Negative Interest Rates Are Coming, but There Is No Chance That They Will Work
Yves here. We’ve sometimes addressed why negative interest rates are a bad idea. A corroborating data point: Sweden ditched its negative interest rate experiment in 2019, and said in mumbled economese that it didn’t do what it was supposed to do.
One of the many times we debunked the official rationale for negative interest rates was in a 2016 post, Economists Mystified that Negative Interest Rates Aren’t Leading Consumers to Run Out and Spend. We’ll hoist at length:
It been remarkable to witness the casual way in which central banks have plunged into negative interest rate terrain, based on questionable models. Now that this experiment isn’t working out so well, the response comes troubling close to, “Well, they work in theory, so we just need to do more or wait longer to see them succeed.”
The particularly distressing part, as a new Wall Street Journal article makes clear, is that the purveyors of this snake oil talked themselves into the insane belief that negative interest rates would induce consumers to run out and spend. From the story:
Two years ago, the European Central Bank cut interest rates below zero to encourage people such as Heike Hofmann, who sells fruits and vegetables in this small city, to spend more.
Policy makers in Europe and Japan have turned to negative rates for the same reason—to stimulate their lackluster economies. Yet the results have left some economists scratching their heads. Instead of opening their wallets, many consumers and businesses are squirreling away more money.
When Ms. Hofmann heard the ECB was knocking rates below zero in June 2014, she considered it “madness” and promptly cut her spending, set aside more money and bought gold. “I now need to save more than before to have enough to retire,” says Ms. Hofmann, 54 years old.
Recent economic data show consumers are saving more in Germany and Japan, and in Denmark, Switzerland and Sweden, three non-eurozone countries with negative rates, savings are at their highest since 1995, the year the Organization for Economic Cooperation and Development started collecting data on those countries. Companies in Europe, the Middle East, Africa and Japan also are holding on to more cash.
The article then discusses that these consumers all went on a saving binge..because demographics! because central banks did a bad job of PR! Only then does it turn to the idea that the higher savings rates were caused by negative interest rates.
How could they have believed otherwise? Do these economists all have such fat pensions that they have no idea what savings are for, or alternatively, they have their wives handle money?
People save for emergencies and retirement. Economists, who are great proponents of using central bank interest rate manipulation to create a wealth effect, fail to understand that super low rates diminish the wealth of ordinary savers. Few will react the way speculators do and go into risky assets to chase yield. They will stay put, lower their spending to try to compensate for their reduced interest income. Those who are still working will also try to increase their savings balances, since they know their assets will generate very little in the way of income in a zero/negative interest rate environment.
It is apparently difficult for most economists to grasp that negative interest rates reduce the value of those savings to savers by lowering the income on them. Savers are loss averse and thus are very reluctant to spend principal to compensate for reduced income. Given that central banks have driven policy interest rates into negative real interest rate terrain, this isn’t an illogical reading of their situation. Ed Kane has estimated that low interest rates were a $300 billion per year subsidy taken from consumers and given to financial firms in the form of reduces interest income. Since interest rates on the long end of the yield curve have fallen even further, Kane’s estimate is now probably too low.
Back to the current post. Aside from the effect on savings (that economists expected negative interest rates to induce savers to dip into their capital to preserve their lifestyles and make up for lost interest income), a second reason negative interest rates hurt, or at least don’t help spending is by sending a deflationary signal. If things might be cheaper in a year, why buy now?
The one wee bit of good news is the Fed doesn’t think negative interest rates are a sound idea. In fact, since 2014 (the year of the taper tantrum), and probably a bit earlier, the central bank realized that it had driven interest rates too low and it was keen to get out of the corner it had painted itself in. But it has yet to work out how to do that without breaking a lot of china.
By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK
As The Guardian and many other newspapers reported yesterday, the Bank of England yesterday announced that it was preparing the ground for negative official interest rates within six months.
As the Bank has suggested, this does not mean that there will be negative rates. But unless they allow for the possibility if that now they will, as they admit, restrict their policy options. In that case this announcement has to be seen as creating the possibility of negative nominal interest rates.
There are a number of things to say.
The first is that this announcement is hardly surprising. There has been a strong, downward, trend in interest rates for 500 years now, which has in the last decade seen them head to around zero. Given the trend, negative rates are the next place to go. Other countries, such as Denmark, already have.
Second, this is no shock to financial markets. Government bonds are already being issued at real negative interest rates i.e., after many years of tying up their money the investor will get back less than they put in. All they are doing is paying the price for security that the government provides.
Third, consumers are also already familiar with negative interest rates. Anyone holding cash now is seeing its value fall in real terms. But again they are buying the security that only a government guarantee on their deposit can provide.
Fourth, the policy is hardly surprising. That’s because savings are sky-rocketing. For those who think this is because of Covid that is, at best, only part of the story. The real one is that if the government runs a deficit (and it is), and injects new money into the economy as a result (and it is) then someone has to hold that new money on the other side of the double entry equation. And since every borrower (and the government is technically that, albeit in a very special way) requires a lender. In this case means that as cash is being injected someone must hold it, in the form of savings. And in that case the government wants to cut the price paid on cash.
Fifth, there is good economic reason for trying to force cash out of the unproductive economy where it is sitting right now. As I have said time and again on this blog, saving is a pretty economically useless activity at the macroeconomic level. It may be personally important (which I will not dispute) but at a macro level it just withdraws money from the economy and reduces the scale of economic activity. The latter is especially true since the link between savings and investment is now very largely broken. Banks, we now know, do not lend out depositors’ money. And money in the stock market is not used to fund new share issues, and so has no relationship with investment. In that case, of course the government wants negative rates: it wants to encourage this money out of saving and into use.
Sixth, it is an unfortunate fact that this will not work. As I have already noted, in practice we already have real negative interest rates. There is nothing new then about this policy. And since existing negative rates have not stopped people saving, making such rates official will have little macro impact. After a crisis people are cautious. They are willing to pay the price of a government guarantee. And if that is a negative interest rate, so be it. I suggest that will continue to be true for several years based on past trends.
My suggestion is, then, that the Bank can try this policy but it will be a vain attempt to stimulate the economy that will not succeed. Much more radical thinking is required to achieve that. I will address that in another post, soon. I will link it when it is up.