There's An Electronic Currency That Could Save The Economy — And It's Not Bitcoin

Source: http://www.businessinsider.com/electronic-currency-2013-11

The United States has been marred in slow economic growth and a weak recovery for years now. Unemployment remains high. This is despite extraordinary efforts by the Federal Reserve to stimulate the economy. This drawn out period of low inflation and high unemployment has gotten more and more people talking about a "new normal" of mediocre growth.

Economists have been looking for ways to give central banks more power to combat recessions and prevent these long, drawn out recoveries. Larry Summers laid out this major impending economic challenge in his recent speech at the IMF. Normally, when a recession hits, central banks cut interest rates to incentivize firms to invest and to spur economic growth. But when interest rates hit zero, those banks lose one of their most important tools to combat recessions. This is called the zero lower bound.

Hitting the zero-lower bound means that interest rates cannot reach their natural equilibrium where desired investment equals desired savings. Instead, even at zero, interest rates are too high, leading to too much saving and a lack of demand. Thus we get the slow recovery.

Until recently, we hadn't hit that bound. But since the Great Recession, we've been stuck up against it and the Fed has been forced to use unconventional policy tools instead. What Summers warned of is that this may become the new normal. When the next recession hits, interest rates are likely to be barely above zero. The Fed will cut them and we'll find ourselves up against the zero lower bound yet again and face yet another slow recovery.

So what's the answer?

University of Michigan economist Miles Kimball has developed a theoretical solution to this problem in the form of an electronic currency that would allow the Fed to bring nominal rates below zero to combat recessions. He's been presenting his plan to different economists and central bankers around the world. Kimball has also written repeatedly about it and was recently interviewed by Wonkblog's Dylan Matthews.

"If you have a bad recession, then firms are afraid to invest," he told Business Insider. "You have to give people a pretty good deal to make them willing to invest and that good deal means that the borrowers actually have to be paid to tend the money for the savers."

But paper currency makes this impossible. 

"You have this tradition that as it is now is enshrined in law in various ways that the government is going to guarantee to all savers that they will get [at least] a zero interest," Kimball said.

If the Fed lowered rates below zero in our current financial system, savers would simply withdraw their money from the bank and sit on it instead of letting it incur negative returns. The paper currency itself — because it's something that can be physically withdrawn from the financial system — prevents rates from going negative.

This is where Kimball's idea for an electronic currency comes in. However, unlike Bitcoin, which prides itself on its decentralization and anonymity, Kimball's digital currency would be centralized and widely used. He would effectively set up two different types o! f curren cies: dollars and e-dollars. Right now, your $100 bill is equal to the $100 in the bank. If you're bank account has a 5% interest rate, you earn $5 of interest in a year and that $100 bill is still worth $100. But what would happen if that interest were -5%? Then you would lose $5 over the course of the year. Knowing this, you would rationally withdraw the $100 ahead of time and keep it out of the bank. This is where the separate currencies come in.

"You have to do something a little bit more to get the negative rate on the paper currency," Kimball said. "You have to have the $100 bill be worth $95 a year later in order to have a -5% interest rate. The idea is to arrange things so let’s say $100 in the bank equals $100 in paper currency now, but in a year, $95 in the bank is equal to $100 in paper currency. You have an exchange rate between them."

"After a year, I could take $95 out of the bank and get a $100 bill or if I wanted to put a $100 bill into the bank, they would credit my account with $95."

Got that? After a year of a -5% interest rate, $100 dollars are equal to $95 e-dollars. This ensures that paper currency also faces a negative interest rate as well and eliminates the incentive for savers to hoard dollar bills if the Fed implements a negative rate. Presto! The zero lower bound is solved.

The benefits of this policy go even further though: We can say goodbye to inflation as well.

"Once you take away the zero lower bound, there isn't a really strong reason to have 2% inflation at this point," Kimball said. "The major central banks around the world have 2% inflation and Ben Bernanke explained very clearly why that is. It's to steer away from the zero lower bound."

He's right. Back in March, Ryan Avent asked Bernanke why not have a zero percent inflation target. Bernanke answered, "[I]f you have zero inflation,! you&rsq uo;re very close to the deflation zone and nominal interest rates will be so low that it would be very difficult to respond fully to recessions."

But if nominal interest rates are allowed to go below zero, then the Fed has ample room to respond to recessions even if rates start out low. This is another major benefit from eliminating the zero lower bound.

What Kimball, whose blog is titled Confessions of a Supply Side Liberal, is most excited about is moving beyond the demand shortfall the economy currently faces to the supply side issues that hold back long-term growth.

"If you care at all about the future of this country, one of the things you need to realize is we need to solve the demand side so we can get back to the supply side issues that are really the tricky thing for the long run," he said. "The way to solve the demand side issues that is the most consistent with not messing up our supply side is monetary policy and making it so we can have negative interest rates."

At the moment, e-dollars are still only a theoretical concept, but Kimball is hopeful that they could be put into action in the near future. He believes that if a government bought in, it could be using an electronic currency in three years and reap the benefits of it soon after. 

"This is going to happen some day," he concluded. "Let me tell you why. There are a lot of countries in the world and some country is going to do this and it's going to be a whole lot easier for other countries to do it once some country has stepped out."

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