Mankiw's Negative Interest Rate Solution

The following link is old but I can't seem to get it out of my thoughts.

April 18, 2009
It May Be Time for the Fed to Go Negative

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

I strongly suspect Mankiw has vastly underestimated how effective his solution would be at thwarting deflation. Mish offered a great heckle but I've decided to do a serious heckle of my own. If nothing else, I've had a month to think about it.

I think Mankiw's solution needs a name. I propose...

Currency Crisis

A currency crisis, which is also called a balance-of-payments crisis, occurs when the value of a currency changes quickly, undermining its ability to serve as a medium of exchange or a store of value.

1. 10% of the currency is destroyed instantly at the time of the Fed's announcement. That's clearly meets the "value of a currency changes quickly" criteria and therefore undermines the currency's ability to serve as a medium of exchange or a store of value.

2. Not knowing which 10% has been destroyed until a full year has passed adds long-term uncertainty. We know that uncertainty breeds fear and panic. Fear and panic clearly undermine the currency's ability to serve as a medium of exchange or a store of value.

3. The currency is destroyed randomly by pulling a number out of a hat. Randomness is the very essence of uncertainty. Once again, more fear, more panic, and it further undermines the currency's ability to serve as a medium of exchange or a store of value.

4. Would the currency truly be destroyed randomly? Imagine the money that could be made for those who knew ahead of time which dollars would turn worthless. Conspiracy theories and rumors about a currency can clearly undermine its ability to serve as a medium of exchange or a store of value.

5. If the government is willing to destroy 10% of the currency instantly, then most reasonable people would entertain the notion that the government might do it again. This adds even more uncertainty, more fear, more panic, and undermines the currency's ability to serve as a medium of exchange or a store of value. Worse, markets tend to look ahead. How much future currency destruction would be priced in immediately?

6. Our currency is backed by faith. It says right on the dollar that "This note is legal tender for all debts, public and private." If it no longer was legal tender, then the dollar would have incorrect information on it (a lie). That would transform the faith-based currency into a lie-based currency. That would clearly undermine the currency's ability to serve as a medium of exchange or a store of value.

Mankiw says, "the expected return to holding currency would become negative 10 percent." Based on what I've written here, I would argue that it could easily approach something closer to negative 100%.

Behold the power of compound unintended consequences and the ability of mainstream economists to ignore them.