Liquidity Traps
Taxing currency as a way out of a liquidity trap

Once an economy falls into a liquidity trap, there are only two options. One is to wait for a positive shock to demand. The other is to create a negative (nominal) interest rate by taxing currency. These conclusions appear in a paper just published by the Centre for Economic Policy Research in London. The authors, Willem Buiter, of the Bank of England’s Monetary Policy Committee and Cambridge University, and Nikolaos Panigirtzoglou of the Bank of England, take the present situation in Japan as their starting point and examine whether there is any possibility of the same phenomenon appearing in Britain.

Here they find that the evidence is far from clear, but note, ‘The UK got through the period 1800-1914 without ever landing itself in a liquidity trap…the average rate of inflation over this 115-year period was slightly negative and the variability of inflation was high.’ Bank Rate did not fall below two per cent for that period before World War I. There should not be any worries today on this score ‘if the political commitment to low and stable inflation and its institutional expression in an operationally independent central bank remain intact’.

If a liquidity trap is to be avoided action has to be taken early to avoid hitting what the authors call ‘the zero interest floor’. A rate of inflation high enough to avoid that floor would have to be targeted. ‘Targeting a higher rate of inflation after you are caught in the trap would be like pushing toothpaste back in the tube.’ In such circumstances one has to wait for fiscal policy or some other shock to do the trick.

But the authors then argue that the zero interest floor is not a ‘God-given barrier’. There is the possibility of creating what would be in effect a negative nominal interest rate by taxing currency. Paying negative interest on securities for which, unlike currency, the identity of the holder is known, is as simple as paying positive interest. It is here that the work of a relatively unknown German-Argentine businessman, Sylvio Gesell (1862-1930), becomes interesting. He is the foremost proponent of the idea of stimulating currency circulation by issuing money that depreciated. The idea was taken up by cranks such as Major Douglas and the Social Credit Party in Canada in the 1930s, but nonetheless Keynes wrote, ‘I believe that the future will learn more from the spirit of Gesell than from that of Marx.’

The mechanics are simple: currency would be date stamped and would be subject to confiscation unless the holder paid to have new stamps put on the notes. When the scheme was tried in Alberta in the 30s it failed because it was deemed unconstitutional and because the provincial government refused to accept its own scrip in payment. It is evident also that there are high costs associated with this system: people would have to queue up to have their money stamped, and the threat of confiscation would have to be credible. But that might prove less expensive than the effects of a long-term liquidity trap. There is, however, one benefit: ‘Taxing currency would…have the nice feature of constituting a tax on the grey, black and outright criminal economies, which are heavily cash based.’

The authors conclude: ‘If there are indeed benighted countries threatened by, or even caught in, a liquidity trap, the policy-makers have one more option they might wish to consider on its merits: Gesell money.’

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The Authors:

Willem Buiter is Professor of Economics at Cambridge University, a member of the Bank of England’s Monetary Policy Committee and a Research Fellow In CEPR’s International Macroeconomics and Transition Economics research programmes. Nikolaos Panigirtzoglou is an Economist at the Bank of England.