Miraculously, we have historical data on the evolution of interest rates in the Netherlands - arguably the birthplace of capitalism - dating back all the way to 1540. Yet during the past 476 years we have never experienced what we experience today: negative interest rates. After the European Central Bank (ECB) began charging negative interest rates to commercial banks (the central bank is the bank of banks), interest rates turned negative elsewhere as well. However, from the point of view of the ECB there exists an almost insurmountable hurdle: paper currency. The “war on cash” is about to erupt. This is what the ECB will (and can) do.

A (Brief) History of Bank Reserves

In the era of the gold standard, things were pretty straightforward. Central banks held gold and issued paper notes and deposits that were redeemable in gold: both count as reserves. Commercial banks, in turn, simply held those central bank notes and deposits as bank reserves.

This custom is still in practice today. Commercial banks can either hold paper bank notes or central bank deposits.

“The Great Rotation?”

In 2014 financial pundits used the term “Great Rotation” for the much expected shift from fixed income to equity markets. Unfortunately, that shift never happened. On the contrary, both stock and bond prices kept climbing to new record highs together. The “Great Rotation” was not so great after all.

This year, another “Great Rotation” will take place, however. Yet not from bond to equity markets. This time it will be a shift, mostly driven by commercial banks, from central bank deposits to central bank notes.

In plain English: commercial banks will no longer hold central bank deposits, but paper currency as bank reserves. They will “rotate” cash from deposits to vaulted paper bills stacked by the millions.

The Math Is Simple

The math is simple: if a central bank charges a negative interest rate of -0.4% on deposits, whereas notes have a near 0% yield, then commercial banks will opt for the latter.

And this happens to be precisely what the European Central Bank (ECB) is doing. It is charging a negative interest rate on deposits, while leaving paper currency at its hypothetical zero percent interest rate.

In fact, it is lowering the rate on these bank deposits. However, the wider the gap, the bigger the incentive to hoard cash instead of deposits and the greater the “rotation.”

European Central Bank´s Policy Is Powerless

This also implies that the ECB´s policy is, in a way, powerless. While the ECB tries to defeat the “ghost of deflation that haunts the economic recovery” by supposedly nudging banks toward lending and expanding credit, it is only stimulating banks to hoard paper bills in high-security vaults.

The ECB is trying to increase inflation but fails. And they will continue to fail until their biggest hurdle will be taken away: the zero percent yield on paper currency.

These Are the Possible Solutions — Either Way They Are Scary

There are various possible solutions to this “problem” — at least from the perspective of a central bank.

The ECB can:

I.Push for a complete prohibition of paper currency

II.Push for a government tax on all paper currency

III.Charge commercial banks a fee to change deposits into paper bills and vice versa

IV.Charge commercial banks something akin to a custodian fee on paper currency in their vaults

I: Prohibition of Paper Currency

In some countries option I seems to be the preferred way. Sweden, for instance, is moving toward a cashless society. Europe is taking steps toward option I as well, increasing the costs of moving into paper currency, by no longer offering the €500-euro bill. However, this option is political: the ECB depends on the introduction of European legislation that seems unfeasible.

II: Tax on Paper Currency

The second option is similar to option I. It also needs to be formalized in legislation and is therefore a political. It is akin to a fiscal “Gesell-rule.” Silvio Gesell was a 19th century monetary economist that first proposed stamping paper currency so its value could be diminished over time. He was considered a monetary crank in his days, but his once insane proposals are now hailed as the central bank’s savior. Some might think it is curious that it was John Maynard Keynes who cited Gesell in his General Theory.

III: Charging Commercial Banks Transaction Costs to Exchange Deposits into Paper Currency

Another proposal appears the most viable at this moment, which was published by the IMF in a working paper titled “Breaking Through the Zero Lower Bound.” In this paper, Agarwal and Kimball propose charging money whenever commercial banks turn deposits into cash and vice versa. The ECB´s deposit facility would function like an expensive hedge fund: every time banks deposit money they pay an entry fee and every time they withdraw deposits (and exchange them for paper currency) they pay a withdrawal fee.

One thing going for this proposal is that the ECB is already a de facto hedge fund: their speculative endeavors into corporate bonds, mortgage paper and soon other assets (stocks?) have turned the ECB into a speculative vehicle on the taxpayers´ behalf.

IV: Charging Custodian Fees on Paper Currency

This proposal is also very straightforward, although it remains unclear whether its implementation requires government legislation. Banks already report how much paper currency they hold in their vault, and the ECB would simply charge a fee (an interest rate, if you will) on the amount of paper currency a given bank holds. The advantage for the ECB would be that paper currency used by citizens is not “taxed” directly, but indirectly. Banks would most likely use option III but for their own clients: they would charge higher and higher fees to withdraw and deposit paper currency.

The War on Cash

One way or another, the ECB will need to tax the nominal value of paper currency. Monetary crank Silvio Gesell will finally be vindicated. The burden will be on all holders and users of euro´s.


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