Nov 13, 2017

Jeffrey Rogers Hummel on Myths about the Fed and Interest Rates

Despite popular wisdom, it is the market and not the Fed who controls real interest rates and their movements.
David Beckworth Senior Research Fellow , Jeffrey Rogers Hummel

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Jeffrey Rogers Hummel is a professor of economics at San Jose State University and writes on macroeconomics and economic history. Jeff joins Macro Musings to discuss his work on the Fed’s interventions during the Great Recession. He also dispels some myths about the extent to which the Fed really influences interest rates. Finally, he explains why he believes that cash plays an important role in society and why recent proposals to abolish cash are misguided.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Jeff, welcome to the show.

Jeff Hummel: It's a pleasure to be on the show.

Beckworth: It's great to have you on. You bring some interesting pieces lately that we're going to get into. Before we do that, I would like to know, how did you get into economics?

Hummel: Well, as you know, my PhD is actually in history, but when I was doing my undergraduate work at Grove City College, I was there at the time when Hans Sandholtz, a student of… was teaching. They also, interesting the history department, they also had Clarence Carson, who regularly wrote for the Freeman of the Foundation for Economic Education. So, I took as many of Sandholtz' classes as I could because I realized that you can't really do history unless you understand economics. Then when I got out of the army and started graduate school at the University of Texas, I took a lot of economics, graduate economics courses, economic history from Gary Walton, from surprisingly Walt Rostow, and I took monetary theory and macro.

Hummel: Then when I was getting ready to do my orals, I asked them to let me minor in one of the three comp areas in the economics department. So, I essentially majored in history and minored in economics in my graduate work. I'm finally, after being ABD for many years when I got around to doing my dissertation, it was on the economics of slavery. Even though it was at the University of Texas, I had to have an economist on my dissertation committee and had the honor of having Milton Friedman be on my dissertation committee. So, when I got back into teaching, it turned out that I could teach both history and economics. I taught both, but there were more jobs teaching economics.

Beckworth: Okay. And you've gone on to write a lot in the field of money and banking and macroeconomics, and we're going to post these three articles that we're going to discuss today on the SoundCloud webpage, but that's a fascinating journey into economics. I want to go ahead and jump into the first article I wanted to discuss with you, and this was the article you wrote that was titled *Bernanke vs. Milton Friedman: The Federal Reserves Emergence as the U.S Economy's Central Planner.* Now, in that article, you begin with a quote that Ben Bernanke gave at his speak at Milton Friedman's 90th birthday celebration. The quote from Ben Bernanke goes as follows. "I would like to say to Milton and Anna regarding the great depression, you're right. We did it. We're very sorry, but thanks to you, we won't do it again." Okay, so how has history judged that statement?

Hummel: Well, both agree. In fact, most economics agree with Friedman that what made the great depression great was the banking panics that began a year after the stock market crashed. But there's disagreement about why the banking panics made the great depression great. To put it in simple terms, Friedman's view was that the banking panics were a negative shock to the money supply, a negative shock to aggregate demand, and therefore to avoid the severity of the depression, it would have been sufficient to have a more expansionary monetary policy on the part of the Federal Reserve that would have prevented the decline. Two fell by about one third and one fell by about 25%.

Hummel: Whereas Bernanke's view is that the banking panics were essentially a shock to financial intermediation, knocking out these crucial institutions in the flow of savings, and therefore the policy implication of that is not an increase in the money stock or only an increase in the money stock, but targeted bailouts to specific institutions. So, I think that's a significant difference in terms of the policy implications.

Beckworth: So, Milton Friedman viewed the Great Depression as a meeting of exchange crisis, the money supply, a large part of it disappeared, that had real consequences, versus Bernanke focusing on the breakdown of financial intermediation, that was the key shock. Okay.

Hummel: Yes.

Beckworth: Okay. That ultimately, what you argue in your article, was what drove the response of the Ben Bernanke Federal Reserve in 2008, 2009 and so on.

Hummel: Yeah. Well, actually, the response begins in August of 2007.

Beckworth: Well, tell us about that.

The Post-Great Recession Fed Under Ben Bernanke

Hummel: Well, basically in August in 2007, you begin to see, as Gary Gorton has pointed out, you begin to see a panic in the repo market and the [inaudible] commercial paper markets. So, the first thing that Bernanke does is he eases up on discounts, trying to encourage banks, and to a certain extent does encourage banks to borrow more money. Then in December he creates the term auction facility, which is designed to get financial institutions to borrow even more money. If you look at the balance sheet of the Fed as the borrowing from the Fed increases, Bernanke sterilizes that by selling off treasury securities, so there is no significant change either in the size of the Fed's balance sheet or in the monetary base. That's phase one of his response, and he continues that until October of 2008. By that time, the Fed is beginning to run out of treasury securities that it can sell off to sterilize the bailouts, and so that's when you get quantitative easing coupled with the paying of interest on reserves.

