«The Swiss National Bank has crossed the Rubicon», says Miles Kimball. It would be reasonable for the Swiss central bank to introduce a fee on paper money.
Miles Kimball, economics professor at the University of Michigan, presented to a number of central banks his idea of a fee on paper currency. In his opinion it is crucial to inhibit the storage of cash to ensure the effectiveness of negative rates. Kimball writes about his idea at «Confessions of a Supply-side Liberal».
Mr Kimball, the president of the Swiss National Bank (SNB), Thomas Jordan, said that the current deposit rate in Switzerland of –0.75 percent could be even more negative. But how low can negative rates go?
If people know that the value of paper currency could go below par, the only limit to how low interest rates can go is full-scale economic recovery. Such an expansion – including in Switzerland’s case a competitive exchange rate – would make further low interest rates unnecessary.
But how low can interest rates go when people can earn a zero interest rate by storing cash?
People disagree about that. But even with a negative rate of –0.75 percent – given some time, let’s say five years – there would be massive paper currency storage. It might take a while until business models are set up to store paper currency. But if people knew the current situation would continue, this would happen at current negative rates. But if I were going to set up a paper currency storage business, I would be afraid that the SNB would disrupt my business – as it should. If people become confident that the SNB won’t do anything to get in the way of their profit by paper currency storage then the ability to set negative rates will be severely compromised. The SNB has already crossed the Rubicon into the territory where they need to do additional things to inhibit massive paper currency storage.
Last year you had a presentation to SNB staff. What did you advise them to do?
I proposed a deposit fee on paper currency. The path that the SNB followed makes it quite plausible. I know that they are open to new approaches. The fact that they went down to –0.75 percent tells you that they are open to try new policies. In the current context it is fairly straightforward and would sound reasonable to say: we start to see signs of a buildup of paper Swiss francs, so we want to inhibit that. We will cut off the arbitrage between paper currency storage and negative rate deposits by introducing a gradually increasing paper currency deposit fee. If banks want to deposit the paper currency with the SNB, they have to pay this fee. I don’t see any reason why the SNB could not defend this. Giving up the currency peg to the Euro was much more controversial.
So, if I would like to deposit bank notes on my account, the bank would charge me, because they have to pay a fee with the SNB. Is this correct?
Yes, if the deposit fee started at zero, but was going to increase every year by 1.25 percent, then even at interest rates of –1.25 percent there would be no temptation to pile up paper currency because there would be no way to profit from such cash storage any more. Notice that at that rate it would take years before the fee would be more than a few percent. With such a small deposit fee, most retailers would still accept cash at par. So the deposit fee should not create problems for regular households who just get paper currency to pay for goods. And hopefully the economy can recover before the deposit fee has to increase further.
You argue for large swings in interest rates to stabilize the economy. To fight a recession, you propose rates could go quickly to negative rates. What kind of level of interest rates would you have advised for the great recession in 2008/2009?
I wrote in “America’s Big Monetary Policy Mistake: How Negative Interest Rates Could Have Stopped the Great Recession in Its Tracks” that if we had a rate of –4 percent in the US in 2009, we would have a robust economic recovery by the end of 2009. In fact, I think a rate of –3 percent would probably have done the trick. To people who doubt that even –4 percent would have been low enough, I answer that you can go as low as you need to. At some point the economy takes off at very fast speed. That brings interest rates up. If measures are taken to avoid massive paper currency storage, then the only limitation on how low you can go on interest rates is that at some point you get an economic recovery.
You advocate negative rates instead of Quantitative Easing, QE. How do these instruments work differently?
QE operates with risk and term premia. With negative interest rates you lower all four interest rates: the central bank target rate, the lending rate, the rate on bank reserves, and the paper currency interest rate. Negative rates bring the whole term and risk structure down. If the risk premium is too high than QE works great. But it becomes harder: If you squeeze term and risk premia more and more, you need larger and larger amounts of QE to have an effect. And if you try to squeeze the risk premium below what it should be, there are probably some bad side effects. In contrast, if you use negative rates to pull the whole term and risk structure down, the economy can still function in a normal way. Banks operate on spreads: if they can lend at a higher interest rate than they borrow, they are fine. I don’t want to be too negative about QE, because during the financial crisis risk premia were elevated, so it was good to bring them down then. And there is a good argument to be made that risk premia have typically been too high even in normal times, so it is good to bring them down some. But there is a limit to how much QE can do.
Not all parts of the economy are evenly stimulated by low interest rates. What would you say about worries that, due to low rates, real estate prices and other asset prices could end up in a bubble?
According to standard economic theory, asset prices in general should be high when interest rates are low. If real estate prices in particular are an issue, you could have property taxes. But the big issue is not that property prices get really high, but the high degree of leverage in real estate. The right policy is to require banks to have 50% equity financing, in addition the individual mortgages should having 50% equity requirements. Only some of the equity financing of mortgages needs to come from the homeowner. Banks could effectively put up the rest by taking a portion of the capital gain or loss on a house when it is sold. The idea of high equity financing is to let the people who are putting up the equity sign up in advance that if prices fall, they will take the hit.
Are there other effects of low interest rates on asset prices?
The equilibrium real interest rates might tend to be low in the future. The transformation from manufacturing to services in many countries like Germany and in the future China could be one reason for that. The future interest rates could be positive, but maybe fairly low. Such a low interest rate in the long run would mean that predictions and expectations what will happen in the more distant future are much more important for asset prices. The debates about such expectations could make asset prices fluctuate more.
Why is the distant future more influential when rates are low?
If interest rates are high, then companies only care about projects that pay out very fast, because otherwise they can’t pay back that interest. On the other hand, if interest rates are very low, companies and people also make investments that may take quite some time to pay off, because the interest burden is modest. If you can wait a long time for the pay-off, people’s ideas of what will happen ten or twenty years from now will become crucial for buying companies or valuing projects. If you have low interest rates, asset prices will not only be high, they will fluctuate more. So we need to have structures in place to deal with that. A higher equity requirement for banks and mortgages will make explicit who is taking the risks. If the risk-bearing is not made explicit through equity requirements, it will be the government and taxpayer who will have to pay for losses to stop a financial crisis.
But would higher equity requirements not outweigh the positive effect of negative rates?
As there is an implicit government subsidy for debt, higher equity requirements are taking away some government subsidy for debt-financed investment. To compensate for that you may need to lower rates further. In a speech Larry Summers said that as aggregate demand is too low, we might need bubbles to increase demand when at the Zero Lower Bound. But having negative rates allow us restrain bubbles with higher equity requirements without worrying about having enough aggregate demand. Negative rates are powerful enough you don’t have to depend on asset bubbles any more to stimulate aggregate demand.
In one article, you argued that Switzerland offers insurance to the world through the safe assets it provides. But how can the country benefit from offering this insurance?
Switzerland should consider establishing a Sovereign Wealth Fund, separated from the central bank. This is now standard when a government has more financial wealth than debt. With negative interest rates large sums could be borrowed, maybe four or five trillion Francs, and they could be invested in exchange traded funds, to avoid get involved in individual companies. The business would that of a bank: borrow cheaply, invest with a higher return. One reason for the criticism of the large foreign exchange reserves of the SNB was the low returns. I think higher returns would lead to greater acceptance of a large fund.