Thursday, May 7, 2009

It certainly fails my "Grandmother" test.

From Worthwhile Canadian Initiative:

A modest proposal for paying negative interest on currency (or something)

Willem Buiter considers various ways to make interest rates negative. The problem is how to pay negative interest rates on currency. His most interesting proposal is to separate the unit of account from the currency. The dollar would remain the unit of account (at least, he hopes it will). But he would replace dollar notes and coins with a new currency, the "rallod", which would depreciate against the dollar. If it depreciated at (say) 5% per year, it would allow nominal interest rates on dollars to go down as low as minus 5%, which should be sufficient to get us out of the recession.

It seems a very complicated proposal, when you read it. It certainly fails my "Grandmother" test. (Grandma could never understand Britain's new decimal currency, and the switch from shillings and old pennies to new pennies, so refused to deal in anything smaller than the pound, which stayed the same.)

So I decided it needed to be simplified.

My first idea, rather than changing the currency, was to change the other units of measurement. After all, we buy apples in kilograms, milk in litres, labour by the hour, etc., so why not just redefine the kilogram, litre, and hour so that they got 5% smaller per year? So even if the price of apples in dollars per kilogram stayed the same, at the end of the year we would get 5% fewer apples per unit of currency. Exactly the same as if the "rallod", were worth 5% less in terms of dollars.

But after careful consideration, and long consultations with colleagues in other departments, I decided that my idea would not make for good relations between economists and other scientists, who seem rather attached to their existing units of measurement. The engineers in particular seemed to suffer from "unit illusion", and couldn't adjust to a world of inflation. So I abandoned my first idea, and returned to thinking about Willem's proposal.

How to simplify Willem's proposal for the "rallod"?

Well, the name "rallod" has to go for starters. It's ugly, and sounds far too radical. The common convention for currency reforms is to introduce a new currency, and call it the "New...." whatever the old currency was. The "New Franc" replaced the old Franc in France. So let's just call it the "New Dollar". And to be doubly sure there is no misunderstanding, we can refer to the old dollar as the "Old Dollar".

And it would be a major hassle and expense to call in all the old dollar coins and bills and print up new dollars to replace them. It would be much simpler for the government and central bank to just make a declaration: "Henceforth, all existing dollar notes and coins are now declared to be New Dollar notes and coins!". One problem solved!

Now, since the New Dollar will be depreciating at 5% per year against the old dollar, and all existing contracts are denominated in old dollars, we will have to remind people that the number of New Dollar notes they will need to pay to fulfill any existing contract (if they choose to pay with currency) will need to be increasing at the rate of 5% per year. That would apply to all debt contracts, wage contracts, price contracts, etc. And the courts would of course enforce that interpretation of the contracts. And there is nothing unjust about doing this, of course, because the New Dollars won't be worth as much as the old dollars.

Alternatively, and perhaps it would be simpler, we could just rewrite all the old contracts, add a 5% per year premium to any price, wage, or rate of interest, so that payment could be specified in New Dollars, if that's what people wanted to pay in.

Actually, now that I come to think of it, do we really need the ugly neologism "New Dollar"? Since we wanted to avoid the cost and hassle of printing new notes and coins, the notes and coins still say "dollar" rather than the "New Dollar". So, to avoid confusion, let's keep the word "Dollar" for the New Dollar. And use the words "Old Dollar" (or "Classic Dollar"?) for any contract written before the New Dollar...I mean the Dollar...was introduced.

Actually, now I think of it some more, isn't there only one thing we need to do? Just pass a law saying that all contracts written in dollars before a certain date must have an additional 5% per year premium written into them?

So a 4% mortgage would now become a 9% mortgage, by law. A contract specifying a 3% wage increase per year would now specify 8%, by law. And so on. And just to anchor inflation expectations to the new currency regime, to help people adjust, the central bank should announce that the inflation target will be raised from 2% to 7%, and that whatever inflation rate people had previously expected, in old dollars, should now be revised upwards by 5%.

So, to recap: raise all existing nominal interest rates by 5% per year; raise all existing wage and price contracts by 5% per year; raise the inflation target by 5% per year; and tell people to expect inflation to be higher by 5% per year. New interest rates and new wage and price contracts can be set wherever they need be, of course. That's my simplified version of Willem's proposal.

Why wouldn't my version work? Only the names are different.


I don't see the problem:

"These include the periodic stamping (for a small fee) of banknotes (without the stamp they would not be valid). The idea is that by imposing a running tax on banknote hoarding, nominal risk-free rates could fall to negative levels.

