Why Negative Interest Rates Will Fail

Negative rates will fail says Frank Hollenbeck in this guest post, because the problem with the economic system is not a problem of either too little consumption or not enough aggregate demand. The problem stems from a distorted economy caused by manipulated interest rates.

It is now just a matter of time before the US central bank follows the central banks of Japan, the EU, Denmark, Sweden and Switzerland in setting negative rates on reserve deposits.

The goal of such rates is to force banks to lend their excess reserves. The assumption is that such lending will boost aggregate demand and help struggling economies recover. Using the same central bank logic as in 2008, the solution to a debt problem is to add on more debt. Yet, there is an old adage: you can bring a horse to water but you cannot make him drink! With the world economy sinking into recession, few banks have credit-worthy customers and many banks are having difficulties collecting on existing loans.

Italy’s non-performing loans have gone from about 5 percent in 2010 to over 15 percent today. The shale oil bust has left many US banks with over a trillion dollars of highly risky energy loans on their books. And the very low interest rate environment in Japan and the EU has done little to spur demand in an environment full of malinvestments and growing government constraints.

Central bank policies have also driven government bond yields into negative territory. Nearly $7 trillion of government bonds are currently trading at negative rates.

None of this has made central bankers question their mantra: that credit drives aggregate demand which drives growth (remembering that “lifting aggregate demand” is a code phrase for lending more money into existence).

But economic theory still presupposes that negative rates are an impossibility. After all, why would you buy a one-year treasury bill for $1,005 that will get you $1,000 in a year, when you can stuff your mattress with the $1,005 and still have $1,005 in a year? Some would say that storing money is costly and risky, but that is also true for most assets.

The reason is actually quite simple and shows how distortive monetary policy has become worldwide: It makes sense to purchase a bill for $1,005 if you intend to sell it to the central bank before it matures  for more than $1,005. In today’s world, the central bank is often ultimately expected to purchase the bill and lose money on it. It’s just another type of debt monetisation.

(And it is, by the way, something the Germans emphatically wanted to avoid when the ECB was initially created.)

We Just Need to Print More Money!

The real problem is the way monetary policy is taught in almost every undergraduate and graduate program in the world. Pick up any macroeconomics textbook and it will explain how interest rates are determined not by the amount of savings available for investment, but by the demand for and supply of “liquidity.” The economy is treated as a car, and interest rates are viewed as the gas pedal. When reality does not match up with the model however, today’s economist, instead of questioning the model and theory, assumes that more of the same will ultimately force reality into the model.

The problem arises from a fundamental misunderstanding about the role of interest rates. Writing in 1912, Ludwig Von Mises had this to say about the current unenlightened view on money:

[This view of money] regards interest as a compensation of the temporary relinquishing of money in the broader sense — a view, indeed, of unsurpassable naiveté. Scientific critics have been perfectly justified in treating it with contempt; it is scarcely worth even cursory mention. But it is impossible to refrain from pointing out that these very views on the nature of interest holds an important place in popular opinion, and that they are continually being propounded afresh and recommended as a basis for measures of banking policy.

How things have changed with Keynes.

Unlike Keynes and his followers, Mises and his contemporaries understood that interest rates reflect the ratio of the value assigned to current consumption relative to the value assigned to future consumption. That is, money isn’t just some commodity that can solve our problems if we just create more of it: instead, it has the key function of coordinating output with demand across time.

So, the more that you interfere with interest rates, the more you create a misalignment between demand and supply across time—and the greater will be the eventual adjustment to realign output with demand to return the economy to sustainable economic growth with rising standards of living (see here and here). Negative rates will only ensure an ever greater misalignment between output and demand.

As with Japan, from whom western central bankers refuse to learn the obvious lesson, unless these “unorthodox” monetary policies are rapidly abandoned then Western economies that pursue a long-term policy of low or negative interest rates can expect decades of low growth. Because recessions are not a problem of insufficient demand. They are a problem of supply being misaligned with demand.

The War on Cash

Meanwhile, since an increase in cash holdings would limit the effectiveness of negative rates, a leading goal of some of the attendees at the recent Davos meeting and of many others has been to push the world toward a cashless society. They know that if they eliminate cash, central banks will have greater control over the money supply and the ability to guide the economy toward their chosen macroeconomic goals.

As long as there is physical cash however, people will hold cash in times of uncertainty. It is a wise alternative when all other options seem unproductive or irrational — and keeping cash in a bank at a time of negative rates is, all things being equal, wholly irrational. Central banks, not surprisingly, would therefore like to take away the ability to hold cash outside the banking system. Worst of all, for Keynesians, people who hold cash outside the system might be saving it instead of spending it. Naturally, from the Keynesian perspective, this must be stopped. [The rest of us however understand that when the banking system isn’t broken, these savings provide the fertiliser for real productive investment.]

The era of negative interest rates is just the latest frontier in the radical monetary policy we’ve been increasingly witnessing since the 2008 financial crisis. The best monetary policy, however, is no monetary policy at all, and central bankers should take an extended holiday so that the world economy can finally heal itself.

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Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank.
This article first appeared at the Mises Daily.
Image source at head of page: Alcino via Flicker https://www.flickr.com/photos/alcino/

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