Beckworth: Let's look a little bit closer at that phase one you just outlined. Between August 2007 and the end of 2008, right when QE1 starts, what you're saying is that the Bernanke Federal Reserve, and you're saying Bernanke, but obviously it was more than just him. It was everyone on board who voted for these policies. What they did was sterilize loaning, sure for every dollar they lent out to banks in distress, they also took a dollar out of circulation. Is that what you're saying?

Hummel: Yes, exactly.

Beckworth: And they did that by selling off some of their treasury securities.

Hummel: Exactly, yes. And they did that because Bernanke has always been an inflation targeter, and he was worried about an increase in the monetary base setting off an increase in the rate of inflation.

Beckworth: Yeah. I guess what's interesting about that is during this period, there was obviously financial stress by then, and then in 2008, we know the economy was contracting. What they were doing was they were keeping the level, the monetary base stable up until late 2008, but by doing the sterilized lending at a time where you think it would probably be important to expand the monetary base in a sense that the demand for liquidity has gone up. It's a stressful environment, financial conditions are worsening, and the Bernanke Fed is effectively picking and choosing where credit gets allocated, but it's not expanding overall the amount of money available.

Hummel: Exactly, yes. Right.

Beckworth: And again, that goes back to what you mentioned earlier, that it's a different view of the crisis.

Hummel: Right.

Beckworth: So, it makes sense if you view the crisis as a mitigation shock versus a money or medium of exchange shock. So, what should he have done, I guess? Kind of going back to this critique, what should he have done during phase one instead of sterilized lending?

Hummel: Well, I think he should have done exactly what Greenspan did when he faced... Greenspan during his long reign at the Fed, faced three potential crises. First of all, the stock market crash of October 1987, just after he appointed, and then Y2K and 9/11. What you see in each of those cases is that although Greenspan over the long run was pursuing a tight monetary policy, and in fact, if you look at the monetary measures tighter than what Volker had been doing, in each of those cases, he initially floods the economy with liquidity until the stress has disappeared, and then pulls it back out. It's particularly clear in Y2K and 9/11. You see a huge spike... well, huge, you see a noticeable spike in the monetary base and the reserves of the banking system. So, I think that what Bernanke should have done was beginning in August of 2007, started to increase the monetary base, and I think open market operations would have been sufficient.

Beckworth: Okay. Now, I have argued as well as Scott Sumner, that the Fed blew it in 2008. What you're arguing is that actually it was before then that the Fed failed to act more aggressively in 2007. Scott and I have argued that the Fed got really worked up about inflation in 2008 because of the commodity price shocks. If you go back and look at transcripts, even the statements, FOMC statements, there's this concern about inflation. There was even considerations of raising rates. I've mentioned before on this show that if you look at Fed funded future contracts, they indicated, for example, in June 2008, that the Fed over the next year would raise interest rates to three and a half percent from two percent. So, the market was actually pricing in a rate hike during this time, the worst time possible, because the fed was really talking up these concerns about inflation. But you argue you need to go back to starting in 2007 with sterilized lending.

Hummel: Right.

Beckworth: And again, you bring the point it goes back to this focus on the intermediation view of the crisis, but I guess kind of stepping back with my perspective and your perspective, could you argue that it's really a myopic focus on low inflation? In other words-

Hummel: Yeah, no, I agree that the reason he sterilizes... I mean, it's a classic example of what's wrong with inflation targeting.

Beckworth: Okay.

Hummel: Which, inflation targeting can work under certain circumstances, but not under all circumstances. And I think part of the problem was that you had oil crisis and energy crisis spiking, but it was a relative price change, not really an increase in the long run rated inflation. So, it was sort of like a supply side shock, and inflation targeting doesn't do well with supply side shocks.

Beckworth: Yeah. I think, and I agree with that assessment entirely, and I think that ECB made the same mistake in 2008 and 2011 doing the same thing, overly concerned. I mean, the economy is clearly going down, which by all other measures would indicate weakening of demand, but the Fed kind of treated this inflation shock like more of a demand shock when it was a supply shock.

Hummel: Now, let me just make the case for starting the responding in 2007. Remember that it's June 2007 when Moody starts its downgrades.

Beckworth: Yep.

Hummel: Mortgage back securities, and that's when the problems show up in the two Bear Stearns managed hedge funds that eventually bring the company down. In August 2007, you also have the run on the French bank BNP Paribas. So, by the end of 2007, the repo and asset backed commercial paper markets are already in free fall.