In the age of the information technology revolution, surely the authorities could devise a simple and practical method of effective taxation of banknote hoards?

There are two cues to a practical method of taxing notes. The first comes from what happened during US financial crises in the 19th century.

Banks under stress of cash drains (depositors withdrawing funds) suspended temporarily the 1:1 link between cash and deposits, so their notes sold at varying discounts. The second comes from the launch of the euro; a conversion of old banknotes into new.

These cues lead to the solution.

The relevant government would announce that existing banknotes were to be converted into new notes at a fixed date, say three years from now, at a discount (for example 100 old dollar banknotes would be converted into 90 new).

In the interim, 1:1 conversion of banknotes into deposits would be suspended. Instead, a crawling peg would be established. At the start, the exchange rate between deposits and banknotes would be virtually 1:1. At the end it would be 0.9 banknotes/deposit.

As the discount grew, retailers would quote different prices for cash or cheque/card settlement. And as to the note switch-over costs, the “experiment” of Europe’s economic and monetary union demonstrates the feasibility.

The looming conversion would provide an essential degree of freedom for monetary policy. In terms of our illustrative arithmetic, the risk-free interest rate could fall to a negative 3.33 per cent a year without triggering cash withdrawals from the banking system.

Is the exercise worth it?

The main reason for believing it is stems from an appreciation of how the bursting of a global credit bubble influences the equilibrium level of risk-free interest rates relative to risky rates of return and in absolute terms.

Most of us would agree that the bursting process ushers in a period during which soberly-measured risk premiums increase sharply.

This means that the risk-free rate must plunge to be consistent with an average overall cost of capital which reflects the new glut of savings.

So, in terms of our illustrative arithmetic, it is plausible that the neutral risk-free nominal rate of interest in the US and Europe, especially taking account of a likely near-term drop of the price level, is significantly negative.

The central bank and government, by devising a system in which such negativity can express itself, can give a big fillip to the recovery process."

If it's one thing the govt can do, it's tax.

Posted by: Don the libertarian Democrat

Hi Don!

There is nothing you can do by taxing money or introducing a new currency that could not be done by changing the expected rate of inflation.

Fiat/fiduciary/paper money is just a symbol, like language. (Structuralism?). Under interest rate control, there is nothing to anchor the meaning of words/money (the price level), except Lewis-conventions (inertia of actual and expected inflation). If we go to bed in one equilibrium and while we slept a magic wand doubles all the prices, and expected prices, we would wake up next morning in the same (real) equilibrium. Just the same as if a magic wand changed the word "cat" to "dog" and vice versa, in our minds and books.

When we are in a Lewis/Schelling conventional/coordinated equilibrium, we stay there, even though there are multiple equilibria. But a symbolically important "declaration", even if it is mere "cheap talk" (not backed by real actions that alter the payoff matrix) can change the focal point and switch us to a different (nominal) equilibrium ("nominal" = where all the prices/inflation rates/meanings of words are different).

The Brits drive on the left. No individual driver has an incentive to deviate from the left equilibrium unless he expects all others to deviate. The government could switch the equilibrium to driving on the right by declaring that Britain is now part of Canada (change the currency). Or it could do it by declaring that Brits will now all drive on the right (announce a new rate of inflation). Either would work, if and only if it is believed to work.

Do dictionaries determine the proper meanings of words, or do the meanings of words determine the proper dictionary?

Don, continued: That's why I was playing with the meanings of words dollar, new dollar, old dollar, etc.

On way to change the equilibrium that is not merely a declaration (cheap talk) is for the government to do something real (get the army trucks to start driving on the right). By pegging the time path of the price of some real good, by buying and selling gold, or whatever, and abandoning interest rate control (which just swaps money for future money) we are no longer in a Schelling/Lewis coordinated game. There is only one equilibrium.

Inflation is a tax on currency. And we don't have to go to any hassle of collecting it. Just print more money. Inflation means a negative (real) interest rate on currency.

I should probably do a sensible version of this slightly silly post sometime, making all this stuff explicit, rather than implicit.


I think that I agree with you, which is why I said the following on Buiter's blog:

"I'm less concerned on the method used, than on the use of the concept"

However, being a dunce, I'm attracted to views that I ( mis ) understand. QE and Stamping are just clear positions to me, and work towards the desired goal by clear incentives and/or disincentives. Stamping is a disincentive to buy short term bonds, as I envision it. QE is a solution to Debt-Deflation. I suppose they come to the same thing, or, as you seem to say, could come to the same thing. I avoid theory at all costs nowadays.

Posted by: Don the libertarian Democrat

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