Below zero August 18, 2012 at 2:11 pm

An interesting observation from the Bond Vigilantes, which moreover has implications for interest rate models that are floored at zero:

As investors we get used to living within certain recognised bounds. For example, it has been commonly assumed that interest rates cannot be sub-zero. There has been the odd historical quirk when we’ve seen negative rates (Switzerland in the 1970s), but that’s more for amusement than general investment consumption. However, there now appears to be the potential for a major investment climate change… Theoretically, a negative interest rate sounds simple – you put £100 in the bank and you get £99 back a year later if the rate is -1%. A rational investor would of course have the alternative of simply keeping their cash under the mattress and not suffering the negative rate, although the incentive to behave rationally would be limited by the administrative burden and security risk of holding cash. The central bank could simply limit this activity by basically not printing enough cash. Therefore the vast majority of money would have to be held electronically and could therefore suffer a penal negative rate. Implementation of sub zero rates is possible.

Their point about the mechanics of negative rates is interesting; absent enough hard cash for investors who wish to hold it, it’s easy to implement negative rates. One does rather wonder what would happen if a lot of cash was tied up under beds though; would the relevant central bank find themselves pressured by cash liquidity issues into printing (somewhat) more cash, much of which would immediately disappear from circulation?

7 Responses to “Below zero”

  1. What if someone produces an electronic mattress — say a Physical Cash ETF, storing pile of banknotes in the same vault infrastructure they use for physical gold ETFs? At more than say 50bps negative rates, it’s doomed to happen.

    The central bank refusing to print cash on demand seems fraught with risk as well, you can’t really distinguish someone who withdraws cash for groceries from someone who will use it, directly or indirectly, for mattress padding purposes.

    They could withdraw high denominations, getting rid of E200/E500 notes would be a good thing, but then even US$100/E100 notes don’t take that much space. You really end up having to mandate electronic payments for everything It’s possible but controversial and more directly voter-visible than usual monetary policy decisions.

  2. If as the original poster suggests cash is kept scarce, so that money’s forced to stay electronic, then very quickly cash will be valued at a premium to electronic money.

    The situation now where cash (electronic and otherwise) and short term bonds are considered safe assets is one we don’t want to throw out the window. It stabilizes banks in times of crises as people increase their deposit holdings after selling off risky assets.

    If physical cash traded at a premium to electronic deposits it would not be very long until physical cash was considered the new safe asset. People would want to hold it to remove the basis risk to electronic cash. Bank deposits would soon be considered “risky” just for the fact that the discount they trade to physical cash would fluctuate.

    This would reverse the situation. Banks would become extremely untenable during periods of flight to quality. Bank runs would become common as people fled to physical cash or some technological alternative, like cig suggested.

  3. Doesn’t inflation mean that the real rate is negative if it hits 0%? Isn’t the real rate the rate people actually care about? Not being an economist, I may be confused, and would be happy for some clarification.

  4. Thank you both. I love the idea of a physical cash ETF. Given that in this world cash would be scare and hence worth borrowing at, err, interest, it would clearly be worth setting such a thing up. You would want to be rather careful that your ETF did not on-lend your cash though…

  5. David – in a rational economic world, yes people should care about the real rate. But they often don’t. Psychologically getting 99 back when you deposited 100 is annoying, even if the presence of deflation means that this is actually a positive real return.

    Also if inflation is 2% and the risk free rate is 1% you can’t avoid value destruction without taking risk, whereas if inflation is -1% and the risk free rate is -2%, you can make a risk free real return of 1% providing you can get enough cash and a big enough mattress to keep it under.

  6. Physical cash ETF wouldn’t work; where can the ETF invest the cash at positive rates? How can it store a physical object at zero cost? Fundamentally physical money has a cost of carry; any storekeeper knows they spend money to keep till floats, to ferry the cash to and from banks, etc. Someone is paying all those secure cash couriers. Note also that the anonymity of cash already puts it at a premium; if I take out cash and pay someone with it, I may make myself part of the chain that tax-avoidance policing will follow; this complicity is what the ill-advised ‘all cash payments are a tax dodge’ statement was about.

    The real interest rate is already negative; inflation is much higher than deposit rates, so putting £100 in today gets you less in a year’s time than you put in, in real terms. When we all start actually paying for our bank accounts instead of leaving it to those on the edge of their overdrafts, there will be no hiding from it. A bank account with £100 in is already £97 a month later.

    Cash as a premium to electronic transactions would just finally move us all to electronic transactions. Perhaps bitcoin-type electronic currencies would be accepted by increasing numbers of outlets. Why would you pay extra to hold cash? The more the premium, the more risk the store-holder carries by accepting your cash, so they won’t lower the prices for cash payment any more than at present.

    Once everyone uses electronic payment, using electronic currencies is all the easier to do. It’s all promissory notes in the end, and cryptography is probably a better mistress than the Old Lady.

  7. @Phil, the physical cash ETF works not by reinvesting the cash but by storing it in a vault. Of course it pays rent to the vault owner and the salaries of the security guards, which are deducted from assets — it spends some of the cash. It becomes worth it when these costs are lower than the negative interest rate the central bank charges on electronic money.

    For the shopkeeper, a cash premium means they can give $100 of customer cash to an intermediary and get say $102 worth of electronic money, instead of just $100 for a direct electronic payment. The risk of the cash being stolen before being deposited with the intermediary is not materially different from what is now, and there’s an extra $2 profit to compensate for it.