deposits (and net wealth) decline as a result of negative interest rates.

About The Author

Eric Lonergan is a macro fund manager, economist, and writer. His most recent book is Money (2nd ed) published by Routledge. He is also a supporter of Big Issue Invest (BII), the investment arm of The Big Issue, and is one of the initial limited partners in BII’s Social Enterprise Investment Fund LP. In a personal capacity, he makes direct investments in social enterprises. He also supports and advises The Empathy Museum.

3 Responses

  1. chris

    On point 5, I’ve long thought Caplin & Leahy’s paper deserves more attention than it’s got:
    They suggest that a modest cut in rates might backfire because the signaling effect (“hey, the economy’s even weaker than the central bank thought so we should hold off that capex project”) can outweigh the orthodox stimulative effect.
    Maybe near the ZLB, their point holds because the inability to cut rates a lot means central banks can’t give sufficient stimulus to offset the signal.
    What is wrong with this idea?

  2. Eric Lonergan

    Thanks Chris. I’m not familiar with this paper – will have a read. I take the that cutting rates is a stimulus when the starting point is “tight” monetary policy – i.e. demand for credit is being held back by the level of rates. When this is not the case, the efficacy of further “easing” is questionable. One version of what you are describing possibly holds in the US currently. If you listen to the management of, for example, Wells Fargo, it sounds like they are limiting the supply of credit until margins improve – so ironically, credit conditions will ease when/if the Fed raises rates.


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