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a blog from young economists at Nova SBE

The Below Zero Lower Bound: How low can you go ?

Exceptional times require exceptional policy measures. Despite the economic theory of the lower zero bound, a new era of negative interest rates has emerged. How can central banks break through the zero lower bound ? And if there is no such barrier as the zero lower bound – how negative can rates go ?

In theory, the zero lower bound refers to the situation in which the central bank cannot lower the short-term nominal interest rates because they reach or near zero. In such a scenario the central bank loses its capacity to stimulate the economy and only fiscal policy can have an effect. If the central bank were to lower the interest rate any further, banks would choose to hold physical currency that pays a zero nominal interest rate rather than earn a negative rate of return on deposits held at the central bank. When passed to the customers, negative interest rates trigger account-holders to withdraw their money and hold it in cash. Negative interest rates – in the words of Harvard economist N. Greg Mankiw – “only […] generate […] a demand for safe assets – and by that I mean […] they are going to be buying a bunch of safes so people can put their money in their safes rather than in the bank.”   Ultimately, the entire economy would become a cash-based system because no rational economic agent will hold assets if their rate of return is dominated by another store of value.

However, five currency areas, namely the European Union, Japan, Denmark, Sweden, and Switzerland have adopted negative interest rates since the financial crisis in 2007. In this upside-down world, borrowers get paid, savers penalized and the zero lower bound is not actually binding. How can we make sense of that?


 Negative interest rates. Source: European Central Bank. Graphic available under:

In fact, holding cash is associated with real costs. First, there is the cost of storing money. Particularly for large amounts of cash, agents  need to acquire storage units and establish safety procedures or insurance against loss, damage and theft. Note that one million dollars weight about 100 kilo in 10 $ bills but only 10 kilo in 100 $ bills . Second, paying in cash is often inconvenient, and, third, trips to the bank in order to withdraw cash require time and energy.  As agents are willing to pay to a certain extent for avoiding these costs, the true lower bound is actually some negative number – zero minus the total costs of holding cash. Economists estimate this cost to be in between 0.5 percent and 2 percent of the face value. This is in line with recent data suggesting that interest rates can go as low as negative 0.75 percent without triggering the hoarding mechanism.


We will present three methods to effectively overcome this lower bound by discouraging hoarding of currency: Introducing a tax on base money, abolishing paper currency, and separating the account function of money.


Historical proposals for overcoming the lower bound include SilvioGesell’s tax on base money – that is physical cash and commercial bank’s balances with the central bank. Basically, the tax extends negative rates to physical currency and, thus, eliminates the possibility of evading negative rates by hoarding cash. Since then, the idea of money that depreciates over time has been taken up by various economists including Keynes, Fischer and Goodman.

However, implementing a tax on currency may be too administratively cumbersome. Coins and bills are bearer bonds, i.e. that the identity of the holder remains anonymous to the central bank and the ownership can be transferred by delivery. Therefore, the owners have to reveal themselves in order to pay the taxes. Moreover, it has to be possible to verify whether interest due has been paid. In accordance with the idea of clipping the coupon, Gesell proposed to stamp currency by an expiration date in return for the interest payment. Unstamped currency will not be officially recognised as legal tender and become worthless. An up-todate example of Gesell money is so-called “regional money”, that customers can pay with in certain regions of Germany, e.g. the “Chiemgauer” in Bavaria, which loses 2 percent of its face value every 3 months if it is not stamped.

In 2009, Mankiw suggested a lottery scheme based on serial numbers to randomly declare bank notes void. The central bank would pick a number between 1 and 9 and all notes whose serial numbers ended by that number would become worthless. Thence, holding cash becomes risky and the expected nominal interest rate on cash negative. As a result, the floor on short-term nominal interest rates is pushed further down; rational agents will prefer assets to cash for interest rates above negative 10 percentminus the cost of carrying cash. This provides plenty of scope for negative interest rates.


Some academics such as Rogoff, Yglesias and Buiter have gone even further and suggested abolishing paper currency entirely, thus eliminating the option of hoarding cash in order to avoid paying negative interest rates. In an economy with an ever-growing range of electronic paymentmethods, physical currency will sooner or later become a redundant mean of payment. Europe’s march toward a digital-only economy seems to be unstoppable and can be best illustrated by the increasing number of shops and even banks that do not accept cash anymore. For instance, cash transactions account for less than 2 percent in Sweden.

Nonetheless,many agents demand paper currency for privacy related reasons. While traceable electronic money helps to fight the underground economy, it implies a drastic change in transaction techniques, unlimited government power and dependence on technology.

To ease the transition into a cashless economy and to achieve social acceptance, Rogoff’s proposal includes starting with the removal of high denomination bank notes from circulation and slowly letting small denominations fall toward disuse. In the foreseeable future, Rogoff advocates a low-cash society rather than a cashless society. Recently, the ECB may have taken the first step towards a low-cash society by announcing that itwill no longer produce 500 EUR bills after 2018. While 500 EUR bills are almost never used to carry out legal transactions, they account for roughly a third of the value of euro currency.


Nevertheless, the most important role of money is not its role as a medium of exchange or store of value but as one of account. In 1932, Eisler first suggested decoupling the numéraire function of money by creating a parallel virtual currency. Paper currency would continue to exist, but prices would be set in units of the numeraire currency. The exchange rate between paper and this currency could be used to create a negative interest rate on physical currency. The main challenge and key to success is to ensure that the numeraire does not follow the paper currency. If this were the case, the transition would have the same effect as simply changing the currency (like the transition from DM to EUR). Succesful examples include countries with hyperinflation, where a more stable foreign currency is used as a unit of account.


All three methods of eliminating the lower bound remove the possibility of avoiding negative interest rates through a broad shift into cash. In theory, there is neither a zero nor a below zero lower bound on nominal interest rates and central banks could push rates into negative territory. However, there is a lack of consensus on the use and effectiveness of negative interest rates and it remains to be seen whether they should be considered a blessing or a curse for the economy, banks and consumers.




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Author: studentnovasbe

Master student in Nova Sbe

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