Is this the Right Time for the Fed to go Negative?, by Willem Buiter,

Ben Bernanke, chairman of the Federal Reserve Bank, has a lot more tools for supporting U.S. economic activity through expansionary monetary policy than he discussed in his Jackson Hole speech, which alluded only to more quantitative easing and credit easing—increasing the size and changing the liquidity composition of the Fed’s balance sheet.

Perhaps out of fear of resurrecting the moniker “Helicopter Ben,” Mr. Bernanke did not refer to the combined fiscal-monetary stimulus that (almost) always works: a fiat money-financed increase in public spending or tax cut. Treasury Secretary Tim Geithner can always send a sufficiently large check to each U.S. resident to ensure that household spending rises. By borrowing the funds from the Fed, there is no addition to the interest-bearing, redeemable debt of the state. As long as households are confident that these transfers will not be reversed later, “helicopter money drops” will, if pushed far enough, always boost consumption.

However, stronger consumer expenditure, while appropriate from a cyclical perspective—any additional demand is welcome—is not what the U.S. needs for long-term sustainability and structural adjustment: to raise the national saving rate, boost fixed investment in plant, equipment and infrastructure, achieve a trade surplus and shift resources from the non-tradable to the tradable sectors.

By way of illustration, an eight percentage point reduction in public and private consumption as a share of GDP could be compensated for by an increase in the trade surplus of five per cent of GDP and in non-housing U.S. fixed capital formation of three per cent of GDP. To achieve this, a much weaker real exchange rate and lower real interest rates are necessary. To pursue these objectives speedily a Federal Funds target rate of around minus three or minus four per cent may well be required right now, in our view. This brings monetary policy up against the zero lower bound (zlb) on nominal interest rates.

The zlb results from the existence of currency (dollar bills and coins) with a zero nominal interest rate. Even allowing for “carry costs” of currency (storage, safekeeping, insurance etc.), this makes it impossible for competing assets like government bills, to offer interest rates much below zero. Stimulating demand in the U.S. economy, while rebalancing the composition of demand and production in the desired directions, requires a much lower Federal Funds target rate than is feasible with the zlb in place.

To restore monetary policy effectiveness in a low interest rate environment when confronted with deflationary or contractionary shocks, it is necessary to get rid of the zlb completely. This can be done in three ways: abolishing currency, taxing currency and ending the fixed exchange rate between currency and bank reserves with the Fed. All three are unorthodox. The third is unorthodox and innovative. All three are conceptually simple. The first and third are administratively easy to implement.

The first method does away with currency completely. This has the additional benefit of inconveniencing the main users of currency—operators in the grey, black and outright criminal economies. Adequate substitutes for the legitimate uses of currency, on which positive or negative interest could be paid, are available.

The second approach, proposed by Gesell, is to tax currency by making it subject to an expiration date. Currency would have to be “stamped” periodically by the Fed to keep it current. When done so, interest (positive or negative) is received or paid.

The third method ends the fixed exchange rate (set at one) between dollar deposits with the Fed (reserves) and dollar bills. There could be a currency reform first. All existing dollar bills and coin would be converted by a certain date and at a fixed exchange rate into a new currency called, say, the rallod. Reserves at the Fed would continue to be denominated in dollars. As long as the Federal Funds target rate is positive or zero, the Fed would maintain the fixed exchange rate between the dollar and the rallod.

When the Fed wants to set the Federal Funds target rate at minus five per cent, say, it would set the forward exchange rate between the dollar and the rallod, the number of dollars that have to be paid today to receive one rallod tomorrow, at five per cent below the spot exchange rate—the number of dollars paid today for one rallod delivered today. That way, the rate of return, expressed in a common unit, on dollar reserves is the same as on rallod currency.

For the dollar interest rate to remain the relevant one, the dollar has to remain the unit of account for setting prices and wages. This can be encouraged by the government continuing to denominate all of its contracts in dollars, including the invoicing and payment of taxes and benefits. Imposing the legal restriction that checkable deposits and other private means of payment cannot be denominated in rallod would help.

In the other major industrial countries too (the euro area, Japan and the U.K.), monetary policy is constrained by the zlb. Conventional fiscal expansion with government debt-financed deficit increases would be ineffective or infeasible because of fiscal unsustainability. Like the Fed, the ECB, the Bank of Japan and the Bank of England therefore should lobby for the legislation necessary to eliminate the zlb. The euro area and Japan, which don’t suffer from deficient saving rates or undesirable current account deficits, could in addition stimulate consumption through helicopter drops of money—base money-financed fiscal stimuli.

All three methods for eliminating the zlb, although administratively feasible and conceptually simple, are innovative and unorthodox. Central banks are conservative. The mere fact that something has not been done before often is sufficient grounds for not doing it now. The cost of rejecting institutional innovation to remove the zlb could, however, be high: a material risk of continued deficient aggregate demand, persistent deflation and, in the U.S. and the U.K., unnecessary conflict between short-term stabilization and long-term sustainability and rebalancing.

—Willem Buiter is chief economist for Citi.


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