A Call for a New Monetary Regime — Liberation from Zero Lower Boundary
Zero lower boundary has been already breached in the sphere of monetary policy in some countries: e.g. Denmark, Japan, Sweden, Switzerland, and the eurozone (Martin & Wigglesworth, 2019). And the blackhole of negative interest rates has been expanding beyond policy rates. It has already penetrated both deposit and lending rates in the private sector. As an example, at the end of July this year, UBS Group AG announced a plan to impose an annual negative deposit charge of 0.75% on its large-account clients with deposits above SFr 2 Mil. in Switzerland (Crow, Morris, & Alice, 2019). In the mortgage sector, furthermore, Jyske Bank, a Danish bank, applies the negative rate of 0.5% on a 10-year fixed-rate mortgage as of this late August (Passy, 2019). How far can the convention of zero lower boundary be breached?
Cash excruciates central bankers under persistent deflation. Its physical and non-interest-bearing features create the asymmetric architecture of our contemporary monetary reality. While central bankers could raise interest rates as high as they wish in their efforts to contain inflation, they face zero lower boundary (ZLB) in their battle with deflation.
Why ZLB? Why is a negative interest rate so problematic? From an operational perspective, commercial banks are more restrained by ZLB than central banks. To illustrate this point, let’s think about deposit rates for the household. Under a negative retail deposit rate regime, cash becomes the vehicle of a structural loophole: households can withdraw deposits and hoard their wealth in physical cash at home to escape from the charge arising from negative deposit rates. The structural loophole could lead to a monetary-policy-induced systematic bank-run, should negative rate reach the territory of the households’ deposit rates. A credible central bank would be vigilant in assessing the consequence of their negative rate policy, which, after a certain negative rate level, could transmit to negative deposit rates that could trigger financial instability.
Of course, a negative policy rate wouldn’t necessarily translate into negative retail deposit rates right away. As a matter of fact, even after central banks succumbed to persistent deflation pressure and breached ZLB, commercial banks in aggregate have demonstrated a tendency to maintain deposit rates above zero (ZLB). As an illustrative example, this trend can be observed among euro area banks since 5 June 2014, when the ECB set the policy rate (the deposit facility rate) to — 0.1% (Schepens, 2018). Another example can be observed in Sweden as well in the past (Eggertsson & Summers, 2019).
Once commercial banks bring down the nominal retail deposit rates to a near zero level, a further deepening of deflation would only increase the real retail deposit rates — net of negative inflation rates. Deposits are the commercial banks’ primary source of funding. In other words, a further deterioration of deflation would only increase the real cost of funding as they restrain retail deposit rates by ZLB.
Meanwhile, the negative policy rate would induce other interest rates — including longer maturity bonds’ yields — to come down. As the term spread — the difference between long-term and short-term rates on the same credit quality — shrinks, commercial banks’ profit margins would decrease. An ECB working paper (Heider, Schepens, & Saidi, 2018) demonstrated the diminishing net effect of negative policy rates: the squeeze in their profit have impelled commercial banks to reduce low yield credible lending and take excess risk to earn better risk premiums on their assets’ side; it also compelled them to seek non-deposit funding sources on their liabilities’ side. The banks’ profit-making strategy shifted from maturity transformation, or term-spread base profit model, to credit transformation, or risk-premium base profit model, when they reduce unprofitable credible lending to seek higher risk investment.
This illuminates the negative, beyond diminishing, effect of negative policy rates in the face of the psychological ZLB among commercial banks. The asymmetric architecture of our monetary reality causes the monetary policy paradox under persistent deflation.
Liberation from zero lower boundary, that’s what central bankers would need under persistent deflationary pressure — even before they face deflation per se! One solution would be to eradicate the architectural loophole by replacing physical cash with a new monetary instrument which is both traceable and interest-bearing. And Central Bank Digital Currencies (CBDC) could be designed to deliver these features.
Roughly speaking, our contemporary money can be divided into three large categories: (McLeay, Radia, & Thomas, 2014): reserves, a liability of the central bank, held by commercial banks at the central bank; deposits, commercial banks’ liabilities, created through banks’ lending activities; and cash, the other liability of the central bank (or the issuing government) accessible to the public in a physical form. While reserves and deposits are interest-bearing, physical cash is not traceable, thus, non-interest-bearing money. This difference creates a critical economic division between physical cash and the two other forms of money.
CBDC is an agnostic term and can be designed in multiple ways (BIS CPMI & MC, 2018). To simplify our discussion, let’s focus on the following three design features — interest-bearing feature, accessibility, and operating hours. If CBDC, a replacement of cash, is designed to be interest-bearing and accessible to the public for 24/7, it would liberate monetary policies from the ZLB and simultaneously substitute most, if not all, of the functions of cash. It sounds beautiful.