Beckworth: Yeah. So, they probably could have been more aggressive even before August 2007. They could have been signaling.

Hummel: Right.

Beckworth: Again, let me step back. A greater tolerance of inflation flexibility, or tolerating a little bit higher inflation. Stepping back even more, looking over the past decade, we have a decade now behind us since this erupts in 2007. I think one of the big takeaways is that inflation targeting is limited, that this commitment to really low inflation, whether it's an unconscious thing or maybe it's something they purposely have done, it has persistently undershot its target of two percent. Now, it's easy to understand why it undershot during the crisis, but even since June 2009, its undershot the two percent target. So, when I look at this, what I see is this commitment to low inflation hampering the Fed's ability to respond appropriately in moments of stress.

Hummel: Yes, I agree. But notice that under Greenspan, he was committed to low inflation, but that didn't stop him when there was an incipient crisis from flooding the system with liquidity.

Beckworth: No, absolutely. That's why I really stress inflation flexibility. A true flexible inflation target you would tolerate overshooting. You wouldn't necessarily be aiming for inflation overshooting, but you would tolerate policies that might cause it. All that matters is in the long run, you keep inflation anchored. In the short run, if there's a temporary overshooting because you're expanding to stem up a financial crisis, that is something that should be tolerated. But it wasn't, of course, as you know, and that's why I advocate at some kind of level targeting nominal GDP level targeting. But let's go to phase two. Phase two they do QE, and that same type of thinking in terms of this being a credit crisis kind of plays into that as well.

Beckworth: I know Bernanke, fair enough, contrasted QE in the U.S with QE that was in Japan. He said, "Look, we're doing credit easing." What they did was reserve or monetary base easing, and that's one of the challenged of why QE wasn't as effective as it could have been. I think QE1 did pack something of a punch, QE2 and QE3 less so. At a minimum, you can see that the driving ideas behind it are very similar to the ideas that drove the response in 2007, 2008.

Hummel: Yeah. Well, particularly the policy of starting to pay interest on reserves. So, in other words, Bernanke's run out of treasury securities to sell to sterilize his bail outs. He realizes he needs to actually do more in the way of bail outs or more in the way of expansion, and is worried about inflation, so how do you prevent an increase in the Fed's balance sheet from generating higher inflation? Well, you give the banks an incentive to hold more reserves. So, we pay interest on reserves. He actually is explicit about this in his memoirs, and so what happens is that the monetary base goes up as the banks accumulate and eventually accumulate over 100% reserve [inaudible], and one, the money multiplier collapses. So, the impact on the broader measure of the money stock is diminished significantly.

Beckworth: Now, taking the Fed's side on this just for playing the Devil's advocate here, they would say the reason we do interest and excess reserves is because it gives us more flexibility. It's a new tool, a new way to manage policy. Yeah, we introduced it in October 2008, and maybe the original motivation was to contain the massive growth in reserves, but we want to keep it because it allows us to set in short term interest rates without having to worry about managing the quantity of reserves. How would you reply to that response?

Response to the Fed’s Floor System Institution

Hummel: Well, I would first point out that, well, and to say something else on their behalf, other central banks have already begun paying interest on reserves. So, it wasn't an unprecedented thing to do. But initially, the plan was to set up a corridor system in which the Fed would target the fed funds, right? Use the discount rate as an upper bound on the federal funds rate, and use the interest rate on reserves as a lower bound. Again, they were explicit about this is the goal, and of course it doesn't even work out that way, and in fact, because the banks are holding so many reserves, the interest rate on reserves becomes actually an upper bound on the federal funds rate rather than a lower bound.

Beckworth: Yeah. So, it becomes more of a floor system than a corridor system.

Hummel: Yes, yes.

Beckworth: And again, they will say they like this, it works for them. One of the big critiques I know that George Seligman has been making is one of the reasons to think about it and step back and pause and consider whether it's working well is the fact that they haven't hit their inflation target. It may give them the flexibility that they want, but the past eight years, nine years indicates they're having a hard time using this new tool in an effective manner to hit their inflation target.

Hummel: I agree, yeah.

Beckworth: Well, let's move on then to another article of yours. I think there's a nice Segway here because as you know, the Fed lowered its interest rate targets down to zero because the zero lower bound. It resorts to QE as a workaround solution to provide additional stimulus. Once we get to this point, we get these massive critiques of the Fed. The Fed is artificially lowering interest rates, it's rigging the system, it's harming savers, it's just a terrible intrusion in the private marketplace. You have written an article that's entitled: *Central Banks Control Over Interest Rates: Myth and Reality.* Speak to us about this common view of the Fed's control over interest rates, and then tell us what's wrong with it.

