The False Promise of Negative Interest Rates

Enter negative interest-rate policy. The central banks of Denmark, Sweden, Switzerland, Japan, and the eurozone have all indulged. The US Federal Reserve and the Bank of England are being tempted.

“Negative interest rate” is a phrase seemingly designed to confuse all but the experts. Instead of paying interest on commercial banks’ “excess” reserves held by the central bank, the central bank taxes these deposits. The idea is to impel the banks to reduce their unspent balances and increase their lending or investments. In the case of the European Central Bank, there is a technical reason: to increase the supply of high-class bonds for President Mario Draghi’s ongoing program of quantitative easing.

The policy is supposed to work by aligning the market rate of interest with the expected rate of profit, an idea derived from the Swedish economist Knut Wicksell. The problem is that whereas until now it had been believed that nominal interest rates cannot fall below zero, an investor’s expected rate of return on a new investment may easily fall to zero or lower when aggregate demand is depressed.

Negative interest rates are the latest attempt to overcome the mismatch of incentives for lenders and borrowers. Making it more costly for commercial banks to park their money with the central bank should lower the cost of commercial loans. The calculation is that it will make more sense for a commercial bank to put money into circulation, whether by making loans or buying government and other securities, than to pay the central bank for holding that money.

But, as the World Bank has pointed out, negative rates can have undesirable effects. They can erode bank profitability by narrowing interest-rate margins. They can also encourage banks to take excessive risks, leading to asset bubbles. Lower interest rates on deposits may cause large sections of the economy to become cash-based, while pension and insurance companies may struggle to meet long-term liabilities at a fixed nominal rate.

But, quite apart from these problems, the real case against negative interest rates is the folly of relying on monetary policy alone to rescue economies from depressed conditions. Keynes put it in a nutshell: “If we are tempted to assert that money is the drink which stimulates the system into activity, we must remind ourselves that there may be several slips between the cup and the drink.” His list of “slips” is well worth recalling:

“For whilst an increase in the quantity of money may be expected...to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money; and whilst a decline in the rate of interest may be expected...to increase the volume of investment, this will not happen if [profit expectations] are falling faster than the rate of interest; and whilst an increase in the volume of investment may be expected...to increase employment, this may not happen if the propensity to consume is falling off.”

Quite so. Economists are now busy devising new feats of monetary wizardry for when the latest policy fails: taxing cash holdings, or even abolishing cash altogether; or, at the other extreme, showering the population with “helicopter drops” of freshly printed money.

The truth, however, is that the only way to ensure that “new money” is put into circulation is to have the government spend it. The government would borrow the money directly from the central bank and use it to build houses, renew transport systems, invest in energy-saving technologies, and so forth.

Sadly, any such monetary financing of public deficits is for the moment taboo. It is contrary to European Union regulations – and is opposed by all who regard post-crash governments’ fiscal difficulties as an opportunity to shrink the role of the state.