Why won’t central bankers introduce CBDC now? The digitization, nevertheless, only alleviates the possibility of the monetary-policy-induced systematic bank-run under a severe negative rate environment. It does not address general financial-distress-induced bank-runs. Central bankers are still assessing the impact of several CBDC designs (Kumhof & Noone, 2018) on the financial stability under financial distresses. Some argue, digitization could exacerbate the consequence of financial crises by accelerating the speed of bank-run from deposits to the risk-free CBDC. There also remain other issues such as security and privacy protection issues.
Should digitization be a problem for whatever the reason it may be, an alternative to CBDC could be to set a “variable exchange rate” between physical cash and the two other interest-bearing money (reserves and deposits) to enable central bankers to transmit the impact of negative policy rates into the cash value through the exchange rate: this would make a two-tier currency regime within a currency issuing territory (Agarwal & Kimball, 2015). Or we can even go phygital, a hybrid system of CBDC and the two-tier system.
Whatever the new monetary system it may be; a paradigm shift of monetary regime — isn’t it too dramatic?
As a matter of fact, our current system itself is a product of the historical evolution in the international monetary order, which has demonstrated a coherent grand metanarrative, a gradual liberation from monetary constraints: from metallic convertibility to fiat money: in other words, from fixed exchange regime to floating exchange rate regime. (On the historical fact, please visit “Is it time for a new monetary regime?” (Suginoo, 2018))
Now, contemplating our future monetary reality, liberation from ZLB, it seems to me, fits into the coherency of the historical evolution.
As of today, apparent deflation is only among a few countries; but deflationary pressure is notable when we see inflation rate against the record high monetary base levels across advanced economies. Trade conflict between the US and China and Brexit represent de-globalization. Protectionism would be deflationary from the perspective of the international trade, but would be inflationary from the domestic economies perspective. So, there is uncertainty in the net aggregate inflation effect of these counteracting forces. Should deflationary pressure intensify, however, and should monetary authorities fail to deliver monetary reform to engineer ‘liberation from zero lower boundary’, it might create an opportunity for emerging private money — e.g. cryptocurrencies — to dominate the monetary universe. In other words, the age of liberal monetary world. The new liberal monetary regime would be different from the free banking system in the past, in which commercial banks are authorized to issue their own money. Whatever form it may take, it would dethrone the status of sovereign money and might further destabilize the system.
To illustrate this point, we can take a quick look at Bitcoin. Despite its alleged use for money laundering purposes, its rise was choreographed as a protest against the current monetary system, reflecting the public distrust on the current centralized monetary system. Satoshi Nakamoto, the mythological Bitcoin founder, was calling for a new monetary system, peer-to-peer currency, that would not involve intermediary. Nevertheless, the paradox of Nakamoto is that his creation just shifted intermediaries from the banking system to miners (double spending validators) and wallet (electronic deposit account) providers (Suginoo, 2018); and miners’ intensive energy consumptions and computational power requirements (De Vries, 2019) created an oligopoly like massive concentration in the structure of miners (only large scale miners can survive the competition of validation business). Nakamoto’s disintermediation manifesto (Nakamoto, N.D.) ironically failed to address the issue of the economies of scale, the very cause of oligopoly, in the double spending validation process and misled his naïve ideological followers. This is just an example of flaws of Bitcoin. It is veiled by several other myths such as the reliability of its security quality (Suginoo, 2018). In reality, the hype of Bitcoin is driven partially by its myths — and also partially by fraud transactions and partially by price speculation — but not by its correct understanding of the truth. The domination of cryptocurrencies over sovereign money might only destabilize the system.
Therefore, the monetary reform to liberate sovereign money from zero lower boundary sounds imperative to me.
Nevertheless, even with liberation from ZLB, the primary scope of monetary policy would remain in the domain of the price stability and the financial stability. It cannot resolve the problems of the stagnated contemporary economic reality across many advanced economies today, which is a result of the structural change in the real economy. Innovation cycle unfolded in the aftermath of post-bubble economic reality. In response to the impaired economic prospect, innovations — such as robotics, blockchain, and AI — were massively mobilised to automate and streamline operation processes and cut down operation cost, especially labour cost, to maximise the per-unit profit margin. While it resulted in a substantial productivity efficiency gain for successful businesses, it ruptured job prospect for workers. It raises a fundamental question what would take to restore job creation. It would require fiscal policy and structural reform, such as the retraining of the workforce (Bond, 2019), to improve the skill set of the working population. That seems outside of the scope of monetary authorities’ responsibility. And we should not blame central bankers for their limitation on those matters.
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