The Myth and Reality of the Fed’s Interest Rate Control

Hummel: Well, I make a distinction in the article between the popular view of the general public and the view of central bankers and monetary economists, which is more sophisticated. The popular view is, and you still see it, is that the Fed sets interest rates and essentially has complete control over interest rates. Now, monetary economists have a more sophisticated view. They realize it's more complicated. But they're, first of all, responsible for the popular misconception because they persistently and misleadingly describe central bank policy as controlling interest rates, and moreover I think they overstate the strength and significance of the central banks' impact, particularly on real interest rates. This has led to a mistaken focus on interest rates as both a target and an indicator of monetary policy. In other words, I don't think you can... in other words, as you mentioned, the goal is to try to separate monetary policy from what's happening to the money supply by focusing on interest rates. I don't think you can do that. I think it's a mistake to try that. It's not going to work, and it's one of the reasons that they're not able to hit their inflation target.

Beckworth: Well, kind of tying this into Fed policy, so, when the Fed does get to the zero lower bound in late 2008 and in 2009 it goes on, that's when you see these critiques emerge. What I think your paper argues or makes a case in saying that is interest rates were going down regardless of what the Fed was doing. So, in other words, the Fed lowered the target for its short term interest rate, but the actual market rates had already fallen, and in fact, the market clearing or equilibrium interest rate was fallen even beyond zero. The Fed of course can't go below zero because people at some point would resort to cash. We've seen the interest rates can go a little bit below zero, but still, this constraint is binding. At some point it becomes worthwhile and the benefits exceed the cost of moving into cash. So, the critique is that the Fed artificially lowered rates, when instead the collapse of the economy pulled rates down, and the Fed’s simply followed it down. That's the argument you make in your paper. Correct?

Hummel: Yes, yeah. Well, the market ultimately determines real interest rates. The Fed has control over the extent to which nominal interest rates succeed real interest rates by its long term control over inflation, but the market determines real interest rates, and that therefore, if you have an extended period of low interest rates or an extended period of high interest rates, it's not the responsible of the central bank. It's not being caused by the central bank. In the short run, the central bank can push up real interest rates up or down a little bit. I think the extent to which they can do that depends on the economic environment, but these short term effects are not going to last, and the underlying theory that's taught in all the money and banking textbooks is that it doesn't last for extended years, that it's only a short run impact pushing real rates slightly up or slightly down.

Beckworth: Yeah. I think what gets confusing about this is that the Fed does have some short run controls you mentioned, and that short run control is more binding, more prevalent during normal periods when interest rates are above zero. But when you get to the zero lower bound, the Fed lose almost complete control of using interest rates, because if in fact the market is pulled the equilibrium or neutral interest rate below zero, there's nothing the Fed can do with interest rates, other than adopting some negative interest rate policy. If it's above zero, then you can think of the Fed having some effect on the margin, and people, I think, generalize from that to any period, including the zero lower bound environment, which is, I guess, one of the consequences of using interest rates like we do for monetary policy.

Beckworth: Let me ask a slightly different question. Another critique that you often heard over the past decade is that interest rates don't matter that much for stimulating the economy. A lot of people have said this. It's some other channel through which monetary policy works. The New-Keynesian kind of paradigm is monetary policy affects the stance of monetary conditions by adjusting the short term interest rate path or the expected path of interest rates relative to the equilibrium path, and so that gap between the natural interest rate path and the actual interest rate path is what sets the stance of monetary policy. Do you think the Fed packs much punch by altering that gap, or is it through some other channel that central banks have their effect on economic conditions?

The Fed’s Influence on the Interest Rate Gap and Views on QE

Hummel: I'm not sure. What gap are we talking about?

Beckworth: The gap between the actual short term interest rate that we observe and the equilibrium one. So, if, for example, if the economy is heating up and market forces are pulling up interest rates, the return in capital is going up, people are wanting to borrow more credit, so the natural interest rate is rising, and the Fed decides to keep rates low, even as the market portions are pushing them up. That gap would indicate a stimulative stance of monetary policy.

Hummel: Well, my argument is that the Fed doesn't have much influence in creating the gap. In other words, I don't think... you kept using the word control over interest rates. They have some influence over interest rates, but I think the extent of the influence is very limited. Then in other words, the Feds in theory could push interest rates below the lower equilibrium, the natural, or what's sometimes called the neutral rate of interest.

Beckworth: Yep.

Hummel: Over an extended period, only if they increase the rate of monetary growth and generate a high rate of inflation. So, I think we need to return to looking at the money supply rather than interest rates as sort of the target and the indicator of what monetary policy is doing.

Beckworth: What about the Fed's view on QE? So, when they did these large skill asset purchases, they invoked the portfolio balance channel theory, which argued that they could affect interest rate yields and a number of assets by taking out the safe assets, take out treasuries, take out agencies.

