In case you are new to this story, Gregory Mankiw, professor of economics at Harvard, proposed negative interest rates in It May Be Time for the Fed to Go Negative.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to [make holding money less attractive].

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money -- for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn't a flaw -- it's a benefit.

My reply can be found in Time For Mankiw To Resign.

The Cash Economy Would Grind To A Halt

What exactly would vending machine operators do? Would owners program all machines to stop accepting dollar bills with a certain digit? What about the bills already accepted? On that line of thinking, I propose a complete shutdown of all vending machines that accept dollar bills would occur several days to a week before the drawing date.

What about merchants? On the date of the drawing and even a few days before, would any merchant accept anything but credit cards, debit cards, checks, or coins? I think not.

No one in their right mind would hold or accept any digit denominated currency. However, quarters would be hoarded! Think of the mounds of quarters people would be hold. A quarter, nickel, and dime shortage would be 100% guaranteed under such a "clever scheme".

Other than buying candy with quarters, the cash economy would literally grind to a halt. And given that people would be carrying less cash than before, spending would actually decline if such a bill were passed.

Thus Mankiw's proposal would do the exact opposite of what he intended.

Addendum Added

Yesterday I added this addendum to Time For Mankiw To Resign.

In Is inflation the answer? Paul Krugman agrees with Mankiw "in principle".

Greg Mankiw says yes. Since that was the answer I arrived at for Japan more than a decade ago, I have to say that it makes sense in principle.

But here's why it won't work now, at least not yet: we're talking about making a credible commitment to fairly high inflation over the medium term, yet you still have distinguished central bankers appalled at the Fed's 2 percent inflation target.

Failed Models

Both Mankiw and Krugman have their economic models and they stick with them no matter how silly those models look in the real world.

On the other hand, I prefer common sense over economic models any day of the week. And common sense dictates that loose lending practices and a cheaper dollar got us into this mess so loose lending standards and a cheaper dollar cannot possibly get us out of this mess. Logically it is as simple as that.

Moreover, even if the Fed could orchestrate inflation, there is no guarantee jobs would come with it or wages would rise with those jobs even IF the jobs came. Both Mankiw and Krugman are ignoring the macro picture, including but not limited to global wage arbitrage.

Home prices and asset prices in general rose much faster than wages during Greenspan's great experiment. Cash out refinancing, and rising consumer credit supported consumption during this experiment as real wages shrunk. Now consumers are cash strapped and Mankiw proposes a method to force consumers to spend more. Any eighth grader would immediately see that such a policy cannot possibly work.

Nixon Shock

The Fed is not in control of wages, and president Nixon, the last clown that tried Wage and Price Controls failed spectacularly.

Mankiw and Krugman Shock

Greenspan's liquidity experiment failed spectacularly in the biggest bubble implosion since the great depression. I am wondering how long it will be before the words "since the great depression" are replaced by the single word "ever".

All interventions fail sooner or later (and history shows the bigger the experiment the bigger the failure), yet Mankiw and Krugman want to try it again!

Mankiw has a Monetarist theory. His theory suggests that throwing money at problems cures them. And so when a student proposes a novel way of forcing cash strapped consumers to spend, Mankiw thought that it was "clever" without doing even so much as a cursory look at the ramifications.

Mankiw should have flunked his student and asked him to produce a paper why such idiocy could not possibly work. Instead, Mankiw praised it.

Mankiw Responds

In an attempt to defuse criticism, Mankiw responded with Observations on Negative Interest Rates.

Most of Mankiw's response was an attempt to defend negative interest rates with mathematical formulas. Moreover, Mankiw did not attempt to rebut any of my arguments about the complete ridiculousness of his original proposal. He did say ...

If people are feeling poorer and want to save for the future, why should we stop them? Unless we think their additional saving is irrational, it seems best to try to funnel that saving into investment with the appropriate interest rate. And given the available investment opportunities, that interest rate might well be negative.

Blatant Arrogance

And who is Mankiw (or any economist) to decide what is best for anyone else? That Mankiw thinks that he or the Fed can decide that it is "irrational" for consumers to want to save is not only blatant arrogance but preposterous.

This is what happens when economists get married to mathematical formulas instead of using common sense.

Mankiw Proposes Theft

Even more galling than his blatant arrogance, Mankiw has no problems with theft. Because confiscating or expiring 10% of someone's money at will is theft of property, and would (at at least should) be a violation of the 5th amendment and due process of law. How anyone cannot see that is beyond me.

However, let's assume such a law was passed, and upheld by the courts. How would people react? Simple, they would pay off every debt they could as they would get an immediate 10% return on their money to do so! Thus credit would implode.

I repeat my call for Mankiw to resign or be fired. Mankiw is unfit to teach economics anywhere, let alone Harvard.