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n1 writes:

Bloomberg reports:

If you believe that government meddling in financial markets was responsible for the last recession and the lackluster recovery, you might be right. But probably not in the way you think.

Imagine what would happen in a free market if everyone suddenly decided that future economic growth would be very slow. The price of safe assets such as U.S. government bonds -- assets that pay off even in a low-growth environment -- would rise sharply. As a result, the real (inflation-adjusted) interest rate, which always moves opposite to the price of safe assets, would fall. In principle, if the demand for safe assets was strong enough, the real interest rate could go deep into negative territory.

Yet two government mechanisms prevent real interest rates from getting too negative. The first is cash: As long as people can hold currency, which loses its value only at the rate of inflation, they won't buy safe assets that yield even less. The second is the central bank's promise to keep the inflation rate low and stable -- at about 2 percent in most developed nations. As a result, people have little reason to hold any asset that yields less than negative 2 percent (perhaps negative 3 percent, considering that cash is bulky and hard to store).

In other words, governments -- by issuing cash and managing inflation -- put a floor on how low interest rates can go and how high asset prices can rise. That's hardly a free market.

[...] The right answer is to abolish currency and move completely to electronic cash, an idea suggested at various times by Marvin Goodfriend of Carnegie-Mellon University, Miles Kimball of the University of Colorado and Andrew Haldane of the Bank of England. Because electronic cash can have any yield, interest rates would be able go as far into negative territory as the market required.

[...] If cash were abolished, I would support the adoption of two complementary measures. First, instead of targeting a positive inflation rate, central banks could target true price stability by aiming to keep the level of prices constant over time. (To be clear, this would be disastrous unless cash were eliminated first.)

Second, currency does provide a service beyond being a store of value and a medium of exchange: It's anonymous and thus ensures the privacy of transactions. In its absence, governments would have to allow the private sector to offer alternatives with the same attractive features.

We've endured a deep recession and a miserable recovery because the government, through its provision of currency, interferes with the proper functioning of financial markets. Why not ensure that doesn't happen again?

Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.

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