Hummel: Right.

Beckworth: By doing that, they took out duration risk, it causes a rebalance in the portfolios, which in turn affect other yields, kind of a cascading effect on interest rates. What they were doing, of course, is they were turning to long term interest rates because short term rates have gone to zero. Do you think that was a very effective approach?

Hummel: I don't think it was an effective approach for the problem that they were interested in solving.

Beckworth: Okay.

Hummel: In other words, my view of quantitative easing or the large scale asset purchases is that most of the money that the Fed has used to engage in those operations is not money that is created the traditional way that central banks operate, but money that it is borrowed. You saw this at the beginning of a quantitative easing when temporarily the Fed, part of that quantitative easing which was going into foreign central banks, was being financed by the treasury borrowing money, depositing in its account at the Fed, and then thee Fed relending it to foreign central banks. To a certain extent, interest on reserves is a way of redirecting the lending of banks from the economy to the Federal Reserve, which then allocates credit.

Hummel: So, in other words, by paying interest on reserves, the Fed has expanded beyond an institution that controls the money supply to becoming also a giant financial intermediary that borrows on one end of its balance sheet and re lends on the other end of the balance sheet. Of course, that can have some impact on the structure of interest rates. In other words, it's like Fanny and Freddy. Fanny May and Freddy Mac have some impact on the structure of interest rates, where the credit flows, and I think the Fed, through its financial intermediation, can have that kind of impact. But I don't think those kinds of operations are what's needed if you want to stimulate the economy.

Beckworth: So, what you're saying is that QE did not work very effectively, but it did turn the Fed into a large financial intermediary.

Hummel: Yeah, a financial central planner.

Beckworth: Okay, central planner. There's people who will acknowledge that. I've talked to someone who works at one of our regional Federal Reserve banks, and he readily acknowledged to me that, yes, the Federal Reserve is effectively the largest fixed income hedge fund right now in the world. Right?

Hummel: Right.

Beckworth: Four and a half trillion dollar balance sheet. Maybe there's some other hedge funds that are bigger. I don't think any other hedge funds are bigger than that, but it's a really large fixed income hedge fund, and he's like, "Look, we're making money for the government." Right? We're funding at the interest [inaudible] reserve rate, we're earning on long term yields, we've been making 100 million dollars or so a year lately for the federal government. What's there to dislike about that? Why not do it? Why not save the government tax payers some money? How would you reply to that?

Hummel: I would reply that just as Fanny and Freddy created enormous distortions by misallocating savings, the Federal Reserve can do the same thing, and that ultimately, if you want your savings efficiently allocated, you should leave it up to the market, which, by the way, takes us back to Friedman's view. In other words, if you're trying to stem off a financial crisis, if you're just injecting money into the economy, you're letting the market decide where the money should be allocated rather than the Fed deciding.

Beckworth: Okay. Now, there are people, of course, who want to see the Fed's balance sheet remain large, even though the Fed has indicated it wants to shrink it. They think the Fed's large balance sheet provides a vehicle to provide safe assets to investors, to the public, so, in other words, the Fed's balance sheets has opened its door to more and more financial firms beyond banks now, many market funds, GSEs can park their funds at the Fed for their reverse repo facility. So, they see the Fed's big balance sheet as this vehicle for increasing financial stability. I mean, Jeremy Stein used to be the board of governors. He's argued this. A number of people have taken this view.

Beckworth: But I think what I hear you saying is that in doing so, the benefit might be some increased financial stability, but it also comes at a cost. The cost is distortions and credit allocations, and you referred to Fannie and Freddie as an example. I think another lesson we learned from Fannie and Freddie is at some point they may not be profitable. Right? At some point, for years they may generate revenues for the government, at least the Fed is. At some point they could take a loss. If there's big enough swings in interest rates, there could be a huge loss in the Fed's balance sheet, and at that point the tax payers would have to bear that loss.

Hummel: Not only that, but the impact of... I mean, it is true that the Fed's remittances to the treasury have gone up significantly since it expanded its balance sheet, but you have to bear in mind that the interest that the Fed is earning on all of these assets is partially offset by the interest that it's paying on reserves. As interest rates go up again, which I think they ultimately will, it's not clear what are going to be the long term effects in terms of revenue for the treasury. In fact, seigniorage has never been an important source of revenue... pardon me, never been. Seigniorage in developed countries in the late 20th century and 21st century became a trivial source of revenue, and so the Fed has increased its seigniorage, so maybe now... I'm not even sure it's reached one percent of GDP as a result of the increased remittances to the treasury.

