Chancellor: Negative rates, negative implications

February 12, 2016

The author is a Reuters Breakingviews columnist. The opinions expressed are his own. 

Negative interest rates are the shiny new weapon in central banks’ arsenal of unconventional monetary policies. Their aim is to penalize the hoarding of cash, and thus encourage more borrowing and spending. Negative rates are also intended to stave off deflation, helping central bankers meet their inflation targets. In principle, investors should love negative rates. Yet when, earlier this month, the Bank of Japan announced it was joining the so-called NIRP club, market turmoil ensued. What’s going on?

The markets appear to have woken up to the fact that this radical monetary trick fails to deliver any of its promised benefits. On the contrary, negative rates undermine bank profitability, threaten the stability of bank liabilities, force households to save more, and discourage credit creation. If carried further, negative rates may threaten an unwarranted intrusion of the state into the private lives of its citizens. It’s time for politicians to try to rein in their overzealous central bankers and kill this dangerous policy before it wreaks more damage.

Negative rates may be novel in practice. But the idea has been around for a long time. They originated in 1890 with a monetary crank named Silvio Gesell, an expatriate German businessman living at the time in Argentina, during one of that country’s recurrent financial crises. Gesell later retired to a vegetarian commune in his homeland, writing monetary tracts for an adoring following of anti-Marxist anarchists. In 1919, he was briefly employed as the People’s Representative for Finance in the Soviet Republic of Bavaria – a stint which lasted less than a week.

Gesell believed that interest rates arose only because people hoarded money. Economic growth would accelerate if the holding costs of cash were increased. His proposal for a stamp duty on banknotes was enthusiastically taken up by Professor Irving Fisher of Yale in 1932, as offering the “speediest way out of depression.” In his 1936 “General Theory of Employment, Interest and Money” John Maynard Keynes also wrote favorably, with some reservations, about Gesell, referring to him has a “strange, unduly neglected prophet”. The prospect of negative rates, however, dissolved after the U.S. economy emerged from the Great Depression.

Contemporary advocates of negative rates argue they are necessary to ward off the threat of deflation – that is, a fall in the general level of prices. Yet a recent paper from the Bank for International Settlements suggests that the conventional abhorrence of deflation is overdone. After examining 140 years of economic history in 39 countries, the bank’s researchers found only a weak link between output growth and deflation. Much has been made of the deflation of the early 1930s. However, the BIS report suggests that this episode was a one-off. Its researchers found no evidence of the kind of deflationary downward spiral famously described by Yale’s Fisher in his 1933 essay, “The Debt-Deflation Theory of Great Depressions”.

In fact, the historical record shows that satisfactory economic growth often coincides with periods when the general price level is falling. Mild deflation has dogged Japan for the last couple of decades. Yet this doesn’t seem to have deterred Japanese households from spending, as economics textbooks suggest should be the case. During its deflation years, Japanese productivity (as measured by output per hour worked) was actually higher than in most other developed economies. At worst, it could be argued that deflation is a symptom of some underlying economic sickness – not a cause in itself.

It’s not just that the theoretical case for negative rates is flawed. Europe’s recent experiment with them shows some worrying developments. Independent economist Andrew Hunt argues that “negative rates are exceptionally toxic to any country’s banking system”, as they hurt bank profitability. Negative rates also appear to be contributing to the flight of long-term deposits from Germany’s banking system. When banks can’t attract long-dated liabilities to match assets of a similar duration, the financial system becomes less stable. “What is bad for banks is bad for credit growth,” says Hunt. Since Swiss rates turned negative, the country’s credit growth has halved.

Negative rates put yet more pressure on the solvency of life insurers and pension funds. More than $5 trillion worth of bonds now sport negative yields. Working families are likely to respond to ever lower returns by putting more money aside for retirement, which requires them to reduce current spending. Under the circumstances, it’s hard to see how businesses would respond to negative rates by investing more.

Given the pain that negative rates impose, it’s perhaps not surprising that economic growth in the euro zone has weakened and that the rate of inflation is falling, which means the European Central Bank keeps on missing its inflation target. To make matters worse, real-estate speculation is picking up in several countries with negative rates. House prices appear to be in bubble territory in both Switzerland and Sweden.

Even if negative rates were capable of delivering their promised economic benefits, they may pose a threat to civil liberties. Keynes noted that Gesell’s proposals involved a “large extension of the traditional functions of government”. In a speech last September, the chief economist at the Bank of England, Andrew Haldane, floated the idea that for negative rates to be effective it might be necessary to abolish bank notes. Every transaction henceforth would be digitally recorded.

Still Keynes didn’t end up endorsing Gesell. He observed that money was not the only asset that people were prone to hoard. If currency notes were taxed, wrote Keynes, “a long series of substitutes would step into their shoes … foreign money, jewelry and precious metals generally.” The recent upward spike in the gold price suggests that if cash is undermined as a store of value, investors will indeed look elsewhere.

If negative rates pose threats to financial stability, undermine economic confidence and encourage speculation in gold and real estate, then central bankers should be forced to reconsider. They claim that negative rates are necessary if they are to achieve their inflation target (which for most of them is a 2 percent annual change in the price level). Yet the BIS has shown that deflation phobia is irrational. It would appear, then, that the mandate of central banks needs changing.

The near-term inflation target that most major central banks follow should be dropped. If this means that occasionally the annual change in the price level is negative, so be it. The alternative is worse, as the dangerous experiment with negative interest rates and other unconventional and untested monetary policies would inevitably continue.

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