Do we need to use negative interest rates or abolish high currency notes?

No, says Scott Sumner. See Review of Strategies for Monetary Policy. Excerpt:

"I’m not convinced the plan is politically feasible, nor am I convinced that it is the best way to stimulate the economy during a period of deflation or depression. The Fed has not even come close to exhausting the potential of conventional options that do not involve negative interest rates.

Lilley and Rogoff are skeptical of the effectiveness of policies such as “quantitative easing” (QE, which means printing lots of money) and forward guidance for policy. But the evidence they cite is not persuasive. It is true that governments that have done QE have not seen a robust recovery, but many studies suggest that QE does have an expansionary effect.3 And note that it is equally true that countries that have adopted negative interest rates have also not seen robust recoveries.

Lilley and Rogoff could argue that central banks in Europe and Japan haven’t driven rates far enough below zero, but one could just as well argue that central banks such as the Fed did not do enough QE, and did not adopt aggressive enough forward guidance. In particular, I’ve advocated a policy of targeting the level of nominal GDP, and adopting a “whatever it takes” approach to quantitative easing to hit the target.4 In my view, this would be more politically feasible in America than steeply negative interest rates, and just as reliable.

Lilley and Rogoff’s pessimism about the effectiveness of conventional monetary policy is part of a broader trend in modern macro, which confuses cause and effect. When low nominal interest rates and QE coincide with weak economic growth, it is often seen as an indication that monetary stimulus doesn’t work, whereas it is actually a sign that previous monetary policy was too tight. Historically, tight money drives nominal GDP growth rates to very low levels (as in the Great Recession), which reduces the equilibrium, or natural rate of interest. As the natural rate of interest falls close to zero, the demand for liquidity increases sharply and central banks respond (defensively) with QE programs.

If the Fed aggressively targeted NGDP growth at a higher rate—say 5%/year—then nominal interest rates would stay above zero and there would be no need for quantitative easing. This is how Australia avoided a recession during the Global Financial Crisis of 2008-09. Lilley/Rogoff reflect the consensus view of economists, which tends to see deflationary episodes as exogenous “shocks” that hit the economy, and not (as I believe) the failure of monetary policy to maintain expectations of adequate nominal GDP growth.

My favorite part of their paper discusses how the government could derive better market forecasts of inflation by creating new types of bonds, where the inflation compensation is capped at 3%/year. By comparing changes in the prices of these bonds with normal inflation-indexed bonds, policymakers could indirectly estimate the probability of inflation rising far above the target. This would provide the Fed with an early warning system for the “tail risk” of major changes in the rate of inflation.

In the comment section of the paper, Andrew Levin (p. 79) suggested that he shared their skepticism about the effectiveness of QE, citing the fact that economic growth did not increase sharply in 2013. But this overlooks the fact that growth did increase modestly in 2013, despite the fact that hundreds of Keynesian economists signed a letter warning that fiscal austerity threatened to push the economy into recession.5 At the beginning of 2013, large tax increases and spending cuts suddenly reduced the budget deficit from $1061 billion to $561 billion, and the modest increase in economic growth during 2013 was almost certainly due to the monetary stimulus adopted in late 2012. Market monetarists like myself predicted that QE would prevent fiscal austerity from slowing the economy, and we were right.

Levin also described a digital cash plan he developed with Michael Bordo, which envisioned 100% safe bank accounts where the deposits are invested in interest-bearing reserves at the Fed.6 Levin points out that these specific accounts would not need deposit insurance, but I’d go even further. If we are going to set up this sort of system, then we should use it as an opportunity to once and for all abolish all government deposit insurance, as the moral hazard created by FDIC has created an increasingly unstable financial system.

“Banks are currently encouraged to take socially excessive risks, knowing that a portion of any losses may be borne by taxpayers.”

Banks are currently encouraged to take socially excessive risks, knowing that a portion of any losses may be borne by taxpayers. With the safe banking alternative described by Levin and Bordo, depositors could choose between safe bank deposits paying lower rates of interest, and riskier deposits paying somewhat higher rates of interest. The funds in the riskier accounts would be used to make bank loans, and there would no longer be a moral hazard problem caused by taxpayer subsidized deposit insurance."