Beckworth: Yeah. It's interesting if you read the discussion of FOMC members. Many of them do recognize the expend in Fed's balance sheet is effectively a creepy nationalization of financial system that if they keep it large, they're effectively usurping activities that formally were done by other firms. Some of them are uncomfortable with that, and I think that's one of the reasons they're willing to shrink the balance sheet. Another reason they may be uncomfortable with it, and I've written on this, and this is purely conjecture on my part, but one other reason might be the political economy of interest and excess reserves in the following way.

Beckworth: Most of the payments that go to banks from interest and excess reserve are going to one of two institutions. One, foreign banks that have branches in the U.S, and second, large domestic banks. The banks that we bailed out during the crisis, and then foreign banks were the ones receiving the line share of interest and excess reserve payments. I think that's a really bad image to come before congress and to discuss. It's just bad optics. As rates do go up, those payments will get larger if the Fed does not dramatically shrink its balance sheet.

Hummel: Right.

Beckworth: And I think that will be a hard sell for the Fed to make, why are they making these interest payments to these foreign banks? I mean, I've looked at this data recently. In 2015, this is kind of a rough estimate here, but I believe six billion dollars in interest and excess reserve payments were made to banks. In 2016, it jumped to about 12 billion. So, there's a big increase. Of course, that increase was due to raising the rates. Now, 12 billion may seem like chump change compared to the defense department, but as time goes on, that number will get a little bit bigger, and I just think that will be a tougher and tougher sell for the bank and why they're making these payments.

Hummel: Agreed.

Beckworth: Okay. Let's then move on to another article you've written.

Hummel: Okay.

Beckworth: This article is also about money, but it's on a particular form of money, and that is currency. Over the past year or so, there has been a lot of discussion about whether we need to get rid of currency. Kenneth Rogoff had a book, *The Curse of Cash*, where he argued along these lines. I believe Larry Summers made a similar argument and a few others. You spotted this. You wrote a review that got published in which journal?

Hummel: Econ Journal Watch.

Beckworth: Econ Journal Watch. We'll put a link to it. Thank you. The title of the article was *The War on Cash*, a review that kind of [inaudible] *The Curse of Cash.* Now, interestingly enough, you wrote this critical review of it, and Kenneth Rogoff actually responded to your critical review of his work. So, why don't you first summarize his work and then provide your critique of it?

Critiquing *The Curse of Cash*

Hummel: Okay. Well, he wants to phase out cash for essentially two reasons. One is he believes that cash is significantly important in the underground economy for illegal activities such as drugs, human trafficking, illegal immigration, and so he sees this as a mechanism for suppressing crime because criminals rely more heavily on cash than others do, and going along with that is that he believes it would force more activities, the underground activities, the legitimate parts of the underground economy to being more effectively taxed, so he thinks there'd be a tax gang for the U.S government or any government that implements that. So, that's one of the arguments.

Hummel: The second argument is that if you eliminate cash, it makes it easier for central banks to push into the territory of negative interest rates. In other words, if central banks start charging negative interest rates on the reserves that the private banks are holding, they can only push that so far as long as cash is there, because people can flee into cash, and banks can start holding their reserves in the form of all cash rather than deposit it at the central bank. Those are the two basis arguments for phasing out cash.

Hummel: Rogoff actually is somewhat careful in making his proposal. In the book he wants to phase out over a decade or more all large denomination notes. In the U.S, that would be 100 dollar bills, 50 dollar bills, 20 dollar bills, and perhaps even 10 dollar bills. He also brings up the possibility of replacing smaller denomination notes with equivalent denomination coins of substantial weight that would make them more burdensome to carry around the harder to conceal. He believes that for less developed countries it's too soon to contemplate phasing out currencies, but he still thinks that they can maybe do something with phasing out large notes. So, that's his proposal.

Hummel: My objectives to it are first of all, he doesn't give any convincing evidence about the extent to which... in fact, none of the advocates of phasing out cash have provided good, empirical estimates of how much illegal activity would be suppressed. They ignore the fact that some of that illegal activity, such as drugs and illegal immigration, actually consists of productive activity, that according to people's subjective preferences, they're better off. He doesn't do a full welfare analysis. In other words, if you phase out cash, you're moving legitimate underground activity or non-invasive underground activity from tax rates of zero to perhaps marginal tax rates of 30%.

Hummel: Given my views on the fact that central banks shouldn't be targeting interest rates, I'm not a big fan of the proposal to go to negative interest rates. I can talk more about that in detail later. Then I think he ignores the value of the underground economy as a safety mechanism. In other words, it was Pierre Ligneau who made the point that criminals may use some of the legal protections in the constitution more often than non-criminals, protections jury trial and search and seizures, protections against self-incrimination. That's not a reason to get rid of them, because they provide a break in government abuses. Similarly, the underground economy is an important mechanism for checking when government becomes too invasive.

