Digital Currency And The Zero Lower Bound

Once upon a time, "money" referred to coins made out of precious metals. Then circulation began to primarily consist of pieces of paper that were redeemable in exchange for fixed quantities of precious metals. But more recently we've shifted to a system of fiat money—a paper dollar is exchangeable for some euro coins or for a little mark on your bank account saying that you have a dollar in there. And in the modern day the vast majority of the money is electronic, rather than physical currency. CAP doesn't ever hand me an envelop full of bills, they directly deposit the money in my bank account. And the majority of that money flows out again in electronic form—Bank of America takes some to pay my mortgage, Chase takes some to pay my credit card bills, Comcast and Pepco take some to pay my utilities, etc. The physical cash is just a small residual element.

But it continues to play an important role in the macroeconomy. That's because it's the main reason for the existence of a "zero lower bound" on interest rates.

The general idea of interest rates is that to the extent that they're lower, people will be less interested in holding currency in the bank and more interested in obtaining some goods, services, or investments. But if our bank started paying a negative interest rate (i.e., charging you to store money) this mechanism would break down. You'd want to largely "invest" in shoeboxes full of pieces of paper with Ulysses Grant's face on them. But this is purely an artifact of the existence of the paper money residuum. If we moved to a system in which all transactions are done electronically (debit cards, credit cards, direct deposit, electronic transfer, etc.) then going from 1 percent interest rate to -1 percent interest rate would be no different from going from 7 percent interest rate to 5 percent interest rate. The gains for macroeconomic stabilization (and tax enforcement) could be huge. And it's only a matter of time before someone tries it. The question is who'll go first? My bet would be on Singapore, South Korea, or perhaps Sweden.