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Permanent Liquidity


28 September 2019


 
Permanent Liquidity Or End Of Currency
 

A financial crisis happens when liquidity in the financial markets suddenly disappears. Central banks are ready to inject liquidity in the financial system. Liquidity is another word for central bank currency. The recent turmoil in the repo market showed that some market participants were in need of central bank currency. That may happen because central bank currency is the ultimate means of settlement.

As reserve requirements are nearing zero, this is a bit odd. It appears that market participants hoard central bank currency. Apparently central bank currency is attractive to hold. That might be easy to solve with a holding fee on central bank currency, a feature of Natural Money. Natural Money has the following characteristics:
  • Central bank currency carries a holding fee of approximately 10% per year, so if you hold central bank currency then € 1,00 turns into € 0,90 after a year, which can make it attractive to lend out money at negative interest rates.
  • Interest rates on bank accounts might be around -2% per year in terms of central bank currency, so people don't pay the holding fee but the interest rate in the market.
  • Cash is a short-term loan to the government and carries an interest rate equal to short-term government loans in the market. Cash and central bank currency have different rates to prevent cash from being hoarded when interest rates are negative.
  • It is expected that interest rates go negative and will remain in negative territory, so once most interest rates are negative, positive interest rates can be phased out to forestall a quest for yield leading to irresponsible risk taking.

  • This article focuses on how liquidity crises can be solved while keeping the amount of central bank currency in the financial system stable and probably close to zero. A comprehensive explanation as to why interest rates may go negative and remain in negative territory can be found here:

    https://www.naturalmoney.org/endofusury.html

    A detailed explanation of the Natural Money proposal can be found here:

    https://www.naturalmoney.org/feasibility.html

    The most interesting feature of Natural Money for ending liquidity crises is the holding fee on central bank currency. Banks facing a liquidity shortage can borrow currency at the central bank at an interest rate of zero. This is unattractive as it is the maximum interest rate a bank can make loans so that the central bank does not end up subsidising a commercial bank. And the currency carries the holding fee.

    Central bank currency is the ultimate means of payment. With Natural Money a bank can borrow central bank currency at zero interest to pay its creditors. Central bank currency is legal tender, so creditors must accept a payment in central bank currency. Those creditors end up holding currency that has a steep negative yield attached to it. And so they may be more interested in any security the liquidity strapped bank has on offer.

    As a consequence only a bank in distress would take up central bank credit at an interest rate of zero. If a bank remains on this credit for a longer period of time, it can be considered bankrupt. It should then attract additional capital, be sold or dissolved.

    There is another profound consequence of the steep holding fee on central bank currency. Holding central bank currency would be unattractive. Except for reserve requirements, there will be no reason to hold currency.

    The excess currency in the system might be offered to the central bank in exchange for securities it has on its balance sheet. Quantitative easing could be undone and the central bank may make a huge profit in the process.

    If reserve requirements are to disappear in the future, which is not unlikely as capital requirements are replacing them, central bank currency may disappear out of the financial system completely and become an accounting unit only.