Hummel: I use the example of alcohol prohibition and laws against marijuana. How likely would it have been if that alcohol, that prohibition would have been repealed if it hadn't been successfully evaded by a large part of the population? Similarly, how likely would we be today moving to marijuana legalization if the laws against marijuana hadn't been so successfully evaded? So, I'm a big fan of the underground economy.

Beckworth: Let's talk about that just a little bit more. What you're saying is that in the underground economy, there are sometimes some useful activities going on down there because policies that may have been intended well may have adverse effects on certain groups, poor people, lower socioeconomic folks who they operate on the margins of society because for whatever reasons, lack of schooling, lack of opportunity, they're not in mainstream America and they have to do it. So, think of maybe laborers or maybe immigrants who maybe they're not able to find work in normal fashion, so they resort to being paid in cash under the table, and this actually keeps them employed, keeps them off the street, keeps them out of prison by being engaged in meaningful activity that they wouldn't otherwise be able to do. Is that kind of the story you're making?

Hummel: Yeah. This is even... I mean, there are various estimates of the size of the underground economy. For the U.S, it's estimated that if you counted underground in the national incumbent product accounts, it would increase GDP by around 10%. But there are countries, even developed countries like Italy, where the estimated size of the underground economy is close to 25% of GDP. That's suggesting that the underground economy is where a large portion of the population actually lives and survives. It's interesting to observe that the size of the underground economy tends to be larger the more invasive, the higher the tax rates, the greater the regulatory burden and all of these other aspects of government intervention are.

Beckworth: Yeah. It's interesting you bring this up now, because we've had guests on here, and it's a part of the national conversation right now, some of the regulations that are state and local levels that are preventing labor mobility from happening like it used to, for example, zoning restrictions that keep the amount of housing supply low in your part of the country over there near San Francisco, or occupational licensing, things like that that prevent people from lower socioeconomic levels to maybe moving to where the jobs could be or getting the work they want to get. Like you said, the underground economy provides, it's kind of a social safety net, an unofficial social safety net that keeps them going, and cash is the medium of exchange in that, and you don't want to stranglehold that last refuge they have.

Hummel: Well, I would divide the argument about the underground economy into two parts.

Beckworth: Okay.

Hummel: The first part is you need to do a welfare analysis. In other words, the underground economy consists of both a truly invasive, violent activity, but also a lot of activity that involves producing goods and services that people desire. So, if you're going to try to suppress the underground economy, you have to, by moving these activities into the regulated economy, you have to do a welfare analysis and see what they... in other words, you may get tax gains, but you have to show that the tax gains will offset the losses, the dead weight loss from moving these kinds of activities into higher, more regulated zones of the economy. That's one aspect of it. Then there's the other aspect, which is even if the welfare analysis showed that the gains would exceed the losses, it still isn't a sufficient justification for getting rid of the underground economy because of its political economy aspects because of the role that it plays in terms of putting a check the power of the state.

Beckworth: I would add another argument, and I've mentioned this before when I was talking to another guest we had on, an episode with JP Koning, and that is dollars are a very important part of the money supply for many people around the world outside the U.S. So, for example, in Zimbabwe, the U.S dollar is or was one of the main currencies used there, and a lot of our currency does get sent overseas, and it's a way for foreigners and countries that don't have stable monetary systems to have a stable medium of exchange. It's kind of like a public good that we provided the rest of the world, and I think getting rid of it would be something that would affect them as well in an adverse manner.

Beckworth: Well, let's move onto the other argument given for getting rid of currency, and that's the zero lower bound argument, or today we'd say the effective lower bound argument, because we know we can go a little bit below zero. But the argument is that in times like the great recession or the great depression like we were talking about earlier, if the natural interest rate, if the market clearing kind of equilibrium has fallen below zero, and central banks in normal operating mode can't lower rates below that, one way to get around that would be to get rid of currency so that you could lower rates.

Beckworth: In other words, central banks right now cannot lower interest rates into the negative territory, because at some point, folks would start migrating towards holding cash as opposed to having their funds in a checking account, savings account, earning a very large negative interest rate. You don't buy that argument. Why not?

Pushing Back Against the Zero Lower Bound Argument

Hummel: Well, first of all, I don't think the policy is needed because I don't think that... this gets back to my article on interest rates. I don't think interest rates are the important indicator of what's happening with monetary policy.

Beckworth: Okay.

Hummel: In fact, Bernanke himself, when he wrote a couple articles on Japan's loss decade, came up with the correct policy when you've got this apparent deflationary problem, which is that the central bank can increase the money supply as long as it’s not borrowing money by paying interest on reserves, can increase the money supply, and it will eventually start driving up prices. In other words, the goal is obviously to stimulate the economy. It can start driving up prices because it could keep buying assets until it owns everything in the economy, and at some point before that happens, people will start spending the money. So, I think the zero lower ground is a non-problem to begin with if you're focusing on the money supply. You can get any stimulation of aggregate demand or any increase in the money supply the central bank can without worrying about interest rates.

Hummel: Now, the problem is this scenario is often referred to as helicopter money. That actually comes from Friedman's work when he was in one of his early articles was explaining why increasing the money supply causes prices to go up. But what's happened is that the notion of a helicopter drop has been coupled with the idea that it has to be coordinated with fiscal policy. That's the objection that Rogoff gives, Bernanke gives that objection. There's no reason it has to be coordinated with fiscal policy. The Federal Reserve through open market operations have plenty of treasury securities, and if there aren't sufficient treasury securities, then it can buy other kinds of assets. It's already bought mortgage back securities. Some central banks are actually buying equities. So, there's no reason why the zero lower bound presents an obstacle to an effective monetary policy. That's my first objection.

Hummel: My second objection is that I don't think it will be very effective, because unlike expanding the money supply to stimulate aggregate demand or achieve whatever macroeconomic goal you want to achieve, a negative interest rate works on the demand for money, not on the stock of money. In other words, it affects velocity. Therefore, unless you're willing to start pushing negative rates successfully lower and lower and lower, it's only going to have a level effect. In other words, essentially negative interest rates are a tax on money. You tax money, people spend it a little bit faster, you have a level effect. That's not as effective as expanding the money supply. So, I don't think the policy would achieve what it was designed to achieve.

Beckworth: Okay.

Hummel: And on top of that, I don't think you should be taxing cash balances.

Beckworth: In the moments we have left, tell us about Ken Rogoff's reply to you. So, you wrote these out, people can argue, disagree with you. What exactly did Ken Rogoff say to you in his reply?

Rogoff’s Reply

Hummel: Okay. Well, much of his reply was sort of... I think he was really pleased to have somebody... I mean, it was clear that I'd read his book closely and had taken it seriously, so it was a very respectful reply. A lot of it was devoted to him just explaining his views or reiterating some of the points that he thought was important about his views. There are three things that are noticeable about his reply. First of all, and this first one also appears, there's a paperback edition of The Curse of Cash, and he's added an afterward, and you can see from his reply and from the afterward that he's backing away in terms of what he's advocating, or at least how he's presenting what he's advocating, because you have the impression when you read the title, The Curse of Cash, leaves you with the impression that even though he's willing to go slowly, his ultimate goal is to get rid of all cash at some point in the future.

Hummel: In his reply to me and in the afterward in the paperback edition, he's saying, "No, no, no. People are misinterpreting me. I just want a society with less cash." In other words, he's trying to reframe his position as sort of a middle of the road option between what we have and the extreme that other people have been criticizing. That's one aspect of his reply that I think comes across very clearly. Secondly, he tries to answer my objection about the fact that he didn't do a welfare analysis by arguing that he was saying, "Well, tax revenue..." that the abolition of cash will be revenue neutral. That was the implicit assumption.

Hummel: In other words, that... and if it's revenue neutral, therefore there's no significant welfare loss. I just think that the assumption that it's going to be a revenue neutral change is undemonstrated and very improbably. In other words, what he's arguing is... let me restate it. He's saying that once you move all of these underground activities into being taxable, you can therefore lower taxes on other economic activities so that the governments will, in essence, have more revenue coming from underground activities, and this will give them the opportunity to give tax breaks to other economic activity, and therefore because of that, these other activities have been unfairly overtaxed compared to the ones that have been under taxed.

Hummel: It strikes me as utterly fantastic that if actually the abolition of cash does generate revenue gangs for government, that they're going to graciously reduce taxes on other sectors of the economy. The third point is that he's conceded that really the case for abolishing cash is stronger for countries where there's a lot more corruption, a lot more underground activity. To quote from his response, he says, "The case for pushing back on wholesale cash is weaker for the United States than for most other countries, first because perhaps 40 to 50% of all U.S dollar bills are held abroad, and second because the U.S is a relatively high tax compliance economy thanks to its reliance on income taxes for government revenue. All right?

Hummel: Yet at the same time, he said that it's too early to eliminate cash in third world countries. So, essentially he's saying that phasing out cash is less of a priority for the U.S and for other countries where it is least needed but easiest to implement, and that it's more of a priority where... in other words, it's more needed where it could be disastrous to implement.

Beckworth: Very interesting. Okay. We are out of time. Our guest today has been Jeffrey Rogers Hummel. Jeffrey, thank you so much for being on the show.

Hummel: Thank you. It was my pleasure.

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